4 Types of Debt Yields

Determining investment yields for most securities is a straightforward exercise. But, this can be more complicated for debt instruments because short-term debt markets have various ways of calculating yields and they use different conventions in converting a period into a year.

There are four main types of yields that you can use to help you out. They are the bank discount yield (also called bank discount basis), the holding period yield, the effective annual yield, and the money market yield. Understanding how each of these yields is calculated is essential to grasping an investment’s actual return on an instrument.

Key Takeaways

• Debt yields help investors determine the overall rate of return for a fixed-income security held until maturity.
• The bank discount yield is a pure bank discount basis.
• Using the holding period yield assumes that any interest or disbursements are paid at maturity.
• Investors can use the effective annual yield to account for compound interest, which makes it a more accurate yield.
• The money market yield allows the quoted yield to be compared to an interest-bearing money market instrument.

Understanding Debt Yields

As an investor, you may have heard the term debt yield. It is commonly used to describe the total rate of return you can expect on a debt instrument held until its maturity date. It typically denotes the return on instruments like fixed-income securities, such as government securities (bonds, T-bills, and others), and corporate bonds among others.

In many cases, the term debt yield is synonymous with bond yields. Both account for interest or coupon payments as well as any fluctuations in the price of the debt instrument until it matures.

Important

Debt yields are commonly used in commercial real estate. This metric helps lenders determine the risk of a loan and how much they can expect to earn on that debt.

1. Bank Discount Yield

Treasury bills (T-Bills) are quoted on a pure bank discount basis where the quote is presented as a percentage of face value and is determined by discounting the bond using a 360-day-count convention. This assumes there are 12 30-day months in a year.

In this situation, the formula for calculating the yield is simply the discount divided by the face value multiplied by 360 and then divided by the number of days remaining to maturity. The equation would be:

​Annualized Bank Discount Yield=(FD​)×(t360​)where:D=DiscountF=Face valuet=Number of days until maturity​

​For example, let’s say Joe purchases a T-Bill with a face value of $100,000 and pays $97,000 for it—representing a $3,000 discount. The maturity date is in 279 days. The bank discount yield would be 3.9%, calculated as follows:

​0.03(3,000÷100,000)×1.29(360÷279)=0.0387,or 3.9% (Rounding Up)​

But, there are problems inherent in using this annualized yield to determine returns. For one thing, this yield uses a 360-day year to calculate the return an investor would receive. But this doesn’t take into account the potential for compounded returns. The remaining three popular yield calculations arguably provide better representations of investors’ returns.

2. Holding Period Yield (HPY)

By definition, the holding period yield (HPY) is solely calculated on a holding period basis, therefore there is no need to include the number of days—as one would do with the bank discount yield. In this case, you take the increase in value from what you paid, add on any interest or dividend payments, and then divide it by the purchase price.

This unannualized return differs from most return calculations that show annualized returns. It is also assumed that the interest or cash disbursement will be paid at the time of maturity. As an equation, the HPY would be expressed as:

​Holding Period Yield=P1​−P0​+P0​D1​​where:P1​=Amount received at maturityP0​=Purchase price of the investmentD1​=Interest received or distribution paid at maturity​

3. Effective Annual Yield

The effective annual yield can give a more accurate yield, especially when alternative investments are available which can compound the returns. This accounts for interest earned on interest. As an equation, the effective annual yield would be expressed as:

​Effective Annual Yield=(1+HPY)365t1​where:HPY=Holding period yieldt=Number of days held until maturity​

For example, if the HPY was 3.87% over 279 days, then the EAY would be 5.09% or 1.0387^365÷279 – 1.

The compounding frequency that applies to the investment is extremely important and can significantly alter your result. The calculation still works for periods longer than a year and will give a smaller, absolute number than the HPY. For example, if the HPY was 3.87% over 579 days, then the EAY would be 2.42% or 1.0387^365÷579 – 1.

Decrease In Value

For losses, the process is the same. As such, the loss over the holding period would need to be made into the effective annual yield. You still take one plus the HPY, which is now a negative number. For example: 1 + (-0.5) = 0.95. If the HPY was a loss of 5% over 180 days, then the EAY would be 0.95^365÷180 -1, or -9.88%.

4. Money Market Yield (MMY)

The money market yield (MMY) relies on a calculation allowing the quoted yield (which is on a T-Bill) to be compared to an interest-bearing money market instrument. These investments have shorter-term durations and are often classified as cash equivalents. Money market instruments quote on a 360-day basis, so the money market yield also uses 360 in its calculation.

As an equation, the MMY, which is also known as the CD-equivalent yield, would be expressed as:

​MMY=TIME TO MATURITYHPY×360​where:HPY=Holding Period Yield​

How Do Debt Yields Work in Fixed-Income Securities?

Debt yields help investors determine how much they can expect to earn from a fixed-income security. This includes corporate bonds and government-issued securities like bonds and T-bills. Also known as a bond yield, it calculates the annual rate of return until the bond is cashed in on the maturity date. This calculation considers the bond’s current market price so when the price goes up, the yield drops. Conversely, if the price drops, the debt yield moves in the opposite direction.

Is a Bond’s Debt Yield the Same as an Interest Rate?

A bond’s debt yield and interest rate are not the same thing. The debt yield is the overall rate of return that the bond pays until it is held until maturity. This includes any interest or coupon payments. A bond’s interest rate (also known as the coupon rate), on the other hand, refers to the fixed interest percentage of a bond’s face value paid to the bondholder. Debt yields can change because they factor in the bond’s price. A bond’s interest rate, though, remains the same even if the bond’s price fluctuates.

Why Are Bond Yields Important?

Bond yields are important because they give an investor an idea of how much they can expect to earn on a bond. These yields allow investors to compare different bonds to find the best possible return for their portfolio.

The Bottom Line

The debt market uses several calculations to determine the yield. Once the best way is decided, the yields from these short-term debt markets can be used when discounting cash flows and calculating the real return of debt instruments, like T-Bills. As with any investment, the return on the short-term debt should reflect the risk, where lower risk ties to lower returns and the higher-risk instruments usher in potentially higher returns.