Bond yields and measuring returns

Redemption yield – although the running yield is a useful comparison of ongoing income, it doesn’t factor in what happens if you hold the bond to maturity. The end profit or loss isn’t included.

A bond’s yield to maturity measures the total return from the investment if it’s held until maturity, taking into account all the income payments and the capital return, and discounting each payment (cashflow) to adjust for when it’s received.

The most accurate way of calculating yield to maturity requires a spreadsheet or complex financial calculator. But there’s also a simpler calculation investors can use to get a good indication of total return. Keep in mind that not using a discount rate means it becomes less accurate for longer-dated bonds.

It’s a simple yield to maturity calculation, that adjusts the running yield calculation above for the difference in the price and the face value of the bond.

Running yield + (gain / years to maturity x 100) / clean price

Though this formula considers whether the bond is currently price above or below par, it doesn’t discount the value of each coupon payment (cashflow) over time. If maturity is many years away, the most accurate way to analyse the yield would be by undertaking a full redemption yield to maturity calculation using a financial calculation or similar software.

Bond duration – What does duration mean? The duration of a bond measures the relationship and sensitivity of the price of a bond for a given change in its yield. It looks at the length of time to maturity and the coupon payments and gives an indication of a bond’s interest rate risk. The higher the duration of the bond, the more it’ll be expected to rise or fall when interest rates change.

The price of bonds with longer to run until maturity will be more sensitive to changes in interest rates, particularly if the coupon is relatively low.

If interest rates are rising, the rate investors can get with cash might look more attractive than the fixed interest amount offered by the bond over the long term. This could lead to a fall in the market price as investors sell the longer dated bonds.

The opposite can also be true – if interest rates are falling, the fixed coupon of the bond starts to look more attractive to investors, particularly over the long term. This could cause demand for longer-dated bonds, and the price they fetch, to rise at a quicker rate than shorter-dated bonds offering the same coupon rate.

The highest duration will be found with long-dated bonds with lower coupons, and the lowest duration in shorter-dated bonds with higher coupons.

Clean prices and accrued interest – the yield formulas for the other types of yield mentioned here use the ‘clean price’. This is the quoted price of a bond on the secondary market. The clean price does not include any accrued interest between coupon payments.

If you’re partway through a coupon period (they’re usually made twice a year), you’ll need to make adjustments to reflect income accrued to the bond. The actual price you will pay will include accrued interest and the cost of the bond – known as the ‘dirty price’.

If you buy a bond immediately after issue or the most recent coupon, the clean and dirty prices will be the same.