It pays to evaluate a bond’s yield

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By Doug Awad

Yield is 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 face (par) value.

If a $1,000 bond’s coupon rate pays $50 a year in interest, its coupon rate is 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 or down in response to what is happening in the marketplace, the 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 will be the same. If you’re concerned only with the amount of current income a bond can provide, calculating the current yield may give you enough information to make a decision.

However, if you’re interested in a bond’s performance as an investment over a period of years, the yield to maturity would be more useful information.

Yield to maturity: Yield to maturity is a more accurate reflection of the return on a bond when you hold it to maturity. 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. That is 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 bought the bond at a premium. Its value at maturity would be less than acquisition cost.

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

1. If you sell the bond before maturity, your effective yield could be different than its yield to maturity.

2. The yield to maturity figures assumes you reinvest the coupon payments at the 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 yield to maturity.

Yield to call: Yield to maturity has a flaw in helping you estimate your return on a callable bond (one whose issuer can chose 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 it were called at the earliest date allowed by the bond agreement. That figure is called yield to call.

A bond issuer will generally call a bond only if it’s profitable to do so. If interest rates fall below the coupon rate, the issuer may call the bond and borrow money at the lower rate.

The larger the spread between the coupon and the lower rate, the more likely the bond is to be called.

After tax yield: It’s important to consider a bond’s after tax yield – the rate of return after taking into account taxes (if any) on the income received from the bond. Some bonds (e.g. municipal bonds and U.S. Treasury bonds) may be tax exempt at the federal level and/or the state level. However, most bonds are taxable.

A tax-exempt bond often pays a lower interest rate than the equivalent taxable bond, but may actually have a higher yield once the impact of taxes are figured in. Whether this is the case depends on your tax bracket and whether you pay any state taxes as well as federal taxes.

If you have questions, call Doug Awad at 854-6866, or e-mail Doug.Awad@raymondjeames.com. He is a resident on the 200 Corridor and his office is on 31st Road, adjacent to Paddock Mall.

This information was partially developed by Forefield, Inc., an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security.

Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Associates, Inc does not provide advice on tax, legal or mortgage issues. These matters should be discussed with an appropriate professional.