By: Phil Kernen
With interest rates rising over the last year to fight inflation, bonds are attractive again. Yields on short U.S. Treasury bills crossed 5%, the 10-year U.S. Treasury note yield is over 4%, and interest in bond portfolios is growing. But the topic of yields is complicated by the multiple calculation methods. Some yield calculations are simple, while others are more complex and consider additional factors. Each reflects an assessment of the value of the cash flows attached to the bond, and it pays to understand which is which to know what you are buying and how to compare in a sea of options.
Investors calculate nominal yield by dividing the annual coupon payments by the face value of the bond. Nominal yield is effectively the bond’s coupon rate which will remain unchanged for fixed-rate bonds and will change over the life of a floating rate bond or indexed bond whose coupon changes in response to changes in the underlying index. Nominal yield is the least useful because it doesn’t consider the bond’s price.
Investors calculate the current yield with an additional factor, relating the annual coupon to the bond’s market price. Recall that the price of a bond moves inversely to interest rates. As rates rise, bond prices go down because the existing cash flows attached to the bond are now worth less in a higher-rate market. Conversely, as rates go down, the cash flows linked to the bond are now worth more in a lower-rate market.
Say you have a bond with a 3% coupon whose face value is $1,000 and a selling price of $1,000. Your bond has a nominal yield of 3%. But imagine market interest rates rise, leaving your 3% coupon worth less, and your new bond price is $900. If you were to buy that same bond today, the nominal yield would still be 3%, but the current yield would be 3.3%. Current yield may be helpful to investors who focus primarily on income, allowing them to better estimate cash flows, but only marginally.
Yield-to-maturity (YTM) considers two inputs that the current yield does not. To account for the purchase of a bond at a premium (the bond has a higher coupon than market yields) or a discount (the bond has a lower coupon than market yields), YTM considers any capital gain or loss the investor will realize by holding the bond to maturity. Second, YTM assumes that the coupon payments are reinvested at the yield-to-maturity rate, earning a greater return for the investor and subsequent higher calculated yield. As a result, YTM is a more comprehensive metric for comparison purposes when considering bonds for sale or purchase with different coupons, prices, or maturities.
Some bonds are callable, meaning the issuer has the right to buy back the bonds at a predetermined price before the final maturity. Yield-to-Call (YTC) addresses situations like this, assuming the issuer calls the bond and the investor receives their money back early. For non-callable bonds, YTC is effectively the same as YTM because the final repayment dates don’t change.
Continuing the example of callable bonds, the Yield-to-Worst (YTW) is the lower yield between YTC and YTM. Consider a bond with a high coupon and a near-term call date. The issuer will likely exercise its call option to repurchase it before maturity at a lower-than-market price and refinance the bond. In this case, the YTC is lower than the YTM and is, therefore, the YTW. If the coupon instead is lower than the market, the issuer will happily pay that lower rate and leave the bond outstanding until the scheduled maturity. In this case, the YTM is lower than the YTC and is, therefore, the YTW. For callable bonds, the YTW is what matters to investors.
With bonds yields of all calculations rising, bonds again offer a return in addition to providing stability for your portfolio. When buying bonds, go past the headline yield to know what it reveals about a bonds value.
Disclosure: This is for informational purposes only and any reference to a specific security does not constitute a recommendation to buy or sell that security. The reader should not assume that an investment in the securities identified or described, was or will, be profitable. For a complete list of disclosures, please click https://mitchcap.com/disclosure/