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Many new investors are surprised to learn that a bond's price and yield, just like that of any other publicly-traded security, change on a daily basis. Strange for an investment with a fixed face value, interest rate and maturity, isn't it? That's because bonds can be sold before maturity in the open market, where the price can fluctuate.

Measuring return with yield

Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated by the following formula:

yield = coupon amount/price. When the price changes, so does the yield.

Here's an example: Let's say you buy a bond at its $1,000 par value with a 10% coupon.

If you hold on to it, it's simple. The issuer pays you $100 a year for 10 years, and then pays you back the $1,000 on the scheduled date. The yield is therefore 10% ($100/$1000).

If, however, you decide to sell it on the market, you won't get $1,000. Why? Because bond prices change on a daily basis of prevailing interest rates.

If the price of the bond in the market is $800, it's selling under face value or at a discount. If the price of the bond in the market is $1,200, it's selling above face value, or at a premium.

Regardless of the market price of a bond, the coupon remains the same. In our example, the bond holder continues to receive $100 a year.

What changes is the bond yield. If you sell it for $800, the yield will be 12.5% ($100/$800). If you sell it for $1,200, the yield will be 8.33% ($100/$1,200).

Yield to maturity

Of course, in real life, things tend to be more complicated. When bond investors refer to yield, they're usually referring to yield to maturity (YTM). YTM is the sum of:

• all the interest payments you'll receive (and assumes that you'll reinvest the interest payment at the same rate as the current yield on the bond)
• any gain (if you purchased at a discount) or loss (if you purchased at a premium)

YTM is a yield calculation that enables you to compare bonds with different maturities and coupons.

The link between price and yield

The yield's relationship with price can be summarized as follows: When price goes up, yield goes down and vice versa. Technically you'd say the bond's prices and its yield are inversely related.

Here's a main point of confusion. How can high yields and high prices both be good when they can't happen at the same time?