Bond yields: the basics
When you buy a bond, you are lending money to someone – usually a company or government. Unlike a dividend, the coupon on a bond must be paid – it cannot be cut or cancelled, or the issuer is considered to have defaulted.
There are several types of bond yield. There’s the ‘coupon rate’ or interest rate, which is simply the rate that the bond pays if it was bought at its initial face value. So a 5% Treasury Gilt 2018 for example, has a coupon rate of 5%.
More useful is the ‘running yield’ or ‘income yield’. This takes account of what you actually pay for the bond. So if the aforementioned bond trades at £110, the income yield is 4.5% (£5/£110 as a percentage). However, this assumes you’ll be able to sell for the same price you bought at, which is not necessarily the case.
So most useful of all is the yield to maturity, or redemption yield. This takes account of not only the annual coupon payments, but also the timing of those payments, plus the amount you will receive when the bond is redeemed.
For example, in the above instance, you’ve bought the bond for £110, but you’ll only get £100 when it matures. So in this case, the yield to maturity is 2.2% (assuming the bond matures exactly four years from the purchase date). It’s a fiddly calculation, but it’s easily available from various financial websites.