A 10-year bond’s yield combines interest income and principal gain/loss to calculate an average annual rate of return. The yield assumes interest payments will be reinvested at the same rate and can fluctuate due to changes in interest rates.
The yield on a 10-year bond combines the bond’s interest income and its principal gain or loss to calculate an average annual rate of return. Also known as the yield to maturity, it assumes that interest payments on the 10-year bond will be reinvested at the same rate. The approach seems complicated only because it requires an understanding of the system by which bonuses make money.
A bond is a security sold by a business or government unit to raise funds and represents the seller’s promise to pay the buyer on a specified date or maturity. Whether it’s a government Treasury bond or a bond issued by a municipality or corporation, the seller also promises to make regular interest payments to the bondholder until the maturity date arrives. For 10-year bond yields, the maturity is 10 years.
If the bond has a face value of $1,000 US dollars (USD), for example, and a coupon rate of 5 percent, that means it will pay $50 USD in a year as long as certain conditions are met. The price of a bond can fluctuate as a result of changes in interest rates, and the two will move in opposite directions. As interest rates rise, the price of the bond falls and vice versa, and such fluctuations may occur more than once between the bond’s issuance and its maturity.
The coupon rate is a percentage of the bond’s face value rather than the price of the bond at any given time, so the yield it provides may be different than 5 percent face. In this example, it would still be $50 because the face value would remain at $1,000, but if falling interest rates pushed the real price of the bond to $1,100, the yield would become 4.55 percent. No matter how many times those changes occur before maturity, they are reflected in the 10-year bond yield.
The other factor is capital gain or loss. If interest rates were to remain stable over the life of the bond, its price would also remain unchanged. The 10-year bond yield in that case would be based on coupon payments only, but an increase or decrease in interest rates and a corresponding increase or decrease in the price of the bond would provide the second component. That would be known at maturity, when all the figures needed to calculate the yield were available.
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