The bond yield is essentially the amount or percentage of return that an investor can anticipate to receive from a bond issue within a specified period of time. It is important to note that calculating this involves making use of current data regarding the current price of the bond rather than the price at the time of purchase. Determining the current status of the bond yield also requires understanding the current annual coupon associated with the bond. The calculation also usually assumes that the buyer will hold onto the bond for at least a period of one year.
A simple formula for calculating a bond yield involves dividing the annual coupon by the price of the bond. As an example, if the bond were priced at $100.00 US Dollars (USD) with an annual coupon of $6.00 USD, the bond yield would be projected at six percent. However, this yield assumes that there will be no change in the price and that the buyer will hold onto the bond for at least one year.
If there is a change in interest rates that leads to a shift in the current price of the bond, the bond yield may indicate a capital loss. Using the same example, if the price of the bond fell to $90.00 USD, this would result in a loss of $10.00 USD, which is partially offset by the coupon of $6.00 USD. However, a capital loss of $4.00 USD for the annual period still remains. By the same token, an upward shift in the price of the bond would increase the capital gains realized from the investment.
Understanding how the bond yield functions is important for investors. By evaluating the factors that are likely to influence the future worth of the bond issue, investors can determine if it is in their best interests to purchase the bond and hold onto it for at least a year. If the projections indicate the bond is highly likely to produce a decent gain for one or two years, the investor may choose to purchase the issue. However, if there are indications the bond will drop in value over that first year, that means the investor would probably not be able to sell the bond for enough to break even, much less make a profit on the investment. In that situation, the investor would be well advised to look into other bonds or go with entirely different investment opportunities.