Yield and interest are highly-related when it comes to bonds. Your yield is based on the interest payments generated by a bond. However, because yield is the total profit you make based on your underlying investment, it might not always be the same as the rate of interest. Specifically, if your investment has associated costs, your total profits might be less than the interest payments you collect. And, if you bought a bond for a different price than its face value, your yield percentage will be different than the bond’s interest rate. Here’s what investors need to know about bond yields and interest rates.
A financial advisor can help you create a financial plan for your investment needs and goals.
What Are Bond Interest Rates?
Interest is the amount of money that that a lender charges for credit, or the amount of money that a borrower pays for a debt. It is expressed as a percentage of the loan’s principal. For example, if you borrow $1,000 and pay $100 per year in interest, your interest rate is 10%.
Bonds are debt assets issued by companies and governments when they want to borrow money. Every bond comes with an interest rate based on its face value, and the company/government that issued the bond pays that interest on a regular basis. Once the bond’s term expires, known as “maturity,” the issuer repays the face value of the bond to its owner.
For example, a company might issue a $1,000 bond with a 20-year maturity and a 10% annual interest rate. In this case, $1,000 would be the bond’s face value; this is the amount that an investor originally paid for the bond. The company would pay $100 per year to anyone who holds this bond (10% of the bond’s $1,000 face value). After 20 years, the company would repay $1,000 to whoever holds the bond.
When it comes to yields, however, it’s critical to understand that a bond’s price and its face value aren’t always the same.
Face value is the price that investors paid to the company when it first issued the bond. For example, a $1,000 bond means that the company sold the bond for $1,000 and it will repay that same amount of money to whoever owns the bond at its maturity.
Once a bond has been issued, however, investors can sell it to each other on the secondary market. A bond’s price is the amount that you paid when you buy it from another investor. Based on factors such as the bond’s interest rate and the market at large, it is not uncommon a bond’s price to fluctuate. The result is that your investment in this asset may not always match its face value.
If the bond’s price and its face value are the same, this is known as being “at par.”
What Is Bond Yield?
Yield is the net profit that you make from holding an investment. It’s typically expressed as an annual percentage of your total investment. For example, say you make a $2,000 investment. Over the course of the year that investment pays you $100. You would have collected a 5% yield from this investment.
An investment’s yield is not the money that you make from selling the asset. Those are your returns. For example, say you hold a stock portfolio. Your returns would be the money that you make by selling the stocks. Your yield would be any dividend payments that the stocks issue while you hold them.
Yield is calculated based on two factors:
- Initial investment. How much you invested initially
- Net income. How much you earned while holding the investment minus any associated costs and expenses
For example, say you own an ETF that invests in bonds. You paid $5,000 for this investment. It generates $250 of interest payments per year and has a management fee of $25 per year. Your net income from this investment would be $225 (the interest payments minus the management fee). This would be a 4.5% yield ($225 of net income divided by the initial $5,000 investment).
In the case of bonds, your yield comes from the interest payments generated by your bonds while you hold them. The interest rate on your bonds will usually be close to your yield, if not exactly the same, but your initial investment and net income can cause them to differ.
When looking at the differences between bond yields and interest rates, here are two comparisons to keep in mind:
Face value vs. price. Your yield is calculated based on the value of your investment, while a bond’s interest rates are calculated based on the asset’s face value (which is the amount of money promised to a bondholder when the bond matures). If the price you paid is different from the bond’s face value, your yield will be different from the bond’s interest rate.
For example, say you have a $500 bond with a 5% interest rate. It will pay you 5% of the asset’s face value, so you receive $25 per year. However, say that you paid $450 for the bond. In this case, your yield would be 5.5%, because we calculate yield based on the value of your investment ($450) not based on the bond’s face value.
Fees and costs. As noted above, your yield will be reduced by any associated costs. Bonds rarely come with associated fees or costs. However, if you have invested in a fund or another portfolio-based asset, these are much more common. In this case, you can calculate your yield based on the interest payments that you have received and then deduct the associated costs. This would leave you with a net income below the bond’s interest rate.
Bottom Line
While yield and interest overlap significantly, as an investor yield is the most important element for your portfolio. This is the money that you’ll make based on the capital that you invested. So before you invest in a bond, make sure to pay attention to both the interest rate and how it compares to the price you’ll actually pay. Also, don’t forget to deduct any costs and fees, because this determines how your investment will perform for you.
Tips for Investing
- The rule of thumb is that you should hold more stocks during an up market and bonds during a downturn. A financial advisor can help you balance stocks and bonds in your portfolio for your investment needs and goals. SmartAsset’s free tool matches you with up to three financial advisors who serve your area. Plus, you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- The bond market is generally dominated by institutional investors, but increasingly retail investors have gotten involved as they seek diverse portfolios. Here’s what you need to know about both investment categories.
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