Smart Bond Investing—Yield and Return
|Price and yield are inversely related: As the price of a bond goes up, its yield goes down, and vice versa.|
Coupon and current yield only take you so far down the path of estimating the return your bond will deliver. For one, they don't measure the value of reinvested interest. They also aren't much help if your bond is called early—or if you want to evaluate the lowest yield you can receive from your bond. In these cases, you need to do some more advanced yield calculations. Fortunately, there is a spate of financial calculators available—some that even estimate yield on a before- and after-tax basis. The following yields are worth knowing, and should be at your broker's fingertips:
Yield to maturity (YTM) is the overall interest rate earned by an investor who buys a bond at the market price and holds it until maturity. Mathematically, it is the discount rate at which the sum of all future cash flows (from coupons and principal repayment) equals the price of the bond. YTM is often quoted in terms of an annual rate and may differ from the bond’s coupon rate. It assumes that coupon and principal payments are made on time. It does not require dividends to be reinvested. Further, it does not consider taxes paid by the investor or brokerage costs associated with the purchase.
Yield to call (YTC) is figured the same way as YTM, except instead of plugging in the number of months until a bond matures, you use a call date and the bond's call price. This calculation takes into account the impact on a bond's yield if it is called prior to maturity and should be performed using the first date on which the issuer could call the bond.
Yield to worst (YTW) is whichever of a bond's YTM and YTC is lower. If you want to know the most conservative potential return a bond can give you—and you should know it for every callable security—then perform this comparison.
Yield reflecting broker compensation is the yield adjusted by the amount of the mark-up or commission (when you purchase) or mark-down or commission (when you sell) and other fees or charges that you are charged by your broker for its services.
YTM and YTC are based on the following assumptions:
Interest rates regularly fluctuate, making each reinvestment at the same rate virtually impossible. Thus, YTM and YTC are estimates only, and should be treated as such. While helpful, it's important to realize that YTM and YTC may not be the same as a bond's total return. Such a figure is only accurately computed when you sell a bond or when it matures.
Reading a Yield Curve
You've probably seen financial commentators talk about the Treasury Yield Curve when discussing bonds and interest rates. It's a handy tool because it provides, in one simple graph, the key Treasury bond data points for a given trading day, with interest rates running up the vertical axis and maturity running along the horizontal axis.
A typical yield curve is upward sloping, meaning that securities with longer holding periods carry higher yield.
The Department of Treasury provides daily Treasury Yield Curve rates, which can be used to plot the yield curve for that day.
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