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Understanding Bond and Preferred Stock Yields

Russ Allen
Instructor

We have written often about bonds and, also about preferred stocks as conservative income-generating investments. Many investors will want to have some money committed to either or both of these vehicles.

When considering any fixed-income type investment, of course one of the main considerations is the return expected from it. The net returns on these investments come primarily from the cash flow in the form of interest (on bonds) or dividends (on preferred stocks). But this is not the only component of the return, and sometimes not even the most important one.

This is true because the income on fixed-income investments is, well, fixed – but the price of the instrument is not.

The prices of preferred stocks and bonds fluctuate, primarily in response to changes in the interest-rate environment. An older bond that pays 8% in an environment where competitive newly-issued bonds pay only 5%, is paying $30 per year per thousand-dollar bond more than its peers. That older bond will be valued more highly. It will be quoted at a premium to its face value.

How to figure yield on bonds and preferred stocks.

Most often as individual investors we will not be buying bonds or preferred stocks directly from the issuers. We will be buying them through stockbrokers in what is called the secondary market. The bonds and preferreds that we buy will have been issued some time ago, maybe many years ago, when interest rates were much different. The prices that we pay today will seldom be equal to the original face amount.

Because of this, there are actually four different measures of yield that we must understand. Fortunately, it’s not difficult. The four measures are:

  • Free Trading WorkshopCoupon Rate
  • Current Yield
  • Yield to Maturity
  • Yield to Worst

Here is a simple example, from a broker’s bond listing:

Corporate Office Properties 5.25% bonds due 2/15/2024. Callable on or after 11/1/2023.

Issue Maturity Coupon Bid/Ask Current Yield Yield to Worst Yield to Maturity
Corporate Office Pptys L P Callable 11/23 2/15/2024 104.956
5.25 106.763 4.917 3.897 3.946

Here are the explanations of the elements of this quote:

Coupon Rate

The Coupon Rate on these bonds is 5.25%. That means each $1,000 face-amount bond will pay $52.50 per year in interest. That does not mean that your yield is 5.25%, since you would probably not pay the exact $1,000 face amount for the bond.

Current Yield

The Current Yield is cash received per year / price paid for the bond. In this case $52.50 / $1067.63 = 4.917%. This is your annual cash-on-cash yield. This is closer to your real yield, but not quite there yet.

Yield to Maturity

When the bond matures in 70 months, on February 15, 2024, the bondholder will be paid the face amount of $1,000. This will be a drop of $67.63 per bond, or 6.763% from the original price of $1067.63. Amortizing this loss over the 70-month remaining life of the bond results in knocking off 0.971% per year, bringing the Yield to Maturity down from 4.917% to 3.946%. If you hold the bond until it matures, then this yield to Maturity is your true yield – unless the bond is called before its maturity date. In that case, the $67.63 drop will have to be amortized over a shorter period, reducing your net yield further. Which is why we also need to calculate…

Yield to Worst

This bond could be called on 11/15/2023, three months earlier than its maturity date. If so, that 6.763% drop will have to be amortized over 67 months instead of 70 months. That knocks another .049% off the net yield, bringing it down to 3.897%. This is the yield number that you should count on, while remembering that it could be the higher yield-to-maturity number of 3.946% if the issuer chooses not to call the bonds.

In this example, the current price of the bond was at a premium to its face value. This made the current yield less than the coupon, and the yield to maturity smaller yet, with the yield-to-worst the smallest number of all.

In cases where the bond or preferred is selling at a discount to par value, these relationships are reversed so that Coupon Rate < Current Yield < Yield to Worst.

Note that preferred stocks also have a yield-to-worst number, calculated in the same way as for bonds. But although many preferreds are callable, and therefore do have a call date, they usually do not a have a set maturity date. So, Yield to Maturity for preferred stocks is not generally applicable and is usually not quoted, but Yield to Worst is. Many preferred stocks continue to trade for many years after their call dates without actually being called.

So, which of these yield measures should we pay attention to?

First, for bonds, if your intention is to hold the bond until it matures or is called in order to collect the interest, then the lower of Yield-to-Maturity or Yield-to-Worst is the number you should use.

For preferred stocks, it’s not quite so cut-and-dried. Since many preferreds do trade for years after their call date, it is impossible to predict when or if they might be called. You will see many cases where the preferred stock has a high coupon rate and is therefore trading at a premium to face value; yet it is past its call date. In these cases, the Current Yield may be very high – 8%, 10%, 12% or even more. And although that high yield might go on for years, it might also end tomorrow. If it were called tomorrow (or any time soon), then your loss on the stock price would be greater than the interest you collected before it was called, and you would have a net loss overall. In that case, the Yield to Worst would actually be negative. The way to look at these is to consider the Current Yield as your benchmark and exclude any preferreds from consideration if the Yield to Worst is negative, or less than some minimum yield that you can live with.

As with any investment, there are risks, and the higher the yield the greater these risks are. In the case of bonds, there is the risk of default or bankruptcy of the issuer. With preferred stocks, there is also the risk of inadequate cash flow to cover the dividend. For this reason, yield alone should never be your sole criterion for choosing an investment.

I hope this has helped you to understand the various yield measures, and how to use them in your consideration of alternative investments.

 

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.