Understanding Bond Yields
By Bill Addiss
Updated: August 28, 2019
How do Bond Yields Work
Bond yield refers to the return an investor receives on a bond. Since bond yield can be calculated in different ways, without a good knowledge of bond yields and the terminology used to describe them, an investor does not have the necessary information needed to choose wisely from among the thousands of bond mutual funds, ETFs, closed end funds, and countless individual bonds available.
A recent Wall Street Journal article by Jason Zweig, from his aptly named Intelligent Investor column, called attention to the the topic of bond yields.
A Wall Street Journal article by Jason Zweig, from his aptly named Intelligent Investor column, called attention to the topic of bond yields.
“Overstating the expected income on… bonds in brokerage or advisory accounts is one of the most pervasive and persistent ways the financial industry fools the investing public,” said Jason Zweig on misleading expected bond yield information.
Here we will explain the different bond yield measurements used, and the distinctions between what they measure.
What is Coupon Yield?
Also referred to as Nominal Yield, coupon yield refers to the annual coupon income (interest income) you are receiving on a bond. This simply states the annual income you are going to receive per bond. For example, a bond with a 6% coupon means you are receiving $60 annually per $1000 bond. Although the coupon is quoted as annual income, it is traditionally paid in semi-annual installments.
What is Current Yield, (CY)?
Also called Cash Flow Yield, current yield indicates the income you are receiving on your bond, factoring in the price you paid to buy the bond. The formula for determining the current yield of a bond is:
Bond Coupon (%)
Current Yield = --------------------------------
Price of the Bond (% of par)
Remember, the coupon tells you what interest rate the issuer is paying on each $1000 bond to the investor. By dividing that by the price you actually paid for the bond, you are determining the rate of income you are receiving on your invested dollars.
For example, a 6% coupon bond trading at a dollar price of $800 (or 80% of its par value), would give you a current yield of 7.5% (6/.80).
What is Yield To Maturity (YTM)?
Yield to Maturity is a bit more of a complicated concept, but very important to understand. The yield to maturity is the rate of return taking into account a number of different variables. Mathematically, we incorporate the following factors in determining the YTM:
- The coupon of the bond (the cash flow coming off the investment)
- The maturity of the bond, and the fact that at maturity you receive the par value ($1000), irrespective of the price you actually paid
- A compounded rate of return on the income received
Remember, the coupon of the bond is the income you earn on each bond, irrespective of the price. To explain maturity of the bond further, in the current yield illustration used above, you only paid $800 for the bond (and are earning a CY of 7.5%). However, the fact that the bond is going to mature at a value of $1000 increases your actual rate of return over that 7.5% because you bought the bond at a discount. That appreciation between the price you paid and the maturity value will increase your total return. This increase in value has to be amortized over the life of the bond. For this computation, we always assume that you will be holding the bond to maturity.
When calculating compounding rate of return, the YTM formula assumes that your income will be compounded over time. Without getting into the algebraic calculations, it’s important (and a bit confusing) to understand that the YTM formula assumes that you are compounding your interest at the YTM rate. In the real world, we don’t actually know what your reinvestment rate is going to be and is called reinvestment risk therefore, the YTM does not compute what your actual rate of return will be. It should simply be used as standard to compare bonds and offer an estimate of what your return might be.
What is Yield to Call (YTC)?
Yield to Call refers to the process of bond retirement before maturity. Most corporate and municipal bonds have an embedded call feature to the bond. A call feature permits the issuer of the bond to retire the bond prior to its maturity, based on a pre-determined schedule, at a pre-determined price (usually above par). The Yield to Call (YTC) says what the yield is to the investor should the issuer call the bond before its actual maturity. An issuer is most likely to call a bond if it is paying a high interest rate. Enacting the call feature allows them to retire that high interest debt, replacing it with lower coupon debt.
What is Yield to Worst (YTW)?
Yield to Worst simply compares the yield to maturity, assuming the bond is permitted to mature, to the yield the investor will earn if the issuer does in fact call the bond. Whichever is the lower of these two yields is called the Yield to Worst, or perhaps better described, the worst possible return (lowest yield) alternative to the investor.
As this article highlights, there are a variety of yields to understand when looking at bonds, bond funds, bond ETFs or other fixed income investments like Certificates of Deposits. By far, the most commonly used yield when describing a bond is the YTM. This is the yield most often quoted in the media, in financial news, in marketing brochures and research publications when talking about the return on a bond.
For investors looking to invest in bonds, a bond fund's current yield is necessary but insufficient information to make a good judgment about the investment's expected return. The YTW for high coupon callable bonds and YTM for low coupon bonds more accurately measure expected return for bonds and bond funds. To reiterate though, whereas the YTM does not assure what the bond will actually return to the investor, for reasons highlighted above it is used as the most important metric to value, compare or discuss bonds.
To avoid being lured into an inadequately yielding investment by attractive interest rate and/or credit risk, be mindful when large gaps exist between current yield and YTW / YTM. A large gap between the current yield, e.g., 4%, and YTW or YTM, of e.g., 2% may indicate an excessive spread and / or mark-up is being charged for the bond or even that a bond fund's dividend is at risk of being cut.
Finally, it is not necessarily a bad thing if a bond or fund's YTW or YTM is materially below the current yield when the case applies to an investor that already had bought that bond or fund before bond prices rose / interest rates fell. Today's YTW and YTM are based on the market price of the investment today and these measures apply to new investors buying the asset today. A seasoned investor's YTW or YTM on the investment in question is that which existed at his or her purchase date.
About the Author
As the principal of an international training firm, Mr. Addiss develops and facilitates educational programs for major financial institutions and governments.