What Is the Bond Equivalent Yield?
Let me explain the bond equivalent yield (BEY) directly: it's a metric you can use to calculate the annual percentage yield for fixed-income securities, even if they're short-term discounted ones that pay out on a monthly, quarterly, or semi-annual basis.
With BEY figures in hand, you can compare these investments' performance against traditional fixed-income securities that last a year or more and provide annual yields. This approach lets you make smarter choices for your overall fixed-income portfolio.
Understanding Bond Equivalent Yield
To grasp how the bond equivalent yield formula functions, you need to know the basics of bonds and how they differ from stocks.
Companies raise capital by issuing stocks (equities) or bonds (fixed income). Equities, distributed as common shares, can offer higher returns than bonds but come with greater risk. If a company goes bankrupt and liquidates assets, bondholders get paid first, and shareholders only collect if anything remains.
Even if a company stays solvent, its earnings might disappoint, hurting share prices and causing losses for stockholders. However, the company must legally repay bondholders regardless of profitability.
Not all bonds work the same way. Most pay annual or semi-annual interest, but zero-coupon bonds pay no interest—they're issued at a deep discount to par, and you collect returns at maturity. To compare discounted securities with traditional bonds, you rely on the bond equivalent yield formula.
Key Takeaways
- Fixed income securities come in different forms.
- Discounted (zero-coupon) bonds have shorter durations than traditional fixed income securities, which makes it impossible to calculate their annual yields directly.
- The bond equivalent yield (BEY) formula can help approximate what a discounted bond would pay annually, letting investors compare their returns with those of traditional bonds.
A Closer Look at the Bond Equivalent Yield Formula
The bond equivalent yield formula is straightforward: divide the difference between the bond's face value and its purchase price by the purchase price. Then multiply that result by 365 divided by the number of days until maturity, which I denote as 'd'.
The first part gives you the standard return, like for traditional bonds, and the second part annualizes it for discounted bonds.
Calculating BEY can seem complicated, but most modern spreadsheets have built-in calculators to handle it for you.
Bond Equivalent Yield Example
Consider this example to see it in action: suppose you buy a $1,000 zero-coupon bond for $900, expecting par value in six months. You'd pocket $100.
Subtract the purchase price from face value: $1,000 - $900 = $100. Divide by $900 to get 11% return. Annualize by multiplying 11% by 365 divided by 182 (half of 365), which equals two, resulting in a BEY of 22%.
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