So what’s the yield? Well, the “7%” coupon income comes as two semi-annual payments of £3.50 in April and October for a total of £7. So you might say that the yield is £7 ÷ £105.90 or 6.61%. That is the flat yield.
But what this fails to account for is that the price of £105.90 will deteriorate over time to £100 at maturity in October 2017. We are in August 2015 at the time of writing, so the bond has got 2.2 years to run. The bond will thus lose value at a rate of £5.90 ÷ 2.2 years, which is £2.68 per annum, 2.53% per annum.
So if you add the flat yield of 6.61% and the capital loss yield 2.53% that gives you a net yield of 4.08%. For some reason this is called the Japanese yield and it is clearly a better indicator of what you can expect to earn on a net basis as an investor.
You can then go one step further and work out what discount rate will give you the current market price at the net present value of the cashflows from the bond.
In plain English, let’s take that one step at a time: discount rates tell you what money in the future is worth today. The bond’s cashflows are all the semi-annual coupon payments of £3.50, together with the final capital redemption value of £100.
This is called the Gross Redemption Yield and is just a bit more accurate than the Japanese yield. And in this case, with the aid of a spreadsheet, it works out at 3.99%.
