Yield Types and the Yield Curve of Bonds

A relationship exists between bond prices and yield. When bond yields increase, prices of existing bonds decrease. Similarly, when bond yields decrease prices of existing bonds increase.

A bonds cash flow and an investor’s required rate of return or interest rate are two components that are used to determine a bond’s price. Four basic types of yields exist which are explained in this section.

Coupon yield: The coupon yield is the stated rate of return over a bond and is determined when the bond is issued. The coupon yield is the specific amount interests that the issuer promises to pay the bondholder per bond each year.

This annual amount of interests can be stated as a percentage of the par value of the bond or in an amount of money. For example, a bond with a par value of $1000 that pays $40 in annual interests owns a coupon yield of 4%.

The coupon yield is fixed for the issue life-time, unless it is variable coupon interest, which fluctuates during all the bonds life.

Current yield: A current yield is the annual return rate of a bond that bases itself in the incomes received in relation to the price of purchase of the bond. The difference between a coupon yield and a current yield is that the division of the current yield is the price of purchase of the bond and not the face value of the same.

The following equation shows how a  current yield is determined:

Current yield  = Coupon interest amount
                           Purchase price of the bond

For example, if a bond is purchased at a par value of $1000 and the coupon is of 5% (the annual interest paid is of $50), the current yield is of 5% as the with coupon yield).

However, most of the bonds are negotiated at a higher or lower par value. Since a bond purchased at $1000 with a 5% of coupon, the current yield would be 4.54% (50/1100).

There is a relation between bond prices, current yields and coupon rates. Equally, bonds that are negotiated at a discount to their par values have current yields that are lower than the coupon rates. To investors interested in high current income the current yield is a useful tool to measure the return.