Bond Yields Can Be Complicated, This Simple Example Will Help

You can opt-out at any time.

Interest income from bonds can be a good source of investment income, but you must understand that your bonds can and will fluctuate in value. The first step to understanding bonds is to learn about bond yields.

Understanding Bond Yields

To explain how bond yields work, I’m going to use an analogy; an example using rental property.

• Let’s say you buy a house for $100,000.
• There is a renter in the house who pays $500 per month.
• Excluding any expenses you might incur, you can calculate that you will receive $6,000 a year ($500 x 12 = $6,000).
• This is a 6% annual return. ($6,000 divided by $100,000).

• Instead of a house, if you purchased a bond for $100,000, and it was paying annual interest of $6,000, we would say the bond has a current yield of 6%.

Bond Discounts

Continuing with the rental property example, assume we are entering a recession, and a major business in your town announces a layoff. You are afraid your renter might move out. The future is uncertain. You list the house for sale. Even though you still have a renter who is paying monthly rent, the best offer you receive for the house is $50,000. The house is trading at a “discount”.

Bond Yields In Bad Economies

If someone buys your house at $50,000, and the renter stays, the new owner now gets $6,000 a year on their $50,000 investment. Their yield is 12%. ($6,000 divided by $50,00) They get a higher return because they were willing to take the risk of buying a stream of income in uncertain times.

Bond Defaults

During a recession there is fear that some companies may get into financial trouble and not be able to pay the interest on their bonds. When a company does not pay interest on its bonds, it is said to be in default.

Even though a bond, or bond fund, pays consistent monthly interest, it will still go down in value during bad economies. The bonds will trade at a discount because there is a greater risk that some of the companies will go out of business and default on their bonds.

Bond Interest Income Is More Secure Than Dividend Income From Stocks

A company must pay interest on its bonds before it pays dividends on its stock, so during uncertain times, your future investment income is more secure if you own an interest paying bond instead of a dividend paying stock.