The yield basis is a method of quoting the price of fixed income assets as a yield rather than dollar terms. This allows bonds with varying characteristics to be easily compared. The yield basis is used by investors to compare different bonds. The yield basis is calculated by dividing the coupon amount paid annually by the bond purchase price of the bond.
What are Bond Yields?
Bonds are quoted in yields and not in dollars. Most bonds are quoted on the yield basis. For example, if a company has a coupon rate of 6.75% of 10 years. The NZ$1,000 bond will have a dollar value of 940.
The yield basis can be calculated using the current yield formula presented as:
The yield tells a bond trader that the bond is trading at a discount or at a correct valuation by matching with the current yield if the yield basis is greater than the current yield. If the yield basis comes to be less than the coupon rate, then it would sell the bond at premium at a premium since a higher coupon rate increases the value of the bond in the market. A trader could then compare it with bonds of other industries.
So while purchasing bonds, the investors should understand what is the difference between the yield basis and the net yield basis. The investor who is buying from the secondary market may buy from brokers or other sources and the dealer/broker could charge you a flat commission and in lieu of the commission charged, the broker may opt to sell you on a net yield basis.
Net Yield and Yield
It includes yield which includes brokers’ profit or commission for the transaction done. This is the difference between what the dealer paid for the bonds and what he sells them for. It’s his markup included in the yield amount. It is important for an investor to know that if the broker is charging him net yield, it means his mark up has already been included in it.
For instance, if an online broker is offering you a 3.75% % yield to maturity (YTM), it’s a given that his profit is already taken care of in it.
While buying bonds, an investor should ask a broker if the bonds are on bet yield basis or will the commission be charged separately.
Comparing bond yields can be difficult due to varying frequencies of coupon payments. Also, different fixed-income investments use a variety of yield calculating methods. So, it has to be first converted into a common platform so that comparing can be easy. These conversions can be straightforward, but problems come when it is compounding and day-count. In these cases, a correct solution is very difficult to reach.
Why Does Yield Basis Matter?
The Yield basis is important for knowing whether a bond is trading at a correct price as compared to other bonds. In particular, the yield basis indicates whether a bond trading is at a discount or at a premium. The Bonds, particularly treasuries, are usually quoted on yield basis.
In particular, the yield basis indicates whether a bond is trading at a discount or a premium. If the yield basis is greater than the coupon rate, the bond is trading at a discount; if the yield basis is lower than the coupon rate, the bond is trading at a premium. Thus, bonds are generally quoted on the yield basis, particularly Treasurys.
Discount yield means to compute expected returns of a bond purchased at a discount held till maturity. Discount yield uses the method for its computing as a 30-day month and a 360-day year. This calculation is commonly used for evaluating Treasury bills and zero-coupon bonds.
Yield to Maturity (YTM)
The YTM is the estimated rate of return on bonds. It presupposes that the buyer will hold it till maturity. It is also assumed that the buyer of the bond will invest each interest payment at the same rate of interest. YTM includes coupon rates within its calculation.
YTM can also be called redemption yield.
Yield to Maturity vs. Coupon Rate
When investors are buying bonds, they need to look at 2 important factors yield to maturity and coupon rate. Investment quality bonds are low risk and offer a slightly higher rate of return than the savings account. They are fixed-income investments which investors use as a steady stream of income. Mostly, the retired people use it after their retirement. Bonds can be added to the portfolio at any time to lower the overall risk profile.
The yield to maturity (YTM) is the percentage of profits until its maturity date. A bond's yield to maturity rises or falls depending on what is its value.
The coupon rate is the annual amount of interest that the owner of the bond will receive. To complicate things further, the coupon rate may also be referred to as the yield from the bond.