Knowing these terms will help an investor navigate the bond universe. By Jeff Brown Contributor
WITH YIELDS SLOWLY rising on bonds and interest-paying holdings, it may be time for investors to re-examine what they own and seek better deals. Experts say it's dangerous to reach for the biggest yield you can get, as abnormally high yields signify outsized risks, but if you find two comparable investments and one pays a bit more then the other, why wouldn't you choose the more generous?
But which yield figure should you use? There's plain vanilla yield, SEC yield, yield to maturity and yield to call. Each gives a different account of what you're likely to earn. Yield to maturity and yield to call offer valuable ways to assess individual bonds, but SEC yield can be better for funds, experts say.
"Clients get extremely confused by yield figures, especially right now with interest rates coming off of historical lows," says Mark Painter, founder of Everguide Financial Group in Berkeley Heights, New Jersey.
In fact, investors are wise not to take any yield figure as gospel, says Michael B. Geraty, senior vice president for fixed income at Noyes, a wealth management firm in Chicago.
"Yield calculations are notoriously unreliable," he says, pointing out that all calculations incorporate potential flaws.
Here are some key terms.
Coupon. This is a bond's starting point – what it paid when first created. A 2.5 percent coupon on a 10-year bond with a face value of $1,000 means the bond will pay $25 a year for 10 years. After that it "matures" and you get $1,000 back.
But things can change in the meantime. If newer bonds start paying more than 2.5 percent, no one will pay you full price for your older, stingier bond, and its price will fall even if the company or governmental agency that issued the bond remains healthy and continues to pay the $25-per-year coupon.
All else being equal, the bond price will fall until that $25 represents a yield competitive with what investors can earn on newer, more generous bonds. So, if new bonds offered 5 percent, the old bond's price would fall to $500, because the $25 coupon would be 5 percent of $500.
Investors know they could reinvest their coupon payments at higher yields than when they started, but the illustration shows the relationship between price and yield. Of course, it works the other way too. If yields fall, investors will pay more for older bonds that are more generous. Generally, the longer the bond has to maturity, the greater the price swings from rate changes, because investors will live longer with the consequences.
Yield. This is a standard way of measuring a coupon payment relative to the bond's current price. It may be figured by dividing the price into the total of coupons paid over the previous 12 months, or into the most recent coupon payment as if it were paid over a year. Funds report "distribution yield," which are typically payments received over the past 30 days times 12, divided by fund share price.
TTM yield. The actual distributions for the past 12 months divided by an average net asset value over the period.
Yield to maturity. This is the annual coupon payments divided by the bond's face value, or the principal you would receive if you kept the bond to maturity. It also assumes coupon payments are reinvested and it accounts for any difference between the bond's current price and face value.
Yield to call. The annual coupon payments divided by what you'd be paid if the issuer called the bond, or chose to repay your principal at the earliest possible date set when the bond was issued is yield to call. Since the call price might not be the same as the bond's face value – it's typically a tad higher – yield to call might be different from yield to maturity. It also accounts for interest earnings and the difference between the current and call prices.
Return. This is the profit an investor could make by both receiving coupon payments and selling the bond at its current market price, for a gain or loss relative to the original price paid.
SEC yield. This figure is determined using rules from the Securities and Exchange Commission to allow easy comparison of one fund with another. Interest earnings for the past 30 days, minus fund expenses, are annualized, or multiplied by 12, and the result divided by the fund's current net asset value. That's the share price from the number of shares divided by the fund's total assets.
"In an effort to standardize yield calculations, the SEC created the SEC yield, which we believe is the best way to compare the yield of different bond funds," says Russell Robertson, owner of Alidade Wealth Partners in Atlanta. "Because it is a standardized calculation, it will give the truest comparison."
Accounting for fund expenses incorporates a key consideration for investors, and SEC yield also assumes interest earnings are reinvested.
While individual bonds have fixed maturities, funds typically seek an average maturity calculated for all the bonds they own. The fund investor cannot simply hold to maturity, and is therefore always exposed to the risk of loss as prevailing rates rise, or gains as rates fall. "Total return" figures show how investors did if they owned the fund's share over a specified period such as year-to-date, the past 12 months or past five years.
Compared to an individual bond, a fund's yield figures are a less reliable gauge of future earnings, since the fund will routinely replace bonds whose maturities have become too short to fit the manager's strategy.
So, which yield should one use? Owners of individual bonds can use yield to maturity if they expect to own the bond to maturity, or yield to call to play it safe. The risk of a call typically rises when falling interest rates allow issuers to sell new bonds to pay off old ones that were more generous.
But it's different for fund investors, since funds have no fixed call or maturity dates.
"SEC yield is best used when looking at funds because it is standardized and allows for apples-to-apples comparison," Painter says.
Still, no measure is perfect, as two bonds or funds may react differently as market conditions change, says Joshua Wilson, chief investment officer of WorthPointe Wealth Management outside Dallas.
"Two funds could have similar SEC yields, yet one might be more sensitive to interest rate changes," he says.
No yield figure provides an ironclad guarantee for future profits. Like stocks, bonds and bond funds have a fair amount of risk.
About the Blog:
Here lives our collection of newsletters, articles, and some occasional guest posts by outside authors (where indicated) who have quoted us. If you're interested, feel free to browse through the archives here.