A bond's "yield" is not one number. The same cash flows produce different yields depending on how you compound, what you discount against, and which spread you quote. The exam tests whether you can convert between these conventions cleanly.
A stated annual rate must always travel with its compounding frequency, called the periodicity. A 6% rate compounded semi-annually is not the same return as 6% compounded monthly. To calculate the annual yield on a bond across these varying compounding periods, convert each quote to a common periodicity before comparing.
KEY: US bonds quote yields with semi-annual periodicity (the "bond equivalent yield" or BEY). European bonds typically quote annual. To compare a US Treasury YTM to a Bund YTM, convert one to match the other.
The effective annual yield (EAY) sets , giving the once-a-year compounded equivalent. EAY always exceeds the stated rate when periodicity is greater than 1.
Current yield = annual coupon divided by current price. It ignores principal gain or loss at maturity and ignores reinvestment. Useful only as a back-of-envelope income gauge.
Common mistakes
- Comparing yields across different periodicities directly. A 6% annual yield is richer than a 6% semi-annual yield. Always convert to the same compounding frequency before ranking.
- Treating current yield as YTM. Current yield ignores the pull-to-par on premium or discount bonds. A premium bond's current yield overstates total return; a discount bond's current yield understates it.
- Computing yield-to-worst as an average or maximum. YTW is the minimum across YTM and every yield-to-call (and yield-to-put if applicable). The issuer picks the option that hurts you most.
Bottom line
- Periodicity must accompany every rate: an 8% semi-annual bond equivalent yield is not 8% annual. Convert via
- Effective annual yield always exceeds the stated rate whenever periodicity is greater than 1, because interest compounds on interest within the year
- Current yield ignores capital gain or loss and reinvestment; YTM captures both under hold-to-maturity and assumes reinvestment at YTM
- Yield-to-worst = the minimum of YTM, every yield-to-call, and yield-to-put, the conservative figure for bonds with embedded options
Exam shortcut
For periodicity conversion, equate effective annual factors, never just multiply or divide rates by frequency. For YTW on a callable bond, compute YTM and yield-to-first-call, then pick the smaller, sufficient in most exam cases. For spread choice, option-free bond goes to Z-spread; bond with embedded option goes to OAS; quick screen goes to G-spread.
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Learning objectives
- yield measures fixed-rate bonds
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