The word “set” has more meanings than any other word in the English language, its entry in the dictionary totaling a record 60,000 words.1 In the investment world, the word “yield” could give “set” a run for its money.
Fixed-income market participants often quote the term “yield,” but the word’s context could be misunderstood because various types of yield exist and each is calculated differently. If an investor purchases a bond paying a 5 percent coupon, that bond doesn’t necessarily have a 5 percent yield. The bond’s yield is a more-robust figure, and may factor in the price of the bond, the number of coupon payments or the callability options, depending on the type of yield.
In this post, we explain the pros and cons behind different types of yields and unpack how some yield metrics are better suited to certain bond markets. Because the “search for yield” remains one of the most salient trends in today’s bond markets, investors can benefit from knowing the differences between various types of yields.
One of the simplest yield metrics is the current yield. This is calculated as the annual coupon interest divided by the market price. For example, a bond purchased at par, or $100, with a 5 percent coupon would have a 5 percent current yield. However, if that same 5 percent coupon bond was purchased at a discount, say $95, the current yield would be 5 percent divided by $95, or 5.26 percent. If the bond was purchased at a premium of, $105, the current yield would be 5 percent divided by $105, or, 4.76 percent.
This measure is often used due to its simplicity and easy calculation. The main problem with this measure is that it is solely based on coupon and does not take into account the amortization or accretion of a bond. Current yield also does not account for the reinvestment of interest or the time value of money.
YIELD TO MATURITY
A meatier metric for yield is the yield to maturity (YTM). The YTM is the discount rate that equates the present value of the bond’s future cash flows (received at coupon and maturity) to the market price of the bond. YTM allows the investor to better compare the present value of the bond’s future payments to future cash flows for various investment options. Unlike current yield, it accounts for the time value of money and assumes that the interest payments are reinvested at that YTM. Also, this metric takes into account the amortization of the premium or the accretion of the discount on the bond. For those reasons, YTM is a better barometer for yield than the current yield.
Two problems with YTM, however, are that it assumes the coupon payments are reinvested at the YTM when in practice the reinvestment rate is often different, and YTM ignores the impact of prepayment options like call options, sinking funds or put options embedded in the bond structure.
YIELD TO CALL
Next, yield to call (YTC) takes into account the callability of bonds. The call features on a bond can be pivotal to the return an investor receives on an investment, and call options are particularly prominent in municipal bonds.
Some bonds are callable, and therefore investors cannot assume the bond will remain outstanding until maturity. YTC is calculated assuming that the bond is called on its first call date. This metric is similar to YTM, but it takes into account the bond’s embedded optionality.
In the municipal bond market there are frequently bonds with 10-year par call options for the issuer. However, bonds may or may not be called before maturity. Therefore, one of the cons of YTC is that it assumes issuers will call at the first call date, which isn’t always the case.
YIELD TO WORST
For a conservative measure of yield, investors can look at the lowest yield possible for every call date, put date and final maturity date scenario (some municipal bonds have more than one call date). This metric is known as the yield to worst (YTW). YTW is generally the most conservative rate of return of the various possible outcomes. At Breckinridge, we typically use the YTW as our favored metric.
As a further iteration of yield, we can differentiate between market yield and book yield. So far, we have spoken about yields based on where bonds are trading at a particular point in time. This is the market yield, and includes market YTC, market YTW and so on. We can also look at yields based on where the bonds were actually purchased, or the book yield. For tax free municipals bonds, the book yield is the tax free yield for tax reporting purposes. Investors can calculate the book YTM, the book YTC, etc., to discover the book YTW based on the price where the bond was bought. By contrast, the market yield reflects that rate of return based on current market prices, and is more volatile.
The book yield and market yield are both relevant measures.
For bonds held for a longer time, the book yield can be useful to determine embedded gains (or losses) if interest rates have declined (or increased) since the purchase. Awareness of both measures can be especially useful when assessing tax ramifications from potential bond sales.
 Guinness World Records, as of July 2019.
Rev # 308365 (9/30/2022)
This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.
Any estimates, targets, and projections are based on Breckinridge research, analysis, and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits. Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. Performance of indices may be more or less volatile than any investment strategy.
Performance results for Breckinridge’s investment strategies include the reinvestment of interest and any other earnings, but do not reflect any brokerage or trading costs a client would have paid. Results may not reflect the impact that any material market or economic factors would have had on the accounts during the time period. Due to differences in client restrictions, objectives, cash flows, and other such factors, individual client account performance may differ substantially from the performance presented.
All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.
Breckinridge believes that the assessment of ESG risks, including those associated with climate change, can improve overall risk analysis. When integrating ESG analysis with traditional financial analysis, Breckinridge’s investment team will consider ESG factors but may conclude that other attributes outweigh the ESG considerations when making investment decisions.
There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency and transparency and for certain companies such data may not be available, complete or accurate.
Breckinridge’s ESG analysis is based on third party data and Breckinridge analysts’ internal analysis. Analysts will review a variety of sources such as corporate sustainability reports, data subscriptions, and research reports to obtain available metrics for internally developed ESG frameworks. Qualitative ESG information is obtained from corporate sustainability reports, engagement discussion with corporate management teams, among others. A high sustainability rating does not mean it will be included in a portfolio, nor does it mean that a bond will provide profits or avoid losses.
Net Zero alignment and classifications are defined by Breckinridge and are subjective in nature. Although our classification methodology is informed by the Net Zero Investment Framework Implementation Guide as outlined by the Institutional Investors Group on Climate Change, it may not align with the methodology or definition used by other companies or advisors. Breckinridge is a member of the Partnership for Carbon Accounting Financials and uses the financed emissions methodology to track, monitor and allocate emissions. These differences should be considered when comparing Net Zero application and strategies.
Targets and goals for Net Zero can change over time and could differ from individual client portfolios. Breckinridge will continue to invest in companies with exposure to fossil fuels; however, we may adjust our exposure to these types of investments based on net zero alignment and classifications over time.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
The effectiveness of any tax management strategy is largely dependent on each client’s entire tax and investment profile, including investments made outside of Breckinridge’s advisory services. As such, there is a risk that the strategy used to reduce the tax liability of the client is not the most effective for every client. Breckinridge is not a tax advisor and does not provide personal tax advice. Investors should consult with their tax professionals regarding tax strategies and associated consequences.
Federal and local tax laws can change at any time. These changes can impact tax consequences for investors, who should consult with a tax professional before making any decisions.
The content may contain information taken from unaffiliated third-party sources. Breckinridge believes the data provided by unaffiliated third parties to be reliable but investors should conduct their own independent verification prior to use. Some economic and market conditions contained herein have been obtained from published sources and/or prepared by third parties, and in certain cases have not been updated through the date hereof. All information contained herein is subject to revision. Any third-party websites included in the content has been provided for reference only. Please see the Terms & Conditions page for third party licensing disclaimers.