One of the key things to research when performing investment due diligence on a bond is to evaluate the bond’s yield or return. This evaluation of a bond’s return or yield can be performed in a number of different methods and should be for the different types of bond yields that exist for corporate and government bonds, according to ASX (2014). These different types of bond yields include among others, the so called running yield, nominal yield, yield to maturity (YTM), yield to call (YTC) and yield to worst (YTW).
It is highly important for any investor to know their target return as well as the risk they are willing to take into account (risk/return profile). When determining an approximate target yield for fixed-income investments, it is clearly significant to make sure to understand the various types and measurements of bond yields. (For more, see: The Top 5 High-Yield Bond ETFs for 2016.)
The Different Types of Bond Yields
The running yield is a measurement of a bond’s return or yield each year as represented as a percentage of the bond’s current market value or price. This is a fairly simple measurement that tells investors what they can expect for a return in the current market. When used to describe a portfolio, a running yield refers to the cumulative return or yield of all investments currently held within that portfolio. This may be somewhat similar to a dividend yield, but instead of describing individual assets, it describes the entire group represented within the portfolio as a whole. Typically, running yields are figured annually, but many investors calculate it more often than this.
The nominal yield is the return of a bond as determined by the percentage of the face value the bond’s annual coupon payments amount to. This means the nominal yield is effectively the bond’s coupon rate. This rate may or may not change depending on the type of bond:
- Fixed Rate Bonds: The coupon rate or nominal yield will be fixed and will not change over the lifetime of the bond.
- Floating Rate Bonds: The coupon payments/nominal yield will change over the life of the bond as dictated by changes in the referenced rate of interest.
- Indexed Bonds: The coupon payments/nominal yield will change in response to movement within its underlying index.
The YTM (yield to maturity) describes the average yield or return that an investor can expect from an issue each year if they (1) purchase it at its market value and (2) hold it until it matures. This value is determined using the coupon payment, the value of the issue at maturity, and any capital gains or losses that were incurred during the lifetime of the bond. YTM estimates, typically assume that all coupon payments are reinvested (not distributed) within the bond. This figure is typically used to compare different bonds an investor is trying to choose between, and is one of the key figures compared between bonds. This is due to the fact it includes more variable than other comparable figures. For example, comparing the nominal yield of two different bonds is only truly helpful when the bonds have the same cost, same life span and same return. However, if any of these are different, the YTM measure becomes a more effective comparison tool.
The YTC (yield to call) simply refers to the bond’s yield at the time of its call date. This value doesn’t hold if the bond is kept until maturity, but only describes the value at the call date, which if given, can be found in the prospectus of the bond. This value is determined by the bond’s coupon rate, its market price and the length of the call date. (For more, see: Bond Yield Curve Holds Predictive Powers.)
The YTW (yield to worst), as the name suggests, describes the worst possible yield possible for a bond without the issuer of the bond going into default. Investors determine this by imagining worst-case scenarios for the issue. These scenarios include all provisions included in the bond like a call, prepayment or sinking fund—anything that would negatively impact the bond’s yield. By knowing the worst yield possible, investors can see how their income will be affected and whether or not it will be sufficient to consider the issue. YTW calculations are determined for all possible call dates in order to provide as much information as possible to investors. It always assumes all conditions or provisions that can be enacted to decrease the yield will be enacted, such as for instance put provisions to lower the coupon rate based upon market conditions. It also assumes no recalculations happen in favor of the investor.
The Bottom Line
Though yield is not the only significant factor to consider when determining which security or issue to invest in, it is nonetheless an important one. The terms and conditions that come with a bond are often not insignificant when it comes to yield and therefore must be examined carefully when performing due diligence before deciding which bond to invest in. Another significant issue that affects the bond’s yield is the fact of risk vs. return. As with all financial securities, the trade-off for greater security is less return. Therefore, it will always depend on the investor’s risk/return profile when it comes to setting a target yield. In each and every case, if a potential investor chooses to purchase higher-yielding or investment-grade bonds or a mixture of both, a profound professional analysis of each security is required.