Yield

The income from a security as a proportion of its market price.

There are, in fact, two types of yields on dated gilts. The case of a Treasury 10 pc with 5 years to maturity currently selling in the secondary market at US$120 will serve to illustrate the two. From the name of the gilt we glean that it pays US$10 per year (10 per cent of the nominal value of US$100). For US$120 investors can buy this gilt from other investors on the secondary market to receive an interest yield (also known as the flat yield, income yield and running yield) of 8.33 per cent:

             Interest yield     =     Gross (before tax) interest coupon   x   100

                                                           Market price

                                        =      US$10    x   100  

                                                US$120

                                        = 8.33%

The flat yield (interest yield, running yield and income yield) on a fixed-interest security is the gross interest amount, divided by the current market price, expressed as a percentage.

This is not the true rate of return available to the investor because we have failed to take into account the capital loss over the next 5 years. The investor pays US$120 but receives only the nominal value of US$100 at the end. If this US$20 loss is apportioned over the five years it works out at US$4 per year. The capital loss as a percentage of what the investor pays (US$120) is US$4/US$120 x 100 = 3.33 per cent per year. This loss to redemption has to be subtracted from the annual interest yield to give an approximation to the redemption yield (also called yield to maturity): 8.33 per cent - 3.33 per cent = 5 per cent. While this example tries to convey the essence of redemption yield calculations, it oversimplifies in that a compound interest-type calculation is required to obtain a precise figure.

The redemption yield or yield to maturity of a bond is the discount rate such that the present value of all cash inflows from the bond (interest plus principal) is equal to the bond's current market price.

The general rules are as follows:

• If a dated gilt is trading at less than US$100 the purchaser will receive a capital gain between purchase and redemption and so the redemption yield is greater than the interest yield.

• If a dated gilt is selling at more than US$100 a capital loss will be made if held to maturity and so the redemption yield is below the interest yield.

Of course, these capital gains and losses are based on the assumption that the investor buys the gilt and then holds to maturity. In reality many investors sell a few days or months after purchase, in which case they may make capital gains or losses dependent not on what the government pays on maturity but on what another investor is prepared to pay. This, in turn, depends on general economic conditions - in particular, projected general inflation over the life of the gilt: investors will not buy a gilt offering a 5 per cent redemption yield over 5 years if future inflation is expected to be 7% per year for that period. Interest rates (particularly for longer-term gilts) are thus strongly influenced by market perceptions of future inflation, which can shift significantly over a year or so, hence the high annual gains or losses in the secondary gilt market.

Gilt prices and redemption yields move in opposite directions. Take the case of our five-year gilt offering a coupon of 10 per cent with a redemption yield of 5 per cent. If general interest rates rise to 6 per cent because of an increase in inflation expectations, investors will no longer be interested in buying this gilt for US$120, because at this price it yields only 5 per cent. Demand will fall, resulting in a price reduction until the bond yields 6 per cent. A rise in yield goes hand in hand with a fall in price.