### Core Financial Modeling

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Learn moreBond Yield Definition: A bond’s “yield” is the annualized return an investor might realize on the bond, including income (the fixed interest payments), its current market price, and other terms, such as discounts and prepayment penalty fees.

**Bond Yield Definition:** A bond’s “yield” is the annualized return an investor might realize on the bond, including income (the fixed interest payments), its current market price, and other terms, such as discounts and prepayment penalty fees.

A “bond” is a loan that a company takes out to borrow money; it must be repaid in full in the future, and the company must pay **interest** on it each year.

From the company’s perspective, the bond yield represents their **borrowing costs**; from an investor’s perspective, the bond yield represents the **potential returns** and the risks associated with the company’s issuance.

This definition above seems simple enough, but it gets confusing because there are **different types of “yield,”** and the yield is different from the bond’s coupon rate.

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Learn moreThe key terms are:

**1) Coupon Rate: **This is the fixed annual interest rate that the bond issuer pays its bondholders. It’s determined at issuance and remains unchanged throughout the bond’s term. For example, if a $1000 bond’s coupon rate is 5%, it pays $50 in interest each year until the bond is repaid:

**2) Current Yield:** Bonds fluctuate in price as interest rates change, and the current yield is calculated as the annual interest payment divided by the bond’s current market price. It’s the percentage return an investor can expect to earn *over the next year* if the bond is purchased at its current market price.

Continuing with the example above, if the bond’s market price is currently $900, the Current Yield is $50 / $900 = 5.6%.

**3) Yield to Maturity (YTM): **This is the annualized return an investor will receive if they buy a bond at its **current market price **and hold it until maturity, assuming the company makes all the required payments and the investor reinvests the interest payments at the same rate as the overall return.

The Yield to Maturity factors in the current market price, face value, coupon rate, time until maturity, and repayment probability.

With the example above, the YTM would be 6.4% (see the formula below) because the investors get an extra “boost” to their annualized return since they purchase the bond at a 10% discount:

**4) Yield to Call (YTC): **For bonds that can be called (i.e., repaid by the issuer prior to maturity), the Yield to Call estimates the return if the bond is called as soon as the call provision allows.

For example, if this company can repay the bond early (in Year 4) but must pay a **3% prepayment penalty fee** (or “call premium” to do so), the Yield to Call is 8.7%:

**5) Yield to Worst (YTW):** This is the lowest potential annualized return an investor could receive from buying and holding a bond until the company repays it (as scheduled or early).

In other words, the Yield to Worst is the **minimum** of the YTCs on all the possible call dates (if the bond is repaid early) and the YTM (if the bond is held until maturity).

Here’s an example of the YTW calculation for a different bond issuance:

Bond yields often act as a **signaling mechanism** for a company’s financial health, and lower yields tend to indicate lower credit risk, while higher yields mean the opposite.

The screenshots above provide several examples of how to calculate different types of bond yields.

In general, the calculation requires several inputs:

**1) Current Market Price:** The current price the bond is trading at, which fluctuates based on market conditions, the issuer’s credit quality, and changes in overall interest rates.

**2) Coupon Rate: **The fixed annual interest rate set when the bond is issued.

**3) Face Value:** This is also known as the “par value,” or the amount the issuer promises to repay to bondholders at maturity.

**4) Maturity:** The time remaining before the bond “matures” (i.e., when it must be repaid by the company).

**5) Repayment Probability:** The likelihood of the issuer repaying the principal at maturity or upon a call. For normal, non-distressed companies, this is assumed to be 100% in most cases.

You can see a simple **Yield to Maturity (YTM) calculation** in the screenshot below:

If you don’t have access to Excel or a calculator, you can also **approximate** the Yield to Maturity with this formula:

The intuition is that each year, you earn interest PLUS a gain on the bond price if it’s purchased at a discount (or a loss if it’s purchased at a premium).

And you earn that amount on the “average” between the initial bond price and the amount you get back upon maturity (the par value).

Let’s apply this formula to the example at the top of this article: A bond with a par value of $1000, a current market price of $900, annual interest of $1000 * 5% = $50, and 10 years until maturity.

In this case, the approximate YTM = ($50 + ($1000 – $900) / 10) / (($1000 + $900) / 2) = ~6.3%.

To do the math quickly yourself, you can say: $50 + $100 / 10 = $60.

Then, $950 is “halfway” between $1000 and $900.

$60 / $1000 = 6%, so you can say that $60 / $950 is “slightly higher than 6%” if you had to answer this question in an interview.

This method is less precise than the real Excel formula or even the IRR function, but it works well when the bond discount or premium is 10% or less, and the holding period is in the 5-10 year range.

Bond yields are sensitive to several factors; the most important ones are:

**Coupon Rate:** All else being equal, a bond with a 10% coupon rate will have a higher yield (all types) than a bond with a 5% coupon rate.

**Maturity:** Longer-term bonds are more sensitive to interest-rate changes than shorter-term ones because interest is paid each year the bond is outstanding, so the interest is paid over a longer period.

**Market Price:** As the market price (or “trading price”) of a bond decreases, its yield increases, and vice versa.

**Company Credit Quality:** Deteriorating credit quality or even a downgrade in a company’s credit rating can reduce the market price of a bond, which means its yield goes up. This type of event reflects heightened credit risk.

In real life, you use the bond yield to:

**Compare Pricing of Different Issuances:** Investors can use bond yields to compare the relative pricing of different bonds. Instead of looking at prices, yields can provide a standardized metric, allowing for a clearer comparison of potential returns from bonds with different face values, maturities, and coupon rates.

**Determine the Cost of Debt in a Valuation:** In corporate finance, the yield on a company’s debt can approximate its cost of debt. For valuation purposes, you’ll need this when determining a company’s Weighted Average Cost of Capital (WACC).

**Estimate How Much a Company Must Pay to Issue New Debt:** An investor can look at current market conditions and investor sentiment by studying the current bond yields outstanding. If yields are high, the company might face higher borrowing costs if it needs to issue new debt.

**Debt vs. Equity Decisions:** If you’re completing a debt vs. equity analysis, you might use the company’s bond yield to quantify its cost of debt and compare its financing options.

These yield metrics all measure the **returns** an investor can expect to receive on a bond, but they do it in different ways.

**–Current Yield**: This tells you the percentage investors would earn on a bond if they bought it today and **held it for a year**, factoring in the market price and the coupon rate on the bond.

**–Yield to Maturity**: This gives the annualized return investors earn if they buy a bond at its current market price and **hold it until maturity**, assuming the company makes all the required payments and the investor reinvests the interest payments at the same rate as the overall return.

**–Yield to Call**: This is similar to the YTM, but investors hold the bond only until **an earlier call date**, not the maturity date, and also receive some type of penalty fee paid by the company in exchange for this early repayment.

**–Yield to Worst**: This is the lowest annualized return an investor might receive from buying and holding a bond until *either* early repayment *or* maturity, i.e., it is the **minimum** of all the YTCs and the YTM.

*Calculating* the bond yield is the easy part, as you can use any of the formulas presented above.

The hard part is *interpreting* the bond yield and using it in real life, whether you’re valuing a company or evaluating an M&A deal.

That takes experience and judgment, and there are no shortcuts other than repeated practice.

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.