Shopping for bonds isn’t as straightforward as shopping for stocks. In the stock market, investors can make purchase decisions based on a single quoted price for a given security. Bond buyers aren’t as lucky.
Each bond offers a particular yield—or expected return—based on its coupon, price and other factors. But because bond prices fluctuate in response to changes in interest rates, yields are constantly in motion. In addition, there are several ways to calculate yield.
To help clarify things, let’s look at a few different types of yield and then discuss which measure might be most relevant to a given investment.
Yield to maturity
The most commonly quoted measure of yield is the yield to maturity. This measures the annual rate of return on a bond investment if you hold the bond to maturity, covering both the interest payments you receive over the life of a bond and the return of principal when it matures. It also assumes you will reinvest all of the interest payments at a rate equal to the yield to maturity.
Of course, if interest rates change you won’t be able to reinvest at a constant rate, meaning your actual rate of return will differ from the original yield to maturity calculation. Also, if you’re not planning to hold a bond to maturity or if the bond is callable (which we discuss later), then the yield to maturity may not be relevant. After all, you can’t know in advance what price you’ll receive when you sell, nor can you know if a bond will actually be called.
Yield to call
If you buy a callable bond, then you may want to focus on the yield to call. Callable bonds can be redeemed (repurchased) by the issuer—or “called in”—prior to maturity. The yield to call is the annual rate of return assuming a bond is redeemed on the first or next call date, depending on when you buy the bond. Some bonds can be called at their par value, but other bonds may be callable at a price higher than par value or “premium.” There are also bonds with a scaled call structure, where the calls start at a premium and then decline with each successive call date, usually ending at a $1,000 par value.
Yield to worst
The most conservative measure of a bond’s yield is the yield to worst, or the lower of the yield to maturity or the yield to call. The name sounds ominous, but yield to worst is just another way of calculating the lowest potential return you might get from a bond. In other words, it can tell you the worst-case scenario, aside from default, for a given investment.
Some investors may prefer to look at the current yield, perhaps the simplest way of thinking about returns. You calculate the current yield by dividing a bond’s annual interest payments by the price you paid for it. The main limitation of this approach is that it doesn’t account for the return of principal, whether at maturity or upon redemption during a sale or call. For example, if you bought a bond at a discount to its face value, you would expect to record a gain when you received the full face value at maturity. Current yield doesn’t factor in such gains. In that sense, it isn’t useful for measuring total return.
Which yield should you use?
Finding the most relevant yield for your bond purchase depends on what type of bond you’re buying—noncallable or callable. For a noncallable bond that you intend to hold to maturity, the yield to maturity is the most useful. For such bonds, yield to maturity and yield to worst are always the same.
For a callable bond, the yield to call or yield to worst would work. If you buy a callable bond at a premium to its par value and look only at the yield to maturity, you may be disappointed with the return you get if the bond is called in. That’s where the yield to worst can help you determine what the lowest potential return would be.
Investing in bonds isn’t easy these days. But understanding the yield you can expect is a great place to start when choosing between bonds.
What is yield?
So what exactly do we mean when we say yield? In essence, it’s another name for the return you can expect to receive from a bond. It generally comprises a series of interest payments and the return of principal (barring default), either at maturity or upon redemption during a sale or call. However, as we show in the accompanying article, there are different ways to think about the returns you receive from a bond. And in most cases, discussions of “yield” are really about the yield to maturity.
Yield shouldn’t be confused with a bond’s coupon, which is the fixed interest payment you receive, typically every six months. The coupon is usually expressed as an annual percentage of the bond’s face value. For example, a $1,000 10-year bond with a 2% coupon will pay $20 a year (usually in two semiannual payments of $10).
The limitation here is that you can’t always buy bonds at their face value, and prices change in response to fluctuations in interest rates. This is because changes in interest rates affect the relative value of a “fixed” income stream.
To understand the difference between a bond’s coupon and its yield to maturity, let’s imagine that you bought the same $1,000 bond mentioned above, but at a discounted price of $950. At that price, $20 of annual payments would mean a coupon of 2% but a yield to maturity of 2.58%. If you bought the same bond at a premium price of $1,050, $20 in annual coupon payments would give you a yield to maturity of 1.46%.
As you can see, prices and yields are inversely related. So when the price falls, the yield rises, and vice versa.
When you buy a bond, its price, and hence its yield, will fluctuate. However, this needn’t concern you if you’re holding to maturity. The yield you receive will be based on the original purchase price, not on the ever-shifting market price.