An investor who buys a bond can expect to receive a return from three sources:
- The coupon interest payments made by the issuer;
- The capital gains (or capital losses) when the bond matures or is sold and
- Income from the reinvestment of the coupon interest payments.
There are three commonly used methods to measure the potential return from a bond – current yield, yield-to-maturity and yield-to-call.
- Current yield simply relates the annual coupon interest to the market price and is calculated by dividing the annual dollar coupon interest by the current price.
- Yield-to-maturity measures the return after including the coupon interest payments and the capital gain or loss on the investment. As it is computed using a trial and error procedure, it is usually calculated using a bond calculator or computer. The calculation assumes that the investor can reinvest the coupon payments at an interest rate equal to the yield-to-maturity.
- Yield-to-call measures the return after including the coupon interest payments and the capital gain or loss on the investment up to the assumed call date of the bond.
The yields on bonds with different maturities but with the same credit quality are often plotted on a graph to form a yield curve. The yield curve serves as a benchmark against which the prices and yields of other bonds can be set.
Government and non-government bonds – the Reserve Bank regularly publishes information on yields and prices for different maturities and coupon rates. This information reflects recent bond issues and therefore provides an indication of the current value of a Government and non government bonds.
This is the benchmark yield curve because the minimum return an investor will demand for investing in a non-government security is the yield on a liquid Government security with the same maturity.
You can use the Government yield curve to price a non-Government bond by determining the yield on the Government bond with the same maturity and adding an appropriate risk premium to that rate. Insert this yield and other details into the bond price formula or calculator and you can calculate the bond price.