Yield: a Flexible Term

One of the most important things to know when you're considering a bond investment is its yield. However, there are several ways to measure a bond's yield, and some are more useful than others for understanding a bond's true value. When someone tells you a bond yields, say, 5 percent, you should make sure you know exactly what they're referring to.

Current Yield

People sometimes confuse a bond's yield with its coupon rate: the interest rate that is specified in the bond documents. A bond's coupon rate represents the amount of interest you earn annually, expressed as a percentage of its face (par) value. If a \$1,000 bond's coupon rate pays \$50 a year in interest, its coupon rate would be 5 percent.

Current yield, however, represents annual interest payments as a percentage of the bond's market value, which may be higher or lower than par. As a bond's price goes up and down in response to what's happening in the marketplace, its current yield will move as well. For example, if you buy that same \$1,000 bond for \$900 on the open market, its current yield would be 5.55 percent (\$50 divided by \$900). If you buy a bond at par and hold it to maturity, the current yield and the coupon rate would be the same. However, for a bond purchased at a premium or a discount to its face value, the yield and the coupon rate are different.

If you're concerned only with the amount of current income a bond can provide each year, calculating the current yield may give you enough information to decide whether you should purchase that bond. However, if you're interested in a bond's performance as an investment over a period of years, the current yield will not give you enough information. In that case, yield to maturity will be more useful.

Yield to Maturity

Yield to maturity is a more accurate reflection of the return on a bond when you hold it until its maturity date. It takes into account not only the bond's interest rate, principal, time to maturity, and purchase price, but also the value of the interest payments as you receive them over the life of the bond. Yield to maturity includes the additional interest you could earn by reinvesting all of the bond's interest payments at the yield it was earning when you bought it.

If you buy a bond at a discount to its face value, its yield to maturity will be higher than its current yield. Why? Because in addition to the interest, you would be able to redeem the bond for more than you paid for it. The reverse is true if you buy a bond at a premium. Its value at maturity would be less than you paid for it, which would reduce your yield.

Example(s): If you paid \$960 for a \$1,000 bond and held it to maturity, you would receive the full \$1,000 principal in addition to the interest. That \$40 profit is included in the calculation of a bond's yield to maturity. Conversely, if you bought the bond at a \$40 premium, meaning you paid \$1,040 for it, your yield to maturity would be lower than the current yield, since you would have a loss from redeeming the bond for \$40 less than you paid.

There are a couple of things to remember about yield to maturity:

1. If you sell the bond before it matures, your effective yield could be different from its yield to maturity.
2. The yield to maturity figures assumes you reinvest the coupon payments at that same yield rate. If you spend those interest payments, or if interest rates fall and you aren't able to get the same yield when you reinvest, your actual yield may be less than the yield to maturity figure.

Yield to maturity lets you accurately compare bonds with different maturities and coupons. It's particularly helpful when you're comparing older bonds that are priced at a discount or at a premium rather than at face value. It's also especially important when looking at a zero-coupon bond, which sells at a deep discount to its face value but makes no periodic interest payments. Because all of a zero's return comes at maturity when you receive the principal, any yield quoted for a zero is always a yield to maturity. Yield to maturity is typically calculated via computer, but you can also get an estimate by using a bond yield table.

Yield to Call

Yield to maturity has a flaw in helping you estimate your return on a callable bond (one whose issuer can choose to repay the principal before maturity). If the bond is called, the par value is repaid and interest payments will cease, reducing its overall yield.

Therefore, for a callable bond, you also need to know what the yield would be if the bond were called at the earliest date allowed by the bond agreement. That figure is known as its yield to call. This calculation is the same as with yield to maturity, except that the first call date is substituted for the maturity date.

A bond issuer will generally call a bond only if it's profitable for it to do so. If interest rates fall below a bond's coupon rate, the issuer is likely to recall the bond and borrow money at the newer, lower rate. The larger the spread between current interest rates and the original coupon rate, and the less time until the first date the bond can be called, the more important yield to call becomes.

After-Tax Yield

It's important to consider a bond's after-tax yield--the rate of return earned after taking into account taxes (if any) on income received from the bond. Some bonds (e.g., municipal bonds and U.S. Treasury bonds) may be tax exempt at the federal and/or the state level. However, most bonds are taxable. A tax-exempt bond often pays a lower interest rate than an equivalent taxable bond, but may actually have a higher yield once the impact of taxes has been factored in. Whether this is the case depends on your tax bracket and whether you must pay state as well as federal taxes.

Example(s): Say you are considering investing in Bond A, a tax-exempt bond paying 4 percent interest, or Bond B, a taxable bond paying 6 percent interest. Assume you are in the 35 percent federal tax bracket and do not have to pay state taxes. You want to find out whether Bond A or Bond B would be a better investment in terms of after-tax yield. You determine that Bond A's after-tax yield is 4 percent (the same as its pretax yield, of course) and that Bond B's is only 3.9 percent once taxes have been deducted. You'd probably decide that tax-exempt Bond A would be more advantageous because of its higher after-tax yield.

The Price-Yield Seesaw and Interest Rates

Unlike most coupon rates, yields aren't static. Depending on investor demand and interest rates, yields go up and down. That's one reason why bond prices often drop when the economy is growing rapidly. Such rapid expansion can lead to inflation (i.e., increases in the cost of goods and services). When that happens, the Federal Reserve Board often raises interest rates to try to slow the economy by making it more expensive to borrow money. As interest rates rise, bond yields tend to rise also. That's because bond issuers must pay a competitive interest rate to get people to buy their bonds.

When bond yields rise, bond prices fall, because bond prices move in the opposite direction from yields. That's true not only of the bond market as a whole, but for individual bonds. When a bond's price rises, its yield falls, and vice versa; when bond prices fall, yields rise. Why? Because whenever interest rates are falling, bonds that are issued today will typically pay a lower interest rate than a similar bond that was issued when rates were higher. That means that older bonds with higher yields are more valuable to investors who are willing to pay a higher price to get that greater income stream.

The opposite is true when interest rates are rising. As bond issuers must pay higher interest rates to be competitive, prices for existing bonds fall. Investors aren't willing to pay as much for older bonds with a lower rate if they can get a newer bond that pays more interest.

Yield and Basis Points

Changes in a bond's yield can be too small to measure in whole percentages. Such changes are often expressed in basis points. A basis point is 1/100th of 1 percent. As a penny is to a dollar, a basis point is to a percentage point. If a bond's yield increases from 4 percent to 4.25 percent, it is said to have gone up by 25 basis points. If a bond's yield goes from 4 percent to 3 percent, it has dropped by 100 basis points.

Note: The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.

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