The term yield has been grabbing headlines recently. In case you were wondering what it is all about, here is a quick explanation.
A bond is a debt obligation. When you buy a bond, you lend money to the company that issued the bond (issuer).
In exchange, the company makes a legal commitment to return your money (principal) on a predetermined date (maturity date), and till it does so, it will pay you a specified rate of interest (coupon rate).
Whether the company makes profits or incurs losses, or its stock price rises or falls, that is irrelevant to the terms and conditions. It still has to pay the interest rate promised and return the money on the specified date.
Let’s use an example. You invest Rs 100 in a 10-year bond paying 5% per year.
- Face Value (FV): Rs 100. The FV is the amount you loaned to the company and it promises to return it to you on maturity.
- Maturity: 10 years. This is the length of time of the financial contract.
- Coupon Rate (CR): 5% per annum. The CR is always tied to the bond’s FV. 5% of Rs 100 = Rs 5 per annum.
The interest rate, also known as the CR, differs from the bond yield.
During these 10 years, this bond will be traded in the market. So buyers may pay more or less than the FV.
A buyer is paying more than the FV of Rs 100. However, return is still Rs 5 per annum. Rs 5 on Rs 100 = 5%. Rs 5 on Rs 110 = 4.55%. So the bond yield has fallen because the bond price has risen.
A buyer is paying less than the FV of Rs 100. However, return is still Rs 5 per annum. Rs 5 on Rs 100 = 5%. Rs 5 on Rs 90 = 5.55%. So the bond yield has risen because the bond price has fallen.
Bond Yield is the interest rate calculated by applying the CR to its market price. It is the return you will get when you buy the bond at that given price and hold it till maturity.
If you understood the above, you would understand the current news on the 10-year US Treasury yields.
These treasury bonds are issued by the U.S. government. Investing in government paper is the safest form of debt. The 10-year Treasury bond yield is also the benchmark that guides other interest rates in the economy. As yields on the 10-year Treasury notes rise, so do interest rates.
Early last year when countries began to implement the lockdown, bond prices rapidly shot up (which means yield falls). Investors wanted somewhere safe for their money. The yield dropped to 0.5%.
Treasury yields also reflect expectations of economy’s strength. When the economy is strong, investors feel less need to own them. When there is a crisis or panic, they are considered the safest possible investment.
After a year of pandemic-induced misery, things are looking up with the vaccination rollout. The sentiment is positive regarding an economic revival. Investors expect inflation to go up. Higher inflation means interest rates will also rise. This resulted in bond prices falling and the yield rising to 1.5%.