Key Factors That Impact Expected Bond Yield

By Marc Katz of Online Trading Academy
Friday, September 14, 2018 2:30 AM EDT

Essential income investor knowledge begins with understanding the ways expected return, or yield, on bonds and bond funds are presented. This awareness is essential to choosing wisely among thousands of bond mutual funds, ETFs, closed end funds, and among countless individual bonds.

An explanation of bond yield and how to calculate bond yield.

To avoid being mislead about bond investments, investors should understand three calculations:

  1. Current Yield: What you earn each year from coupon payments or dividends divided by what you pay for the bond or fund.
  2. Yield-to-Worst ('YTW'): What you earn from coupon payments or dividends less the annual amortization of the amount above par you might pay for a high coupon bond for as long as the bond is expected to be outstanding.
    To understand YTW, it is important to consider how long a bond is expected to be outstanding, i.e., the earliest, or "worst" date you will be repaid. For example, many municipal bonds and non-investment grade corporate bonds allow the bond's issuer to call such bonds prior to maturity at a pre-set price. Upon reaching the Call Date, if the bond coupon on the existing bond is higher than the coupon plus expenses the issuer will pay for new bonds maturing on the existing bond's Maturity Date; it is expected that the issuer will retire the existing bonds.
    Generally speaking, higher coupon bonds when interest rates are low are likely to be called at the earliest Call Date. So, your YTW is what you earn from coupon payments or dividends less the annual amortization of the amount above par you pay for such a bond until the first Call Date.
  3. Yield to Maturity ('YTM'): What you earn until the Maturity Date from coupon payments or dividends less (plus) the annual amortization of the amount above (below) par you paid for a bond.
    To generalize, an issuer of a low coupon callable bond would unlikely call the bond before maturity. Thus, for such callable bonds, YTM is the operative calculation to determine your expected return.

Thus, a bond or bond fund's current yield is necessary but insufficient to make a good judgment about the investment's expected return. YTW for high coupon callable bonds and YTM for low coupon bonds more accurately measure expected return for bonds and bond funds.

We encourage investors to inquire about a fixed income investment's current yield - the return for the immediate period and YTW / YTM – the return for the entire expected hold period.

To avoid being misled into an inadequately yielding investment for its degree of interest rate and/or credit risk, be mindful when large gaps exist between current yield and YTW / YTM. A large gap between the current yield, e.g., 4%, and YTW or YTM, of e.g., 2% may indicate an excessive spread and / or mark-up is being charged for the bond or even that a bond fund's dividend is at risk of being cut.

Finally, it is not necessarily a bad thing if a bond or fund's YTW or YTM is materially below the current yield when the case applies to an investor that already had bought that bond or fund before bond prices rose / interest rates fell. Today's YTW and YTM are based on the market price of the investment today and these measures apply to new investors buying the asset today. A seasoned investor's YTW or YTM on the investment in question is that which existed at his or her purchase date.

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Danny Straus • 5 years ago • Member's comment

Good stuff. But you haven't posted anything new in a while...