Hello everyone,
I would appreciate some clarity regarding some FI terminologies and concepts, in particular the term “yield”. So when reading the finance texts I take “yield” to be somewhat synonymous to the coupon/interest return on a bond, for example, the annual yield of a fixed rate 5% bond sold at par calculated as 50/1000. Now if for some reason the bond price increases to $1,500, PMT is still fixed at $50/Yr so the Yield is now 50/1,500 = 3.33%, down from 5%. I’ve always thought of higher yields as being more valuable (higher yield “pays more” interest) and preferred over lower yield bonds. Its been a while since I’ve taken CFin so I’m a little rusty. Can someone demystify my confusion. Thank you in advance.
Yields and price move in opposite direction. If a bond yield is high, this means investors require a high rate of return to hold the jump to default risk of the bond. This means the price is ‘low’. And vice versa.
In your example, say a 5% coupon bond priced at par initially. Now say its price is 150 as you say. This means investors wanted to hold that 5% coupon so much, that the price of the bond increased by 50%. This means the yield has dropped significantly compared to the yield at issue.
You would compute the yield as the IRR of the cash flows assuming you pay 150 now (the price of the bond), receive the coupons, and receive par at maturity. If there were 5 more years to maturity say, the yield would be close to-4% (its negative because you are paying 50 above par, but only receiving 5x5=25 in coupon to maturity in my example).
“Yield” is synonymous with “return”, but not necessarily with “coupon”.
If the price goes to 1,500 and the term to maturity is 10 years, the yield to maturity would be exactly 0 because you put up $1,500 today to get back 10*50 plus the face of 1,000. As you vary the term to maturity, the yield to maturity will change and will not be 3.33%. You would achieve a 3.33% yield to maturity only if the bond were perpetual.