July was a strong month for risk assets, with equities up modestly, IG corporate spreads tighter, IG municipal returns positive, and strength in both higher-beta IG bonds and high yield fixed income.
Hello this is Cara Early, and welcome to the Breckinridge podcast. Today, I'm joined by Jeremy Jenkins, a member of the Breckinridge Consultant Relations Team. Today, we will discuss a variety of yield measures for bonds and bond portfolios. Bond yields are often quoted but may not be explained enough. To start, Jeremy, is there one yield figure that's universally used for bonds?
Not really. The term "yield" is, like you said, often quoted but it's probably often misunderstood because there are many different types of yields and each is calculated in a different way. It's important to understand the pros and cons behind different types of yields and how some yield metrics are better suited to certain bond markets.
Okay. Let's take a step back. If I'm buying a bond with a 5% coupon, isn't my yield just 5%?
Not necessarily. The 5% in that example is actually, like you said, your coupon. The coupon is simply the interest on the bond usually paid semiannually for corporate and municipal bonds. Yield is generally a more robust figure. Depending on the type of yields which we'll discuss shortly, it will factor things like the price of the bond, the number of coupon payments to maturity or call date, and the coupon rate itself. This typically results in a yield figure that's different than the coupon figure.
Well, can you give us some examples of the various types of yield?
Sure. One of the simplest metrics is current yield. That is simply the annual coupon interest divided by the market price.
Okay. So a bond purchased at par, or 100, with a 5% coupon would have a 5% current yield, yes?
Yeah, correct, but if that same 5% coupon bond was purchased at discount, say $95, the current yield would be 5% divided by 95 which is about 5.25, about 5.26%. If the bond, however, was purchased at a premium of, say, 105, the current yield would be 5% divided by 105, that comes to about 4.75, 4.76%.
All right, so there's a pattern here. A premium bond will have a current yield less than the coupon rate, a par bond will have a current yield equal to the coupon rate, and a discount bond will have a current yield greater than the coupon rate.
What are the pros and cons of using this approach?
So this measure is really only useful insofar that it's an easy calculation. To calculate more useful measures of yields, you would need a computer or a financial calculator but for current yield, you just need to know division. The major drawbacks for current yields are that it doesn't consider amortizing or accretion of a bond price that will eventually move to par amount. It also doesn't account for the time value of money and subsequent reinvestments of interest over time. These are meaningful drawbacks.
We've all also heard the term yield to maturity. How is that calculated?
The yield to maturity is an internal rate of return figure on a bond, assuming you hold it to maturity. It does, unlike current yield, account for the time value of money. It is based on the bond's interest payments and assumes the interest payments are reinvested at that yield to maturity. It also assumes the investor holds the bond to maturity. Finally, this metric does take into account the amortization of a premium or the accretion of a discount.
Okay, so this seems more robust but what are some of the cons of yield to maturity?
While the yield to maturity does account for a reinvestment of coupon interest, it assumes that reinvestments are at the same yield to maturity rate, which obviously given fluctuations in interest rates, that's usually not the case.
Okay, so what other types of yields can we discuss next?
Investors may have heard of yield to call, which is calculated assuming that the bond is called on its first call date. Some bonds are callable and, therefore, investors shouldn't assume the bond will remain outstanding until maturity. This is similar to yield to maturity, but it takes into account the bond's embedded optionality. Now this measure is typically more relevant in municipal bonds given the likelihood of issuers calling bonds away. It's less relevant in the investment grade corporate bond world due to the maturity of the bonds there being non-callable.
Yes. I know the Breckinridge data shows that in the muni market, there are frequently bonds with a 10-year call option for the issuer.
That's right, although bonds may or may not be called before maturity. Therefore, one of the cons of yield to call is that it assumes that issuers do call which is not always the case.
Gotcha. Well, is there a way we can be just as conservative and look at the lowest yield that you could calculate for every possible call date, put date, and final maturity date?
Yes, that metric is known as the yield to worst. This is generally considered the most conservative of all yield metrics. For instance, if a bond has a call date prior to maturity, the yield to call and the yield to maturity calculated and the lower of the two would be the yield to worst. In other words, the more conservative rate of return of the two possible outcomes. At Breckinridge, we typically use yield to worst.
Great. Well, we've spoken a lot about yields based on where the bonds are trading at a particular point in time. Can we look at yields based on where the bonds were actually purchased?
Yes, that's what's called the book yield. So just like you can have the market yield to worst, the market yield to call, you can have the book yield to maturity or the book yield to call and so on. The book yield gives you the internal rate of return based on the price a bond was purchased at whereas the market yield is reflecting that rate of return based on current market prices. Both of these are relevant measures. Typically for bonds that have been held for many years, you want to be cognizant of the book yield since it's based on the price you purchased the bond at. So for example, if interest rates have declined since the purchase date, you likely have an embedded gain. The opposite is true if rates have risen, you likely have a loss. Being aware of both measures, both market yield and book yield, is useful especially when assessing tax ramifications for potential bond sales.
Okay, this has been very helpful, Jeremy. Thank you. I hope you in the field have found this informative and we hope you join us on our next podcast.
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