The investment return of a bond is the difference between what an investor pays for a bond and what is ultimately received over the term of the bond. The bond yield is the annualized return of the bond. Thus, bond yield will depend on the purchase price of the bond, its stated interest rate — which is equal to the annual payments by the issuer to the bondholder divided by the par value of the bond — plus the amount paid at maturity. Because the stated interest rate and par value are stipulated in the bond indenture. the price of the bond will vary inversely to prevailing interest rates. If interest rates rise, then the price of the bond must decrease to remain competitive with other investments, and vice versa.
Bond prices — not including accrued interest — vary inversely to market interest rates: bond prices will decline with rising interest rates, and vice versa. Bonds with longer effective maturities, or durations. are more sensitive to changes in interest rates, as can be seen in the diagram below, showing the price/yield curves per $100 of nominal value, as the market interest rate varies from 1% to 16%, for a bond with 3 years left until maturity and one with 10 years left, both with the same 6% coupon rate and paying interest semi-annually. Note that both curves intersect at $100 when the market yield = coupon rate of 6%.
The price of the bond will also depend on the creditworthiness of the issuer, which indicates the risk
of the investment. The higher the credit rating of the issuer, the less interest the issuer has to offer to sell its bonds. The prevailing interest rate—the cost of money—is determined by the supply and demand of money. As for virtually everything else, supply and demand determine price, so for bonds, the greater the supply and the lower the demand, the lower the price of the bond and, correspondingly, the higher the interest rate, and vice versa. An often used measure of the prevailing interest rate is the prime rate charged by banks to their best customers.
Most bonds pay interest semi-annually until maturity, when the bondholder receives the par value, or bond principal. of the bond back. Zero coupon bonds pay no interest, but are sold at a discount to par value, so the interest, which is the difference between par value and the discounted issue price, is paid when the bond matures. Nonetheless, the yield of the zero coupon bond is the annualized return, which allows it to be compared to coupon bonds.
Nominal Yield, Coupon Rate
Nominal yield. or the coupon rate. is the stated interest rate of the bond. This yield percentage is the percentage of par value —$5,000 for municipal bonds, and $1,000 for most other bonds—that is usually paid semiannually. Thus, a bond with a $1,000 par value that pays 5% interest pays $50 dollars per year in 2 semi-annual payments of $25. The return of a bond is the return/investment, or in the example just cited, $50/$1,000 = 5%.