What Is Yield Basis?

What Is Yield Basis?

I'm here to explain yield basis directly to you—it's a method of quoting the price of a fixed-income security as a yield percentage, not as a dollar value. This approach lets you easily compare bonds with different characteristics. You calculate the yield basis by dividing the annual coupon amount by the bond's purchase price.

Key Takeaways

Let me break down the essentials for you. The yield basis quotes fixed-income securities like bonds as a yield percentage rather than a dollar amount, making it straightforward for you as a bond buyer to compare various bonds' characteristics before purchasing. This yield quote informs you whether the bond is trading at a discount or premium relative to others. When you buy a bond on a net yield basis, that yield incorporates the broker's profit or markup for handling the trade.

Understanding Yield Basis

Unlike stocks quoted in dollars, most bonds are quoted on a yield basis, and I'll walk you through an example. Suppose a company bond has a 6.75% coupon rate and matures in 10 years from issuance, with a $1,000 par value trading at $940.

You calculate the yield basis using the current yield formula: Coupon divided by Purchase Price. In this case, the annual coupon is 6.75% of $1,000, which is $67.50. So, $67.50 divided by $940 equals 0.0718, or 7.18%. That's how the bond gets quoted to you at a 7.18% yield basis.

This yield tells you the bond is trading at a discount since 7.18% exceeds the 6.75% coupon rate. If the yield basis were below the coupon rate, it'd mean the bond is at a premium, as a higher coupon boosts its market value. From there, you can compare it to other bonds in the same industry.

Bank Discount Yield

For pure discount instruments, you use the bank discount yield formula: r equals (Discount divided by Par Value) times (360 divided by t), where r is the annualized yield, Discount is Par Value minus purchase price, t is days to maturity, and 360 is the bank convention for a year.

This differs from current yield because it bases the discount on par value, not current price, and assumes simple interest without compounding. Treasury bills, for instance, are quoted solely on this basis.

Take a Treasury bill with $1,000 face value selling for $970, maturing in 180 days. The calculation is [($1,000 - $970)/$1,000] times (360/180), which is ($30/$1,000) times 2, equaling 0.06 or 6%. Since Treasury bills pay no coupon, you earn the discount amount if you hold it to maturity.

Special Considerations

When you're buying bonds, understand the difference between yield basis and net yield basis. On the secondary market, you might go through a broker who charges a flat commission, but sometimes they sell on a net yield basis instead.

Net yield includes the broker's profit in the yield itself—that's their markup, the difference between what they paid and what they sell to you. If a broker offers a bond at 3.75% yield to maturity on a net basis, their profit is built into your price, with no extra commission.

Always ask your broker if bonds are on a net yield basis or if there's a separate commission. They might add other fees, like for broker-assisted trades not done online. Your total cost could also include accrued interest from the last payment to settlement date.