How is the Yield on a Bond Calculated?

A bond can have several different yield values depending on the bond’s structure: 

• Yield-to-maturity: A security’s yield if the investor were to buy and hold the security until the maturity date. This is calculated using the interest rate, length of time, and price paid and assumes interest payments will be reinvested at the same yield.
• Yield-to-call: A security’s yield if the investor were to buy and hold the security until the call date. This is calculated using the coupon rate, length of time, and market price and is only valid for securities callable prior to their maturity.

Investors purchasing bonds want to pay the least amount of money they can, as that bond will provide the highest yield. At the time of purchase, the investor compares the yield-to-maturity and the yield-to-call to see which would yield the highest return. The lower yield is considered the “yield-to-worst” to investors. 

Example:

A borrower issues a callable 10-year $1,000 par value bond that has an interest rate of 3.00% for $1,050 and is callable in five years. 

• If the bond is held to maturity and not called, the yield-to-maturity is approximately 2.43%. Note that the yield to maturity of 2.43% is lower than the 3.00% coupon rate because the investor paid a $50 premium on the bond ($1,050 paid for a $1,000 par value bond). 
• If the bond is called away from the investor five years prior to the maturity date, the yield-to-call is 1.95% because the investor received fewer above market interest payments to offset the $50 premium before the bond was called.

As this example shows, if the bond is called away, the investor loses 0.48% in the expected yield of the bond.

What’s important here?

A bond's yield is dependent on its: 

• Delivery date
• Maturity date
• Coupon
• Price
• Call date (if relevant)
• Redemption price (par unless the bond is called, in which case its call price) 

A bond can have several different yields depending on its structure. An investor will look at all the possible bond yields and purchase the bond at a price that generates the highest yield.