As published in Cuffelinks on 8 December 2016
Bonds are usually a very simple investment. In their most common form you lend your funds to a company or a government, and in return they pay you interest on set dates and return capital at maturity. But some bonds and hybrids have call dates which can add a level of complexity when quoting a yield
There are four different ways to quote a yield:
- Yield to maturity
- Running yield
- Yield to call
- Yield to worst
Yield to maturity is a total return calculation used by investors that plan to hold bonds until maturity, while running yield projects income for the coming year. However, yield to maturity may not always provide the best insight into the expected return of a bond, especially if there is a call date or multiple call dates.
A call date gives the bond issuer the option to repay the investor but it is not an obligation. As some bonds have many call dates, there can be a range of yield to calls, which makes yield to worst the most important measure for investors.
It’s important to understand the yield to worst for callable bonds is the lowest possible return for that bond, but there is upside potential if the company chooses not to repay at this date. Yield to worst may be substantially different to yield to maturity or yield to call. Further, as the price of bonds change, so too does the yield to worst calculation.
Note: There is a brief glossary at the end of this article.
Four yields
1. Yield to maturity (YTM)
The yield to maturity refers to how much a security will earn if it is held to its maturity date.
It is the annualised return based on all interest payments plus face value or the market price, if it was purchased on the secondary market. Most bonds are issued with a face value of $100, but as they are tradable investments, the price will move up and down depending on a number of factors.
Yield to maturity includes any capital gain or loss if the purchase price was below or above the face value. For this reason, the yield to maturity is considered the most important measure for bullet bonds or those with a hard maturity date and no call dates, as it provides a way to compare other securities. In this case, yield to maturity is the same as yield to worst.
For example, the Qantas June 2021 fixed rate bond was issued at a yield of 7.5%, and is currently offered at a premium to face value price of $114.05. If we calculate yield to maturity we find it is 4.07% compared to the coupon rate of 7.5%. This means that the effective return over the life of the security, if bought today, would be 4.07% taking into account the current premium price of the security.
Note that the calculation makes the assumption that all coupon (interest) payments can be reinvested at the yield to maturity rate.
2. Running Yield (RY)
Another measure to compare the return of bonds is the running yield. Running yield uses the current price of a bond instead of its face value, and represents the income an investor would expect if they purchased a bond and held it for a year. It is calculated by dividing the coupon by the market price as shown below.
For example, if you purchase the same Qantas bond as shown above for the current market price – also known as the capital price – of $114.05 and this bond pays a coupon of 7.5% on the face value ($100), you will receive a cashflow of $7.5 a year. Given this return is achieved at a premium to face value of $114.05, instead of $100 face value, your actual return will be less than 7.5%.
Using the equation above, your running yield would be 6.57% - (7.5/114.05 x 100 = 6.57).
As the bond price increases, running yield decreases, and as the bond price decreases the running yield would increase.
It is important to note that running yield does not incorporate any capital gains or losses. As such, institutional investors do not view this as a particular useful way to analyse bonds.
3. Yield to call (YTC)
Many bonds are callable at the option of the company before the final maturity date. That is, the bonds can be repaid early. For example, subordinated bonds issued by banks and other financial institutions often have call dates, which may be five, ten, twenty or more years until final maturity.
The company has the option but not the obligation to repay at the call date. With some bonds, the call dates continue after the first call date and are every interest payment date thereafter until maturity. With others, there may be only an annual opportunity.
If a particular bond’s price rises to be above par and is at a premium, then the chances of an early call will increase. Theoretically, the company can then issue new bonds at a lower interest rate.
Investors trying to work out the possible returns on callable bonds need to assess the range of returns available, including various yields to call and the yield to maturity to get a sense of what is possible.
For example, property developer Sunland has issued a fixed rate bond due to mature on 25 November 2020. It is currently trading at a premium of $102.50, so that yield to maturity is 6.82% per annum. But is has two call dates – see the table below.
In this case yield to maturity is the same as yield to worst (see below), both offer the lowest return of 6.82% per annum.
What is key is that as the price of the traded bond changes, so too do the yields. If the purchase price of the bond increased from $102.50 to $106, then the yields would change as shown below. The lowest possible return is no longer yield to maturity but rather yield to first call.
4. Yield to worst (YTW)
Yield to worst tells you what the lowest yield would be, if the company decides to call your bond at the worst possible time, or if it chooses not to call your bond – which means you get a lower yield than if they had called it.
We view this as the superior way of measuring yields, as bonds are there to offer investors downside protection. As such, the YTW is the lowest yield that an investor can expect if the company or government does not default.
Yield to worst could be the same as yield to call if the first call is the worst outcome for you; it could be the same as yield to maturity if you are worst off when the company chooses not to call at all; or it could be lower than both of them where you are worst off if the company calls on the second or subsequent call date.
The yield to worst for an investor purchasing the USD Broadspectrum fixed rate bond at its current offer price of $106.25 is that the company calls the bond at the first possible opportunity. This measure lets an investor know the lowest possible return – but there is an opportunity for upside if the company does not repay at the expected first call date. The best return is 6.33% per annum at maturity, but it’s likely the company will repay early and refinance in a cheaper market.
Bond investing can be relatively simple when held to maturity, no calls are involved and there’s no credit default, but it’s important for any investor to know which yield is being quoted whenever they buy or sell a bond.
This article was originally published in Cuffelinks and can be viewed here.
We are a proud sponsor of Cuffelinks – you can register for their newsletter here.
Glossary
Call date
The date prior to maturity, that a callable bond may be redeemed by the issuer. If the issuer determines there is a benefit to refinancing the issue, the bond may be redeemed on the call date at par, or at a small premium to par depending on the terms of the call option.
Coupon
The coupon is the rate of interest paid on a bond. Coupons can be paid annually, semi-annually or quarterly or as agreed in the terms of the security. The coupon rate can be fixed or floating for the term of the security. If it is a floating rate then it is likely that it will be linked to a benchmark such as the 90 day bank bill rate.
The coupon rate is set by the issuer based on a number of factors, including prevailing market interest rates and its credit rating. Fixed rate bonds in Australia predominantly pay a semi-annual coupon whereas floating rate bonds predominantly pay a quarterly coupon. Indexed linked bonds usually pay quarterly coupons.
For example, a $500,000 bond with a fixed rate semi-annual coupon of 8% will pay two $20,000 coupons each year.
Discount to face value
Bonds may trade at a discount to face value in secondary markets where coupon, demand and market perception of the entity influence the price of secondary trades. Bonds usually have a face value of $100. If a bond is acquired at a discount price, say of $75, then the bondholder will make a capital gain of $25 assuming the company makes a full repayment of $100 face value at maturity.
Premium
A bond's value in the secondary market can be greater than its face value. The bond is then deemed to be selling at a premium. This will occur if the coupon is higher than the yield of a fixed income security.