A bond yield represents the percentage return an investor earns from holding a bond, usually expressed as an annualized percentage. The calculation and interpretation of bond yields vary depending on the type, making it a vital metric for assessing the investment attractiveness of a bond.
1. Current Yield
Definition:
The current yield is the ratio of the annual coupon payment of a bond to its current market price.
Formula:
Characteristics:
- Reflects the relationship between annual income from coupons and the bond’s market price.
- Does not consider the yield generated from the difference between the purchase price and face value at maturity.
- Useful for evaluating the immediate income from coupon payments.
Example:
If a bond pays an annual coupon of $50 and its market price is $1,000, the current yield is 5%.
2. Yield to Maturity (YTM)
Definition:
Yield to maturity is the annualized return an investor earns if the bond is purchased at the current market price and held until it matures.
Formula:
There is no direct formula; it is calculated using an equation that equates the present value of future cash flows (coupons + face value) to the bond's current market price.
Characteristics:
- Takes into account both the coupon payments and the difference between purchase price and face value.
- Considered the most comprehensive measure of bond yields.
- Widely used for comparing different bonds.
Example:
If a bond is purchased at a discount (below face value), the YTM will be higher than the current yield. Conversely, if purchased at a premium (above face value), the YTM will be lower than the current yield.
3. Yield to Call (YTC)
Definition:
Yield to call is the return an investor earns if the bond is called (redeemed by the issuer) before its maturity date.
Formula:
Similar to the yield to maturity formula but uses the call price and call date instead of face value and maturity date.
Characteristics:
- Applicable only to callable bonds.
- Indicates the return if the issuer opts to redeem the bond early.
- Often lower than the yield to maturity.
Example:
If a bond has a call date in five years and a call price of $1,050, the YTC considers these values for its calculation.
4. Adjusted Yield
Definition:
Adjusted yield considers taxes or other costs that may impact the investor's final return.
Characteristics:
- Commonly used for municipal bonds that may be tax-exempt.
- Compares the after-tax yield of bonds.
Formula:
Example:
If the tax rate is 30% and the pre-tax yield is 5%, the after-tax yield will be 3.5%.
5. Tax-Equivalent Yield
Definition:
Tax-equivalent yield determines the yield a taxable bond must provide to match the return of a tax-exempt bond.
Formula:
Characteristics:
- Used to compare tax-exempt municipal bonds with taxable bonds.
- Beneficial for investors in higher tax brackets.
Example:
If the yield on a municipal bond is 4% and the tax rate is 25%, the tax-equivalent yield will be 5.33%.
6. Yield to Worst (YTW)
Definition:
Yield to worst is the lowest possible yield an investor may receive if the bond is called or otherwise redeemed early.
Characteristics:
- Accounts for all possible call dates.
- Used to evaluate the minimum expected return.
7. Real Yield
Definition:
Real yield is the yield adjusted for inflation, reflecting the true value of returns to the investor.
Formula:
Characteristics:
- Used to assess the future purchasing power of returns.
- Important in high-inflation environments.
Example:
If the nominal yield is 5% and the inflation rate is 2%, the real yield is 3%.
8. Nominal Yield
Definition:
Nominal yield is the fixed return associated with the bond based on its face value, regardless of its market price.
Formula:
Characteristics:
- Fixed for the lifetime of the bond.
- Does not reflect market price changes or inflation.
Example:
If the bond's face value is $1,000 and the annual coupon is $50, the nominal yield is 5%.
Conclusion
The various types of bond yields provide different perspectives on the potential return from a bond, helping investors make informed decisions. Choosing the right yield type depends on investment goals, market conditions, and personal preferences. Understanding these metrics enables investors to balance risk and return effectively.
