2.2 Bond Yields and Pricing
Key Takeaways
- Nominal yield is the coupon rate based on par value.
- Current yield uses market price and moves opposite to price.
- YTM is the most complete yield measure for non-callable bonds.
- YTC applies to callable bonds; YTW is the lower of YTM and YTC.
- Yield order differs for premium, discount, and par bonds.
- Yield-curve shape signals market expectations.
The Four Yields
Nominal yield (coupon) is the stated rate on par and never changes: $70 on a $1,000 bond is a 7% nominal yield.
Current yield measures annual income against the current price:
Current Yield = Annual Interest ÷ Market Price
A 7% bond ($70) trading at $875 yields $70 ÷ $875 = 8.0%. Current yield exceeds the coupon on a discount bond and falls below it on a premium bond.
Yield to maturity (YTM) is the total annualized return if held to maturity, capturing coupons plus the gain (discount bond) or loss (premium bond) versus par. It is the standard for comparing non-callable bonds. The exam-friendly approximation:
YTM ≈ [Annual Interest + ((Par − Price) ÷ Years)] ÷ [(Par + Price) ÷ 2]
Worked example: A 6% bond at $950, 10 years left. Annual interest $60; annual gain ($1,000 − $950)/10 = $5; average price ($1,000 + $950)/2 = $975. YTM ≈ ($60 + $5)/$975 = 6.67%.
Yield to call (YTC) substitutes the call price and years-to-call for par and years-to-maturity. It matters most for premium callable bonds, which issuers are likely to call when rates fall.
Yield to worst (YTW) is the lower of YTM and YTC — the most conservative figure a rep should quote to a client on a callable bond.
The Bond See-Saw: Yield Order
Knowing the order of the four yields by price state is worth several exam points. The mnemonic: for a discount bond everything is higher than the coupon because the investor gains the discount; for a premium bond everything is lower because the investor loses the premium.
| Price | Yield order (low → high) |
|---|---|
| Discount | Coupon < Current Yield < YTM < YTC |
| Par | Coupon = Current Yield = YTM = YTC |
| Premium | YTC < YTM < Current Yield < Coupon |
Why YTC is the extreme: for a discount bond, calling it early pays par sooner, accelerating the gain — so YTC is the highest. For a premium bond, an early call forces the loss of premium over a shorter period — so YTC is the lowest and equals YTW.
Duration and Volatility
Duration estimates how much a bond's price moves for a 1% change in rates. Longer maturity and lower coupon both raise duration, hence volatility. A zero-coupon bond has duration equal to its maturity — the most price-sensitive structure of all. Reps use this to match a client's risk tolerance: short-duration bonds for stability, long-duration for rate-sensitive plays.
The Yield Curve
The yield curve plots yield against maturity for bonds of similar credit quality (usually Treasuries):
| Curve | Shape | What it implies |
|---|---|---|
| Normal (positive) | Upward | Longer terms pay more; healthy growth expectations |
| Inverted (negative) | Downward | Short rates exceed long rates; classic recession signal |
| Flat | Horizontal | Little term premium; transition or uncertainty |
| Humped | Peaks mid-curve | Intermediate yields highest; unusual transition |
A normal curve reflects investors demanding extra yield for the time and uncertainty of long maturities. An inverted curve — short-term yields above long-term — has historically preceded recessions, because investors expect rates (and growth) to fall. A flat curve often appears when the market is transitioning between a normal and an inverted shape, signaling uncertainty about the economy's direction. The shape is driven largely by Federal Reserve policy at the short end and by inflation and growth expectations at the long end.
Putting the Yields Together: A Worked Comparison
Suppose a client is comparing two bonds, each $1,000 par with a 5% coupon. Bond A trades at $920 (a discount) and Bond B trades at $1,080 (a premium); both mature in 10 years. Bond A's current yield is $50 ÷ $920 = 5.43%, already above the 5% coupon, and its YTM is higher still because the investor also collects the $80 discount over 10 years. Bond B's current yield is $50 ÷ $1,080 = 4.63%, below the coupon, and its YTM is lower still because the $80 premium is lost by maturity. This is the see-saw in action: the discount bond's yields all sit above the coupon, the premium bond's all sit below it.
A representative who internalizes this can answer most yield-ordering questions in seconds without any calculation, simply by spotting whether the bond is priced above or below par.
Quoting Yields to Clients
FINRA rules require that confirmations and recommendations present the lower of YTM or YTC (the yield to worst) on callable bonds, so a client is not misled by an attractive-looking YTM that the issuer can cut short with a call. For a premium callable bond this means quoting the YTC; for a discount callable bond the YTM is typically the worst case. Always frame the yield discussion around the client's actual holding period — a buyer who plans to sell in two years cares about price volatility far more than about a 10-year YTM.
On the Exam
The most common calculation is current yield. Also expect: ordering yields for premium vs. discount bonds, identifying that YTC is most relevant for premium callable bonds, recognizing YTW as the lower of YTM/YTC, and interpreting yield-curve shapes — especially the inverted curve as a recession indicator.
A bond with a 6% coupon is trading at $1,100. The current yield is approximately:
For a bond trading at a discount, which yield is the highest?
An inverted yield curve is best described as a condition in which:
When recommending a premium callable bond, a representative should quote the client the: