What Is the Bond Equivalent Yield?
In financial terms, the bond equivalent yield (BEY) is a metric that lets investors calculate the annual percentage yield for fixed-come securities, even if they are discounted short-term plays that only pay out on a monthly, quarterly, or semi-annual basis.
However, by having BEY figures at their fingertips, investors can compare the performance of these investments with those of traditional fixed income securities that last a year or more and produce annual yields. This empowers investors to make more informed choices when constructing their overall fixed-income portfolios.
Bond equivalent yield (BEY) is a rate that helps an investor determine the annual yield of a bond (or any other fixed-income security), that does not provide an annual payout. In other words, bond equivalent yield helps an investor find an “equivalent yield” between two or more bonds. It helps an investor to annualize the returns of monthly, quarterly, semi-annual, or such other discount bonds to facilitate an apples-to-apples comparison.
Bonds and other such fixed-income securities offer periodic interest payments to investors. These interest payments otherwise referred to as coupon payments, provide a steady stream of income for bond investors.
But there are some types of bonds that pay little or no interest at all to investors. Instead, these bonds are offered to investors at a very deep discount to their par value (face value). Those deep discount bonds that do not offer any interest at all are called zero-coupon bonds since their coupon payment is nil.
In such cases, the investor returns will be the difference between the purchase price of the deep discount or zero-coupon bond and its maturity value. BEY is primarily used to calculate the value of such deep discount or zero-coupon bonds on an annualized basis.
Understanding Bond Equivalent Yield
To truly understand how the bond equivalent yield formula works, it’s important to know the basics of bonds in general and to grasp how bonds differ from stocks.
Companies looking to raise capital may either issue stocks (equities) or bonds (fixed income). Equities, which are distributed to investors in the form of common shares, have the potential to earn higher returns than bonds, but they also carry greater risk. Specifically, if a company files for bankruptcy and subsequently liquidates its assets, its bondholders are first in line to collect any cash. Only if there are assets left over do shareholders see any money.
But even if a company remains solvent, its earnings may nonetheless fall short of expectations. This could depress share prices and cause losses to stockholders. But that same company is legally obligated to pay back its debt to bondholders, regardless of how profitable it may or may not be.
Not all bonds are the same. Most bonds pay investors annual or semi-annual interest payments. But some bonds, referred to as zero-coupon bonds, do not pay interest at all. Instead, they are issued at a deep discount to par, and investors collect returns when the bond matures. To compare the return on discounted fixed income securities with the returns on traditional bonds, analysts rely on the bond equivalent yield formula.
Bond Equivalent Yield Formula
Bond Equivalent Yield = ((Face Value−Purchase Price) ÷ Purchase Price) × (365 ÷ d)
- d = days to maturity
The face value (also known as the par value) of the bond is essentially the price that will be paid to the investor on maturity of the bond. This will usually be stated on the bond offering.
Also note that, if the bond is a coupon paying bond, the par value will be the basis for calculating the coupon payments.
The purchase price of the bond is, as the name indicates, the price the investor paid for acquiring the bond. This price will be lesser than the par value in the case of a deep discount or zero-coupon bond.
The number of days until maturity of the bond (d) is essentially is the date on which the par value of the bond will be paid to the investor and is also clearly stated in the bond offering
The BEY formula comprises of two parts. The first part calculates the return on investment:
(Face Value−Purchase Price) ÷ Purchase Price
The second part annualizes the return calculated in the first part:
365 ÷ d
Bond Equivalent Yields Explained
The equivalent bond yield is a formula that allows investors to compare the yield of any short-term securities they have purchased at a discount to a bond that has an annual yield.
This can be used for bonds that pay on a semi-annual, monthly, or quarterly basis.
Having this metric available can help investors to make better decisions as to what investments they should choose for their portfolio.
In order to adequately understand how to use the BEY formula, you’ll need to understand some basic information about bonds and how they are different from stocks.
When a company wants to raise some capital, it can choose to issue stock, which is equity in the company, or bonds, which are a type of fixed income.
When an investor has equity in a company, they have the potential for a greater return on the company than they would receive from bonds.
However, they are also taking on increased risk.
The risk is higher for stock because should the company declare bankruptcy and its assets are liquidated, bondholders will be paid first.
Stockholders are the last to receive money and have a good chance of receiving little or nothing.
Even if the company does not go bankrupt, it may suffer a loss of revenue, causing stock prices to decline, resulting in a loss for stockholders.
However, no matter how a company performs, it is still required to pay bondholders.
Though bonds possess a far greater level of security when compared with equities, there are several types of bonds with different properties.
The majority of bonds provide investors with semi-annual or annual interest payments.
However, zero-coupon bonds do not offer interest at all. Investors will instead purchase these bonds at a significant discount beneath the par value and receive returns when the bond has matured.
In order to compare the returns on these zero-coupon bonds with traditional bonds that provide an annual interest payment, an investor must use the BEY formula, which annualizes the return.
For an example of the BEY formula in use, suppose that an investor purchases a $2,000 zero-coupon bond, which they pay $1,700 for.
The investor is expecting to be paid the par value for the bond in six months.
This means the investor will make a $300 profit.
$2,000 – $1,700 = $300
To calculate the return on investment, you need to divide the $300 profit by the $1,700 that was paid for the bond, which will show a return on investment of 17.6%.
Then, you annualize the 17.6%.
To do this, multiply 17.6% by 365 divided by the number of days remaining until the bond matures.
For six months, this would be 2.
Therefore, the BEY would be 17.6% x 2, which would be 35.2%.
When calculating BEY for an investment the below points are worth bearing in mind as a quick recap of what it is, why it’s used, and how to use it:
- Bond Equivalent Yield helps investors find the equivalent yield between two or more bonds
- BEY is primarily used to calculate the value of deep discount or zero-coupon bonds on an annualized basis
- Calculation of BEY involves three factors – par value or fair value of the bond, purchase price of the bond and the time to maturity
- BEY ignores the effect of compounding and therefore might not provide a true and fair picture in certain situations.