We have written often about bonds and, also about preferred stocks as conservative income-generating investments. Many investors will want to have some money committed to either or both of these vehicles.
When considering any fixed-income type investment, of course one of the main considerations is the return expected from it. The net returns on these investments come primarily from the cash flow in the form of interest (on bonds) or dividends (on preferred stocks). But this is not the only component of the return, and sometimes not even the most important one.
This is true because the income on fixed-income investments is, well, fixed – but the price of the instrument is not.
The prices of preferred stocks and bonds fluctuate, primarily in response to changes in the interest-rate environment. An older bond that pays 8% in an environment where competitive newly-issued bonds pay only 5%, is paying $30 per year per thousand-dollar bond more than its peers. That older bond will be valued more highly. It will be quoted at a premium to its face value.
Most often as individual investors we will not be buying bonds or preferred stocks directly from the issuers. We will be buying them through stockbrokers in what is called the secondary market. The bonds and preferreds that we buy will have been issued some time ago, maybe many years ago, when interest rates were much different. The prices that we pay today will seldom be equal to the original face amount.
Because of this, there are actually four different measures of yield that we must understand. Fortunately, it’s not difficult. The four measures are:
-
Coupon Rate
-
Current Yield
-
Yield to Maturity
-
Yield to Worst
Here is a simple example, from a broker’s bond listing:
Corporate Office Properties 5.25% bonds due 2/15/2024. Callable on or after 11/1/2023.
Issue | Maturity Coupon | Bid/Ask | Current Yield | Yield to Worst | Yield to Maturity |
Corporate Office Pptys L P Callable 11/23 | 2/15/2024 | 104.956 | |||
5.25 | 106.763 | 4.917 | 3.897 | 3.946 |
Here are the explanations of the elements of this quote:
Coupon Rate
The Coupon Rate on these bonds is 5.25%. That means each $1,000 face-amount bond will pay $52.50 per year in interest. That does not mean that your yield is 5.25%, since you would probably not pay the exact $1,000 face amount for the bond.
Current Yield
The Current Yield is cash received per year / price paid for the bond. In this case $52.50 / $1067.63 = 4.917%. This is your annual cash-on-cash yield. This is closer to your real yield, but not quite there yet.
Yield to Maturity
When the bond matures in 70 months, on February 15, 2024, the bondholder will be paid the face amount of $1,000. This will be a drop of $67.63 per bond, or 6.763% from the original price of $1067.63. Amortizing this loss over the 70-month remaining life of the bond results in knocking off 0.971% per year, bringing the Yield to Maturity down from 4.917% to 3.946%. If you hold the bond until it matures, then this yield to Maturity is your true yield – unless the bond is called before its maturity date. In that case, the $67.63 drop will have to be amortized over a shorter period, reducing your net yield further. Which is why we also need to calculate…
Yield to Worst
This bond could be called on 11/15/2023, three months earlier than its maturity date. If so, that 6.763% drop will have to be amortized over 67 months instead of 70 months. That knocks another .049% off the net yield, bringing it down to 3.897%. This is the yield number that you should count on, while remembering that it could be the higher yield-to-maturity number of 3.946% if the issuer chooses not to call the bonds.
In this example, the current price of the bond was at a premium to its face value. This made the current yield less than the coupon, and the yield to maturity smaller yet, with the yield-to-worst the smallest number of all.
In cases where the bond or preferred is selling at a discount to par value, these relationships are reversed so that Coupon Rate < Current Yield < Yield to Worst.
Note that preferred stocks also have a yield-to-worst number, calculated in the same way as for bonds. But although many preferreds are callable, and therefore do have a call date, they usually do not a have a set maturity date. So, Yield to Maturity for preferred stocks is not generally applicable and is usually not quoted, but Yield to Worst is. Many preferred stocks continue to trade for many years after their call dates without actually being called.
So, which of these yield measures should we pay attention to?
First, for bonds, if your intention is to hold the bond until it matures or is called in order to collect the interest, then the lower of Yield-to-Maturity or Yield-to-Worst is the number you should use.
For preferred stocks, it’s not quite so cut-and-dried. Since many preferreds do trade for years after their call date, it is impossible to predict when or if they might be called. You will see many cases where the preferred stock has a high coupon rate and is therefore trading at a premium to face value; yet it is past its call date. In these cases, the Current Yield may be very high – 8%, 10%, 12% or even more. And although that high yield might go on for years, it might also end tomorrow. If it were called tomorrow (or any time soon), then your loss on the stock price would be greater than the interest you collected before it was called, and you would have a net loss overall. In that case, the Yield to Worst would actually be negative. The way to look at these is to consider the Current Yield as your benchmark and exclude any preferreds from consideration if the Yield to Worst is negative, or less than some minimum yield that you can live with.
As with any investment, there are risks, and the higher the yield the greater these risks are. In the case of bonds, there is the risk of default or bankruptcy of the issuer. With preferred stocks, there is also the risk of inadequate cash flow to cover the dividend. For this reason, yield alone should never be your sole criterion for choosing an investment.
I hope this has helped you to understand the various yield measures, and how to use them in your consideration of alternative investments.
This content is intended to provide educational information only. This information should not be construed as individual or customized legal, tax, financial or investment services. As each individual's situation is unique, a qualified professional should be consulted before making legal, tax, financial and investment decisions. The educational information provided in this article does not comprise any course or a part of any course that may be used as an educational credit for any certification purpose and will not prepare any User to be accredited for any licenses in any industry and will not prepare any User to get a job. Reproduced by permission from OTAcademy.com click here for Terms of Use: https://www.otacademy.com/about/terms
Editors’ Picks
AUD/USD holds above 0.6500 in thin trading
The Australian Dollar managed to recover ground against its American rival after AUD/USD fell to 0.6484. The upbeat tone of Wall Street underpinned the Aussie despite broad US Dollar strength and tepid Australian data.
EUR/USD comfortable below 1.0800 lower lows at sight
The EUR/USD pair lost ground on Thursday and settled near a fresh March low of 1.0774. Strong US data and hawkish Fed speakers comments lead the way ahead of the release of the US PCE Price Index on Friday.
Gold pulls away from daily highs, holds above $2,200
Gold retreats from daily highs but holds comfortably above $2,200 in the American session on Thursday. The benchmark 10-year US Treasury bond yield stays near 4.2% after upbeat US data and makes it difficult for XAU/USD to gather further bullish momentum.
Google starts indexing Bitcoin addresses
Bitcoin address data is live on Google search results after users realized on Thursday that the tech giant started indexing Bitcoin blockchain data. However, mixed reactions have followed the tech giant's reversed stance on the cryptocurrency.
A Hollywood ending for fourth quarter GDP
The latest revisions put Q4 GDP at 3.4%, the second fastest quarterly growth rate in two years. Much of the upside was attributable to stronger consumer spending, yet fresh profits data affirmed it was a good quarter for the bottom line as well with profits up by the most since the Q2-2022.
RECOMMENDED LESSONS
Making money in forex is easy if you know how the bankers trade!
Discover how to make money in forex is easy if you know how the bankers trade!
5 Forex News Events You Need To Know
In the fast moving world of currency markets, it is extremely important for new traders to know the list of important forex news...
Top 10 Chart Patterns Every Trader Should Know
Chart patterns are one of the most effective trading tools for a trader. They are pure price-action, and form on the basis of underlying buying and...
7 Ways to Avoid Forex Scams
The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams: Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. Here’s another report of a forex fraud. So, how can we avoid falling in such forex scams?
What Are the 10 Fatal Mistakes Traders Make
Trading is exciting. Trading is hard. Trading is extremely hard. Some say that it takes more than 10,000 hours to master. Others believe that trading is the way to quick riches. They might be both wrong. What is important to know that no matter how experienced you are, mistakes will be part of the trading process.