The Multifaceted Uses of "Yield" in Fixed Income Investing
After historic fixed income declines in 2022, anyone reading
about bond investing in 2023 likely encountered headlines proclaiming, “bonds
are back” or “the income is back in fixed income.” It's true that the bond
market has experienced meaningful changes recently. Yields have repriced at
levels higher than they have been in years, and with many economists saying a
recession could be just around the corner, highquality bonds become more and
more attractive to investors.
With the renewed interest in fixed income, it's more
important than ever that investors understand the different metrics in
evaluating bonds and bond funds. A natural place to start is the seemingly simple concept
of “yield.” When an investment manager or financial advisor discusses a fixed
income security or a bond fund, the conversation often begins with a discussion
of yield — or how much income an investment generates. But the topic quickly
becomes complicated due to the many different measures of yield that exist
(yieldtomaturity, yieldtoworst, SEC yield, distribution yield, etc.). It's
no surprise that everyday investors looking to make informed decisions about
fixed income may feel uneasy.
Yield: Understanding the Basics
For starters, it's easy for those unfamiliar with bond
investing to confuse the terms “yield” and “coupon.” Coupon yield refers
to the income an investor can expect to receive while holding a particular
bond. It is expressed as an annual interest rate that does not change during a
bond's lifespan. For example, if you were to buy a fixedrate bond at a price
of $1,000 with a coupon yield of 5 percent, you would receive annual payments
of $50 until the bond reaches maturity.
In the example above, the bond has a par value — the
price at initial offering — of $1,000. And while the par value of a bond doesn't change, its current market price can change. Just like stocks, bond
prices go up and down based on many factors, including changes in interest
rates and investors' perceptions that the bond issuer may not be able to meet
the bond's obligations.




Definitions
 Coupon (also referred to as coupon payment or nominal yield): The annual income an investor can expect to receive while holding a particular bond. It is expressed as a percentage of the bond's par value, and it does not change during the life of a bond.
 Current yield: A bond's coupon yield divided by its current market price. It changes as the bond's current market price changes.
 Par value (or face value): The price of a bond when it was first issued.
 Premium bond: A bond purchased for more than its par value.
 Discount bond: A bond purchased for less than its par value.





To continue the example, imagine that a few years after
buying a bond at a par value of $1,000 with a coupon rate of 5 percent —
interest rates for the same type of bond were to fall to 1 percent. Now someone
with a newly purchased bond will only receive $10 a year — while you are still
receiving annual payments of $50 from your bond. Suddenly your bond becomes
very attractive to someone who would like to receive a $50 coupon, and they may
be willing to pay a premium — a price higher than par value — for your
bond.
If someone were to buy your $1,000 (par value) bond for
$1,200 (premium), you would profit $200 by trading the bond. The person who
bought your bond will continue to receive a coupon yield of 5 percent ($50 per
year), but they will ultimately earn less money than you would have,
because they had to pay more for the bond.
This is where the term current yield comes from.
Current yield is a bond's coupon yield divided by its current market price. In
this example, the current yield of the bond would fall to 4.17 percent ($50
annual coupon divided by $1,200 bond price).
On the other hand, if interest rates go up — the opposite
happens to your bond. For example, if you purchased a bond at $1,000 with a
coupon rate of 5 percent — and a few years later interest rates for the same
type of bond increased to 8 percent, your bond's current market value would
decrease. Perhaps someone would only be willing to buy your bond for $700 — a discount to par value. The bond's current yield would then be 7.14% ($50 annual coupon
divided by $700 bond price). (A quick note, while the coupon yield of a fixedrate
bond will remain constant for its lifetime, there are also floatingrate
bonds that change rates based on fluctuations in a referenced rate of
interest — such as the federal funds rate.)




Individual
Bonds vs. Bond Funds
For the sake of simplicity, this article has explained how certain metrics apply to individual bonds. However, most people who invest in fixed income will buy bond funds — a collection of fixed income securities. Yields for a bond fund are calculated by looking at the aggregated attributes of its individual holdings.
For example, a bond fund may hold hundreds or thousands of individual bonds. The fund's managers are constantly buying and selling bonds of various maturity dates in an effort to take advantage of opportunities currently available in the marketplace and achieve a fund's stated investment goals. Therefore, a bond fund does not have a single maturity date. Rather, a fund's maturity can be evaluated by different metrics, such as average effective maturity — the weighted average of the maturities of its underlying bonds.
Some metrics apply only to bond funds and not to individual bonds, such as 30day SEC yield and distribution yield — which will be explained later in this article.





Where “Yield” Gets More Complicated
Coupon and current yield provide a basic understanding of
the return from your bond, but they have limitations. For one, these measures
don't consider the value of reinvested interest, and they are not helpful when
your bond is called early or when you want to evaluate a bond's lowest possible
yield. Below are examples of more advanced calculations to help make these
determinations.
YieldtoMaturity:
Yieldtomaturity (YTM) is a critical measure for evaluating
the total return an investor can expect from a bond if it is held until its
maturity date. YTM accounts for a bond's price, coupon payments, and the time
remaining until it reaches maturity.
An important assumption of YTM is that all of a bond's
coupon payments are reinvested at the same yield until maturity. This
assumption allows investors to estimate both the current income generated by
the bond and the potential capital gains or losses they may experience by
holding it until maturity. YTM is widely used in the financial industry as a
means of comparing different bonds with different coupon rates, maturities, and
market prices. (In the context of a bond fund, YTM is calculated from
the weighted average total yield of the fund's holdings — assuming all interest
payments from the underlying securities are received until maturity.)
YieldtoCall:
Yieldtocall (YTC) is similar to YTM. However, YTC measures
the comprehensive return an investor can expect from a bond if the issuer opts
to exercise the bond's call option prior to its scheduled maturity date. YTC
assumes all coupon payments are reinvested at the same yield until the bond's
potential call date. This measure helps to contrast various bonds with
different coupon rates and time to potential calls. (In the context of a bond fund,
YTC is derived from the weighted average total yield of the fund's holdings, assuming
all interest payments from the underlying securities are received until the
possible call date.)
YieldtoWorst:
Yieldtoworst (YTW) is a measure that helps investors
assess the lowest potential yield they could receive from a bond and provides
insight into potential downside risks.
Certain bonds have embedded call options — which allow the
bond issuer to return the investor's principal and stop interest payments prior
to the bond's maturity date. Early redemptions can lead to a lower overall
yield than the bond's stated coupon rate, which could impact a fund's overall
income. By considering the worstcase scenario, investors gain insight into the
potential downside risks associated with a fixed income investment. (In the
context of a bond fund, YTW is the weighted
average of the individual bonds' YTWs.)
SEC Yield (30Day SEC Yield):
The Securities and Exchange Commission (SEC) yield is a
standardized measure that applies only to bond funds and not individual fixed
income securities. This metric is used to evaluate a fund's income potential.
The SEC requires funds to calculate and disclose this yield to provide
investors with a standardized basis for comparison. SEC yield is computed based
on the dividends, interest, and net asset value of the fund's holdings, accounting
for any expenses incurred by the fund.
The SEC yield represents the yield an investor could expect
to receive over the next 30 days, assuming the fund's income remains constant.
It is a useful metric for assessing the current income generation potential of
a fund, making it easier to compare different fixed income investment options.
Distribution Yield:
Another measure that applies only to funds, distribution
yield focuses on the annualized income distributions paid out by a bond fund
rather than its total return. Distribution yield accounts for both the coupon
payments and any capital gains or losses generated by a bond fund, relative to
its current market price, reflecting the total income stream it offers. By
comparing the distribution yields of different investment options, investors
can assess the incomegeneration potential and make informed decisions based on
their income needs and goals.
It's important to note that distribution yield is subject to
changes based on various factors, including fluctuations in interest rates,
changes in the underlying portfolio of the investment, and shifts in market
conditions.




Distinguishing Different Uses of "Yield"
Yield to Maturity (YTM): This
metric is useful for investors who plan to hold a bond for a long period of
time or until full maturity. It represents the total annual rate of return that
a bond will earn when it makes all interest payments and repays the original
principal. YTM assumes all securities will be held until maturity.
Yield to Call (YTC): This
measure is useful for investors considering the potential outcomes of a bond
being called prior to its designated maturity date. YTC reflects the annualized
rate of return a bond will yield if it experiences an early call, factoring in
all interest payments and the return of principal.
Yield to Worst (YTW): This
metric is useful for investors interested in evaluating the longterm total
return for a bond. YTW measures a bond's lowest possible yield, assuming it
does not default. This measure is typically thought of as being more
conservative than yieldtomaturity as YTW takes into account bonds that may be
called.
SEC Yield (30Day SEC Yield): This
metric is useful for investors seeking to compare the income return currently
priced into different bond funds. Also referred to as “standardized yield,” SEC
yield is a hypothetical calculation of net income earned. It reflects the
dividends and interests earned during the most recent 30day period covered by
a fund's filings with the SEC.
Distribution Yield: This
metric is useful for investors looking to evaluate a bond fund's regular income
streams. It is calculated by taking a fund's most recent payment divided by its
net asset value (NAV) and expressed as an annual rate. It is likely the
simplest form of yield to understand as it represents the actual payment
investors are receiving and is not forwardlooking.





Why It All Matters
For those interested in investing in fixed income,
understanding the various measures of yield is essential for evaluating
investment options and managing risk. Each measure serves a specific purpose
and should be considered. This knowledge empowers investors to make informed
decisions based on their financial goals and risk tolerance, ultimately
enhancing their potential for longterm success in the fixed income market.
Understanding yield measures is an essential skill for investors seeking to
optimize their returns while managing the potential risks associated with bonds
and bond funds.