What is yield on a bond?
The yield on a bond in simple terms is the rate of return you get from investing in the bond. The concept of yield is similar to the returns you get from your fixed deposit. The only difference between a bond yield and fixed deposit is that in fixed deposits, the interest rate is fixed while a bond yield is determined by the bond market.
Example - If you invest in a bond that is trading at a yield of 8%, the return you will get from your investment in the bond if you hold the bond to maturity is 8%. A point here, coupon rate of bond can be higher, lower or equal to a bond yield, i.e coupon rate can differ from yield. For example, if a bond has coupon rate of 9%, and bond yield is 8%, then rate of return on the bond is 8% not 9% coupon rate.
Why does the yield and coupon rate differ?
The yield and coupon rate differs due to the price at which the bond trades in the market. As bonds are traded securities, price of the bonds changes due to demand and supply and this price reflects the yield of the bond. A bond with a coupon of 9% and is sold at Rs 100 to investors, will give a yield of 8% when the price increases to Rs 104, due to higher demand for the bond in the market.
The calculation for yield is the YTM or yield to maturity calculation, where the bond price determines the yield on the bond through a simple discounted cash flow method.
Why do yields go below or above coupon rate?
When government of India issues a bond, with a coupon rate of 6.1% at a price of Rs 100 and maturing in 10 years, the yield and coupon rate are same at 6.1% at the time of issue. If this bond trades at Rs 100 all through its maturity period, the yield will be 6.1%, same as coupon rate.
However, if there is higher demand for this bond in the market than supply, then the bond price goes up, say Rs 101 and in this case the bond yield will be at around 5.95% lower than coupon rate of 6.1%. On the other hand, if demand is weak, the price will fall to Rs 99 and bond yield will be at 6.25%, higher than coupon rate of 6.1%.
The demand-supply gap for bonds in the market is determined by various factors like inflation, government borrowing etc.
Why the term high yield?
High yield as the term suggests is just that, high yield. When you invest in any security that offers high yield, you get payout that is over what you would receive from what you can get in the normal market. Bonds that offer higher yields
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