Interest Rates Yield

By: EconomyWatch Content   Date: 5 November 2009

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Interest rates yield is the return offered by a fixed-income investment, such as bonds. The yield on a bond is dependent on:

  • Purchase price of the bond

  • Annual interest payments

Usually the term “yield” is used to describe long-term interest rates.

Interest Rates Yield: Types of Calculations

The calculation of yield on bonds reflects the return offered by the bond as a percentage of either its nominal value or its current price.

There are three types of calculations used to determine the yield:

  • Nominal yield: This yield is calculated by dividing the annual income on the bond by its nominal or 'par' value. Thus, a $200 bond paying an annual interest of 4.75% has the nominal yield of 4.75/100 x 200 = 9.5%.

  • Running or current yield: Current yield is calculated by dividing the annual income on the bond by its current market price. So, if the market price of the $200 bond paying an annual interest of 5% has dropped to $195, the current yield on the bond at that time would be 5/195 x 100 = 2.56%.

  • Redemption yield: This yield states the overall return on a bond, if it was to be held till its maturity date. Redemption yield not only reflects the interest payments received by a bondholder, but also the overall gain/loss he will make when the bond matures.

Interest Rates Yield: Relation between Yield and Bond Prices

There is an inverse relationship between interest rates and bond prices. When interest rates decline, bond prices usually rise and vice versa. For example, an investor buying a bond worth $1,000 is earning 6% interest payment (yield) or $60 interest every year. If interest rates increase by 1%, these bonds will start yielding a 7% interest payment or $70 per annum. Since investors can now buy bonds delivering higher interest payment (higher yield), they will prefer these bonds to the ones paying 6% interest. This decline in the demand for bonds with 6% interest rate would result in a decline in the value of these bonds.

This is why rising interest rates yield is generally considered undesirable for existing bond investors.


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