When buying a bond, you want to know how much return you’ll get. A bond’s yield is a measure of expected return—based on its coupon, price and other factors. But understanding bond yields can be tricky. First, because bond prices fluctuate based on changes in interest rates, yields are constantly in motion. Second, there are several ways to calculate yield. Let’s look at four of them:
- Current yield is the most straightforward measure. It divides the bond’s annual interest payments by the price you paid for it. But unfortunately, it doesn’t tell the whole story, as it doesn’t take into account the return of principal, which happens when a bond matures, is sold or is called. For example, if you buy a $10,000 bond for the discounted price of $9,500, you’ll record a $500 gain when the bond matures—but the current yield doesn’t factor in those gains.
- Yield to maturity measures the annual rate of return you would receive on a bond investment—taking into consideration all interest payments, return of principal and the time value of money—were you to hold it to maturity.
- Yield to call measures the annual rate of return on a bond assuming that the bond is redeemed on the first (or next) call date.
- Yield to worst measures the lowest potential return you might get from a bond without the issuer actually defaulting. It is the lower of the yield to maturity or yield to call.
So which yield matters most? It depends on whether the bond is callable or not. For a callable bond, the yield to call or yield to worst would let you determine your lowest potential return. For a noncallable bond, yield to maturity is the most useful because, barring default, you’ll get back the principal when it matures.