Bond yields will differ, depending on several factors

Q. I bought a bond from my financial adviser for the first time. He told me I would get 2.1 percent, but it says it’s paying 4.875 percent. Did he make a mistake?

A. This is a common point of confusion, especially for new investors. You need to know that all bonds have three yields. In general, here’s what they are and how they work.

When a bond is issued, it is given a legal description. The “nominal yield” or “coupon rate” is the stated percent of annual interest that a bond will pay per $1,000 of face or “par” value. For example, an “XYZ Corporation Bond 5 percent” due Feb. 1, 2020, will pay $50 per $1,000 annually until maturity. So, if you buy a $10,000 bond, you’ll receive $500 annually. The nominal yield never changes.

Once a bond is issued, it’s free to trade in the open market. And it can fluctuate up or down in fair market value, based on the changes in interest rates and other factors. This is where it’s especially important to understand “current yield” and “yield-to-maturity.”

Current yield is the annual income that a bond pays divided by its current price. It changes as a bond fluctuates in value. Let’s consider our XYZ Corporation bond in three situations:

•If prevailing rates are 5 percent and our bond is selling at 100 percent of par, the current yield will be 5 percent ($50 divided by $1,000). This is a par bond.

•If prevailing rates are 7 percent and our bond is selling at 80 percent of par, the current yield will be 6.25 percent ($50 divided by $800). This is a discount bond.

•If prevailing rates are 3 percent and our bond is selling at 120 percent of par, the current yield will be 4.17 percent ($50 divided by $1,200). This is a premium bond.

Yield-to-maturity is the expected return on a bond if it is held to maturity. This is a more complicated calculation because it takes into account the annual income and the average annual capital gain or loss that would be realized at maturity. But this is truly the bottom line in terms of bond yields.

The nominal yield, current yield and yield-to-maturity will be the same if you buy a bond at par and hold it until maturity. Otherwise, they will all be different. In the case of a discount bond, the yield-to-maturity will be the highest of the three yields. For a premium bond, it will be the lowest.

Fair and ethical business practices require financial advisers to quote bonds to their customers using yield-to-maturity, subject to one exception. Sometimes, an issuer reserves the right to call a bond for early redemption. In this case, financial advisers must quote bonds using yield-to-maturity or yield-to-call, whichever results in the worst yield to the customer. And it appears this is what your financial adviser has done.

Planning tip: To get more information about investing in bonds, go to finra.org and select Investors/Smart Investing/Choosing Investments/Bonds.