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, high-quality 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 (yield-to-maturity, yield-to-worst, 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 fixed-rate 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.

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 fixed-rate bond will remain constant for its lifetime, there are also floating-rate bonds that change rates based on fluctuations in a referenced rate of interest — such as the federal funds rate.)

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.

Yield-to-Maturity:

Yield-to-maturity (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.)

Yield-to-Call:

Yield-to-call (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.)

Yield-to-Worst:

Yield-to-worst (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 worst-case 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 (30-Day 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 income-generation 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.

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