Flat Yield vs Redemption Yield: Bond Yields for the CISI Exam

Bond yields are the calculation candidates dread most, and they should not. The flat yield is a one-line sum. The redemption yield you mostly need to understand rather than compute. And the relationship between the two, which is where the exam earns its marks, follows one simple rule once you see it. Here is the whole thing.

Flat yield: the one you calculate

The flat yield, also called the running yield or current yield, is the annual coupon as a percentage of the bond's current market price.

Flat yield = (annual coupon ÷ market price) × 100

The coupon is a percentage of the bond's nominal (face) value, usually £100, so work out the cash coupon first, then divide by the price you actually pay.

Worked example. A bond has a nominal value of £100, a coupon of 5%, and trades at £125. The cash coupon is 5% of £100 = £5. The flat yield is (5 ÷ 125) × 100 = 4%. Notice the flat yield (4%) is below the coupon rate (5%), because the bond is trading above its nominal value. Hold that thought, because it is the key to the whole topic.

Redemption yield: the one you understand

The flat yield ignores something important: if you hold the bond to maturity, you get the nominal value back, which may be more or less than you paid. The redemption yield, or gross redemption yield, also called the yield to maturity, folds that capital gain or loss into the return alongside the coupon. It is the total annual return if you hold the bond to redemption.

For the foundation paper you generally need to understand what the redemption yield captures and how it compares to the flat yield, rather than compute it by hand, since the full calculation is involved. What you must get right is the comparison.

The rule that ties them together

Here is the relationship the exam loves to test. It hinges on whether the bond trades above or below its nominal value.

Trading at a premium (price above nominal). You paid more than £100 and you only get £100 back, so there is a capital loss to maturity. That drags the total return down. The order is: redemption yield is below the flat yield, which is below the coupon rate. In our example: coupon 5%, flat yield 4%, and the redemption yield lower still.

Trading at a discount (price below nominal). You paid less than £100 and you get £100 back, so there is a capital gain to maturity, which lifts the total return. The order flips: coupon rate is below the flat yield, which is below the redemption yield.

Trading at par (price equals nominal). No capital gain or loss, so all three are equal: coupon, flat yield and redemption yield are the same.

Learn that as a single picture. Premium drags returns down so redemption yield is lowest; discount lifts them so redemption yield is highest; at par everything lines up. Get that and you can answer the comparison questions without touching a calculator.

Where people slip

The first trap is computing the coupon off the price instead of the nominal value. The coupon is always a percentage of nominal, usually £100, not of what you paid. Cash coupon first, then divide by price.

The second is muddling the order at a premium versus a discount. Do not memorise two lists; understand the one idea behind both. A capital loss to maturity pulls the redemption yield below the flat yield; a capital gain pushes it above. The direction follows from whether you overpaid or underpaid relative to what you get back.

Bonds are not the only calculation the CISI tests. Equities have the dividend yield, and both feature in the Securities exam and the Introduction to Securities & Investment.