When it comes to bond investing, you need to know about the two types of yields: the yield to maturity and the current yield. They absolutely affect how much your bonds are worth on the open market.

One of the most (if not the most) important factors in determining bond yields, and therefore bond prices, is the prevailing interest rate. Essentially, the stated interest rate on your bond will be compared to the current interest rate for equivalent debt instruments. Whether this is higher or lower makes a big difference in the amount for which you could sell that bond.

Current Yield

Current yield is the interest (expressed as a percentage) based on the amount you paid for the bond (rather than on its face value). A $2,000 bond bought at par value (at $2,000) receiving 6 percent interest would earn a current yield of 6 percent. The current yield will differ if you buy the bond at a price that is higher or lower than par. For example, if you bought a $2,000 bond with a rate of 6 percent for $1,800, you have paid less than par and bought the bond at a discount. Your yield would be higher than the straight interest rate: 6.67 percent instead of the stated 6 percent. To calculate that yield, multiply the $2,000 face value by .06 (the stated interest rate), and you get $120 (the annual interest payment). Now divide that by $1,800 (the amount you paid for the bond) to get .0667 or 6.67 percent current yield.

Yield to Maturity

Generally considered the more meaningful number, yield to maturity is the total amount earned on the bond from the time you buy it until it reaches maturity (assuming that you hold it to maturity). This includes interest over the life of the bond, plus any gain or loss you may incur based on whether you purchased the bond above or below par, excluding taxes. Taking the term of the bond, the cost at which you purchased it, and the yield into account, your broker will be able to calculate the yield to maturity. (You need a computer to do this; the math is extremely complicated.) Usually this calculation factors in the coupons or interest payments being reinvested at the same rate.

Knowing the yield to maturity makes it easier to compare various bonds. Unlike stocks, which are simply bought at a specific price per share, various factors will come into play when buying a bond, including term of maturity, rate of interest, price you paid for the bond, and so on. The idea here is to determine how well the bond will perform for you.

Importance of Interest Rates to Yield

Interest rates vary based on a number of factors, including the inflation rate, exchange rates, economic conditions, supply and demand of credit, actions of the Federal Reserve, and the activity of the bond market itself. As interest rates move up and down, bond prices adjust in the opposite direction; this causes the yield to fall in line with the new prevailing interest rate. By affecting bond yields via trading, the bond market thus impacts the current market interest rate.

The simplest rule of thumb to remember when dealing in the bond market is that bond prices will react the opposite way to interest rates. Lower interest rates mean higher bond prices, and higher interest rates mean lower bond prices. Here's why: Your bond paying 8 percent is in demand when interest rates drop and other bonds are paying 6 percent. However, when interest rates rise and new bonds are paying 10 percent, suddenly your 8 percent bond will be less valuable and harder to sell.

The Yield Curve

The relationship between short-term and long-term interest rates is depicted by the yield curve, a graph that illustrates the connection between bond yields and time to maturity. The yield curve allows you to compare prices among bonds with differing features (different coupon rates, different maturities, even different credit ratings). Most of the time, the yield curve looks normal (or “steep”), meaning it curves upward — short-term bonds have lower interest rates, and the rate climbs steadily as the time to maturity lengthens. Occasionally, though, the yield curve is flat or inverted. A flat yield curve, where rates are similar across the board, typically signals an impending slowdown in the economy. Short-term rates increase as long-term rates fall, equalizing the two. When short-term rates are higher than long-term rates (which can signal a recession on the horizon), you get an inverted yield curve, the opposite of the normal curve.