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.
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.
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.
- 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.
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.
A Closer Look at the Bond Equivalent Yield Formula
The bond equivalent yield formula is calculated by dividing the difference between the face value of the bond and the purchase price of the bond, by the price of the bond. That answer is then multiplied by 365 divided by "d," which represents the number of days left until the bond's maturity. In other words, the first part of the equation is the standard return formula used to calculate traditional bond yields, while the second part of the formula annualizes the first part, to determine the equivalent figure for discounted bonds.
Although calculating the bond equivalent yield can be complicated, most modern spreadsheets contain built-in BEY calculators that can simplify the process.
Still confused? Consider the following example.
Assume an investor buys a $1,000 zero-coupon bond for $900 and expects to be paid par value in six months. In this case, the investor would pocket $100. To determine BEY, we take the bond's face value (par) and subtract the actual price paid for the bond:
- $1,000 - $900 = $100
We then divide $100 by $900 to obtain the return on investment, which is 11%. The second portion of the formula annualizes 11% by multiplying it by 365 divided by the number of days until the bond matures, which is half of 365. The bond equivalent yield is thus 11% multiplied by two, which comes out to 22%.
