A 10-year bond yield combines the bond’s interest income and its capital gain or loss to calculate an average annual rate of return. Also known as the yield to maturity, it assumes the 10-year bond’s interest payments to be reinvested at the same rate. The approach seems complicated only because it requires an understanding of the system by which bonds earn money.
A bond is a security sold by a business or government unit to raise funds and represents the seller’s promise to repay the buyer at a specified date or maturity. Whether it’s a government treasury bond or a bond issued by a municipality or a corporation, the seller also promises to make regular interest payments to the bondholder until the maturity date arrives. In the case of the 10-year bond yield, the maturity is 10 years.
If the bond has a face value of $1,000 US Dollars (USD), for example, and a coupon rate of 5 percent, that means it will pay $50 USD in one year as long as certain conditions are met. The price of a bond can fluctuate as a result of changes in interest rates, and the two will move in opposite directions. As interest rates go up, the bond’s price goes down and vice versa, and such fluctuations can take place more than once between the bond’s issuance and its maturity.
The coupon rate is a percentage of the bond’s face value rather than the bond’s price at a given time, so the yield that it provides can be different from the nominal 5 percent. In this example, it would continue to be $50 USD because the face value would remain at $1,000 USD, but if falling interest rates pushed the bond’s actual price to $1,100 USD, the yield would become 4.55 percent. No matter how many times those changes occur before maturity, they are reflected in the 10-year bond yield.
The other factor is the capital gain or loss. If interest rates remained steady through the bond’s lifetime, its price would also be unchanged. The 10-year bond yield in that case would be based only on the coupon payments, but rising or falling interest rates and a corresponding increase or decrease in the bond’s price would provide the second component. That would be known at maturity, when all of the figures necessary to calculate the yield would be available.