When comparing bonds, yield is exactly what investors are looking for. It’s the income or return they are receiving on the product and the purpose for the investment. However, it can become a bit tricky in determining exactly what the yield is when you consider it comes in several different forms and that bonds fluctuate in price and duration. So let’s break down the types of yield to help you better understand the return you’re actually receiving on your investment.
- Coupon Yield: This is the return attached to the bond offering. For example, a $1,000 bond with a coupon yield of 4% will pay out $40 per year, usually split into semiannual payments of $20 twice a year.
- Current Yield: Bond prices fluctuate as we hold them and can also be bought at discounts and premiums above or below their stated value. The current yield shows us what the bond is returning compared to its current price. For example, taking the bond from above, if the price were to fall to $950 the bond is now yielding 4.21% ($40/$950). The payments received from the bond will remain constant even though the price of the bond may fluctuate. This can be used as a quick snapshot.
- Yield-To-Maturity: This is where things can get a bit more complicated, although this is a more accurate representation of return. The YTM computation considers one big assumption (that is often times false), that as you collect the interest payments every six months you reinvest them at the same interest rate as the bond. The calculation considers the coupon rate, price, how long until the principal will be paid back, and also how much that principal will be. The computation is complicated and can be done with a calculator online.
The YTM on a discounted bond will always be higher than the current yield and that’s because when we receive the principal back, the extra money is considered profit. For example, if you purchased the bond for $980 when you receive the $1,000 that extra $20 adds to the YTM. The reverse is true for bonds selling at a premium so be careful when comparing current yields. Looking at a quick example, with the help of an online calculator the YTM of a $1,000 bond bought for $980 paying 5% with a 10-year maturity turns out to be 5.262% while the current yield of the same bond is only 5.10%.
- Yield-To-Call: When you purchase a callable bond, you become subject to the risk that the seller purchases it back from you long before maturity. This often happens with premium bonds carrying higher coupon yields because if interest rates decline, they will be able to resell the bond and pay lower interest payments than they were before. When a bond is called it can make your return much lower than anticipated, although they pay much higher interest rates than non-callable bonds to compensate the investor for the risk of the bond being called. The calculation is done the same as YTM but be careful because if the bond is called, you won’t receive the continuous income you were expecting.
Different bonds carry different types of risk and each have a certain goal in mind. It’s important to understand your goal for the investment first and then make your investment selection as it will narrow your search down to what fits your needs. Be sure to talk with your advisor to make sure the bond’s characteristics fit you.
Bond brokers can often times try to fool you by spitting out different yield numbers that all sound great, however may not be entirely accurate or represent your situation. Having a strong grasp on bond yields can certainly help understand what you’re truly invested in and help increase returns along the way.