Interest rates and yields can be confusing. A rate, whether it
comes from a bank on a certificate of deposit or from a bond, is simply
the rate of interest paid annually on a security. The yield is generally
something that you run into when investing in bonds, because it
accounts for the purchase price you paid for the bond and the maturity
of that bond. For most purposes, the current yields on a bond and a bank
certificate of deposit are comparable. Yield to maturity, however, is a
way of comparing the total returns on bonds held to maturity, and it
doesn't apply to CDs.
Rates
A rate on an investment, whether it is a CD or a bond, is the
amount of interest that will be paid each year. If your interest rate is
2 percent, you will receive $20 each year on every $1,000 invested. In a
bond, the interest rate is the coupon -- the percentage listed in the
bond description, such as U.S. Treasury 2 3/4 percent bonds due Nov. 15,
2042, which pay $27.50 each year per $1,000 face value bond. It doesn't
matter whether you pay more or less than $1,000 for that bond -- you
will still receive $27.50 each year per bond, because that is the rate
of interest assigned when that bond was issued.
Yields
Yields are a bit more complex. The two most common types of yields
are current yield and yield to maturity. Current yield is the amount of
interest you receive each year divided by the amount you paid for the
CD or bond. For example, if you paid $1,000 for a security with an
interest rate of 2 3/4 percent, and you are receiving $27.50 in interest
payments, your current yield is 2 3/4 percent. However, if you only
paid $900 for your bond, you are still receiving $27.50, but your
current yield is $27.50 divided by $900 or 3.05 percent.
Yield to Maturity
Yield to maturity is a complex formula that takes into account the
length of time until maturity and an assumed reinvestment rate on the
interest received. The best way to find yield to maturity is using an
online bond calculator. For example, if you had bought the above
Treasury bond on Dec. 17, 2012, at a price of $966.80, your yield to
maturity would be 2.917 percent, according to the figures from the U.S.
Treasury auction for that date.
Prices
If you pay a higher price than par -- which is the face value, or
$1,000 -- your current yield and your yield to maturity will be lower
than your interest rate. If you pay a lower price, your yields will be
higher than the interest rate.
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