What Bond Investors Need to Know About Yield
Investment and Asset Management
To evaluate bond performance, investors are told to compare yields. Yet definitions of “yield” aren’t always straightforward. This article defines several, including current yield, yield to maturity and yield to call. The right type of yield depends largely on whether the bond is callable or noncallable. A sidebar explains why investors trying to compare short- and long-term bonds should consider consulting the yield curve.
For most investors, bonds play an important role in a diversified portfolio. There are several types of bonds, including corporate bonds, municipal bonds and U.S. Treasuries. But although the relative risks and rewards vary, different bond types operate in substantially the same way. They pay investors a set amount of interest, typically on a semiannual schedule, and return the original principal at maturity. Along the way, the price of the bond fluctuates.
To evaluate the performance of bonds, investors often are told to compare yields — essentially, the expected return on individual securities. Yet this isn’t as straightforward as it sounds because there are a couple of definitions of “yield.” Let’s review these definitions and how they relate to your investments.
First off, it’s important not to confuse a bond’s current yield with its coupon rate. The coupon rate is the annual interest you receive as a percentage of a bond’s par (face) value. For example, if a $100 bond pays $5 of interest each year, its coupon rate is 5%.
Current yield represents a bond’s annual interest payments as a percentage of the price you paid for it. So if you buy a bond at face value, the current yield and coupon rate are the same. But if you buy a bond at a discount or premium, the two measures diverge. Say you purchase a $100 bond in the secondary market for $85. In that case, the current yield would be 5.9% ($5/$85).
Current yield has the advantage of simplicity and it reflects the amount of income a bond will generate each year. But it may not be the best gauge of your overall return. Current yield doesn’t reflect reinvestment of interest payments or the gain or loss you may realize upon return of principal. For instance, if you buy a $100 bond for $85, you’ll enjoy a $15 gain when you receive the full face value at maturity. Conversely, if you pay a premium for the bond, you’ll experience a loss.
Yield to maturity
If you wish to measure the performance of a bond over several years or compare its expected returns to other bonds, yield to maturity (YTM) can be valuable — particularly if you plan to hold the bond to maturity. YTM measures the annual return on your investment based not only on annual interest payments, but also on the eventual return of principal at maturity. Typically, a calculation assumes that interest payments will be reinvested at the calculated YTM rate. If interest rates change over the life of the bond, your actual rate of return will be different.
If you don’t expect to hold (or don’t have the opportunity to hold) a “callable” bond to maturity, YTM is less relevant. That’s because it’s difficult to predict how much you’ll receive for the bond, or when you’ll receive it.
Yield to call
A callable bond can be redeemed before it matures, on one or more “call dates.” Some bonds are redeemable at face value, while others may be redeemed at a premium. Another option is a scaled structure. Here, the bond is redeemable at a premium on the first call date and then the call price declines on each successive call date until it reaches face value.
Yield to call (YTC) typically provides the best method of measuring callable bonds. It’s calculated in the same way as YTM, except that YTC assumes that the bond will be called on the earliest possible date. If the bond isn’t called, or if it’s called on a later date, your actual return typically will be greater than the YTC. Issuers are likely to call a bond if they believe they can borrow funds at a lower rate than what they’re paying on the bond. So, the lower current interest rates, and the shorter the time until the earliest call date, the more relevant YTC becomes.
Which measure is best?
The “right” yield depends on the type of bond you hold. For noncallable bonds you expect to hold to maturity, YTM probably will provide the most useful information. For callable bonds, consider calculating their YTC. Finally, there’s the more conservative option: yield to worst. This simply means taking a bond’s YTM or YTC, whichever is lower, to estimate your lowest potential return.
Bonds are an important component of most balanced investment portfolios. But keep in mind that it’s possible to lose money investing in them. Talk to your financial advisor about selecting and evaluating bond investments.
Tracing the curve
If you’re trying to compare short- and long-term bonds, consider consulting the yield curve. This measure is a graph that shows the relationship between bond yields and the length of time until maturity. Generally speaking, the longer the time frame, the greater the risk for the investor and, therefore, the higher the yield.
Typically, a steep yield curve means investors are concerned about tying up their funds in long-term bonds (for example, because they believe interest rates will rise), so they demand a greater yield. Occasionally, the yield curve is flat or even inverted — that is, short-term yields are the same or higher than long-term yields. Some experts believe that this situation signals an economic downturn or recession. However, an inverted yield curve doesn’t necessarily mean you should avoid long-term bonds.
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