To invest in fixed income securities, including bonds and certificates of deposit, an investor should understand the terms yield and interest rates.
Yield is the dollar amount an investor earns from an investment, such as interest and dividends, during a certain time. In contrast, an interest rate is a percentage of a loan’s principal that a borrower pays to a lender.
The interest rate is the return an investor earns from debt instruments, such as certificates of deposits and bonds. As such, the interest rate on a debt is incorporated in a debt instrument’s yield.
Read more: Bond Interest Yields vs. Stock Dividend Yields
Difference Between Yield and Interest Rate
What is the difference between yield and interest rate? The return an investor earns for investing in stocks, bonds or another security is the security’s yield. Typically, a security’s yield is stated as an annual figure.
In the case of debt instruments, such as bond types, the security’s yield consists of a series of interest payments referred to as the coupon. In contrast, the yield for stock consists of the dividends that are paid to a shareholder.
The shareholder dividends represent a share of a company’s quarterly profit, rather than a profit earned on the sale of a company’s shares.
Example of Stock Yield
Assume that a company pays a quarterly dividend of 75 cents and that its stock price is $75. In this case, the company’s annual dividend is 4 percent. If, however, the company’s stock price doubles, but the dividend remains the same, the yield equals 2 percent.
Example of Bond Yield
A bond’s yield is termed yield-to-maturity, or YTM. The YTM equals the return a bondholder will receive after the bond matures. The basis of that yield is the interest rate the bond issuer agrees to pay.
Read more: How to Calculate Earnings Yield
Loan Interest Rates
A loan’s interest rate is the rate a lender receives on an annual basis until a loan is repaid. When it relates to consumer lending, the interest rate is expressed as the loan’s annual percentage rate (APR).
For instance, assume a bank grants a one-year loan of $1,000, for which the bank will earn 10 percent simple interest. In this case, the borrower repays the $1,000 principal as well as the $100 in interest on the principal borrowed.
If a lender charges the borrower a compounded interest rate, that interest is calculated on the sum of the loan’s outstanding principal plus the interest that has accumulated up to the date the interest is compounded.
Debt Security Interest Rate
Like the individual consumer, an organization pays interest on the debt securities it issues. In this case, an organization issues bonds, which are purchased by investors. In doing so, the investor assumes the role of a lender.
The interest that the investor is paid is referred to as a coupon rate. The interest rate paid is based on the principal amount of the debt instrument. The interest is paid periodically.
A security’s coupon rate might be real, nominal or effective, so the income an investor receives by holding a fixed income security will vary. A nominal rate, in particular, is a loan’s or a bond’s quoted rate. The amount paid is determined in part by the principal the borrower receives.
On the other hand, a real interest rate is based on a nominal interest rate. For instance, if a nominal interest rate is 6 percent, but the inflation rate is 3 percent, the real interest rate equals 6 percent minus 3 percent, or 3 percent. This figure alerts the investor to the actual return she will earn when she invests in a particular fixed-income debt security.
In contrast, the effective interest rate is a compounded interest rate. If a borrower pays a compounded interest rate, the interest will be compounded frequently and the interest rate is likely to be higher than a simple or nominal rate.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.