- Smart Investing
What is a bond yield
On the financial news report, ou might have heard, “the yield on a 10 year Government of Canada Bonds has dropped to 1.23%” What does that mean?
First let’s remember that a bond is essentially a loan from either the government (in this case) or from a corporation (called of course a corporate bond) that pays interest to you for the risk of holding that loan. At the end of the term, you get your principal back (the money you originally invested). More information here.
It is the opposite of getting a personal loan or a mortgage. With a loan or mortgage, you get the money up front and then give back a bit of it at a time to the lender in interest. At the end of the term (10 year mortgage or 25 year mortgage), you need to pay back the entire amount borrowed (the "principal"). When you buy a bond you loan the government the money and they pay you back a little at a time in interest. They also pay you back the principal at the end. Sometimes, they don’t pay you any interest during the term of the bond but just accumulate the interest and pay you at the end (Canada Savings Bonds worked like that)
When bonds are issued they have a coupon payment, which is just another way to say interest rate. Early paper bonds actually had little coupons that could be detached and cashed in. The name coupon stuck. When a bond is issued the government sets the coupon so that it is competitive in the market – that people will want to buy it.
Now, there are already many bonds in the market – both government and corporate and they all mature at different times. For example, let’s take the date January 1, 2020. On that date, a 10 year bond issued on January 1, 2010 (Coupon = approximately 3%) would mature and you would receive back your principal. A 20 year bond issued on January 1, 2000 (Coupon = approx. 6%) would also mature and it would also pay back its principal, and so on.
Bonds are bought and sold all the time. What if you wanted to buy a 20 year bond (with a 6% coupon) issued in 2000 in 2010? Since that bond matures in 10 years, it is now effectively the same as a 10 year bond. So, how much would you pay for it? That bond has a 6% coupon. So, a $100 bond would pay $6/year. A new bond in 2010 had a coupon of 3%. So most people would prefer to buy the old bond and get 6% versus the new bond at 3%. In fact, the law of supply and demand states that people would compete to buy the 6% bond until the price equaled that of the new bond (let's assume the new bond price is fixed which is not true but it makes the explanation easier). Therefore, a buyer would pay more for the bond that what it was originally sold for. When you hear that bond prices are going up it means interest rates are going down. Existing bonds with higher rates therefore become more valuable and their prices increase.
Which finally brings us to yield. The yield is simply the interest rate you’ll get for a particular bond to maturity. So that we can see how things are changing, financial people typically pick a common benchmark – in this case the 10 year Government of Canada Bond and look at the price of a bond with a 10 year term remaining. That can either be a new bond, a 10 year old bond (with a 20 year initial term) or any other bond of the same type (Government of Canada Bond) with 10 years remaining. The prices of all those bonds will be the same and that is the yield. They use yield because interest rate could be confused with coupon rate which was the initial interest rate of the bond. The yield is the interest rate you'll receive from now until maturity.
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