Bond Yields

WHEN YOU BUY A BOND, the best guide to your likely return is the yield—but it isn’t always. Why not? There are two potential issues. First, a high yield is often a sign that the bond’s issuer is in shaky financial condition and could default on its interest payments. This is the big concern with high-yield junk bonds, discussed later in this chapter.

But even if the issuer is in fine financial shape, the yield you’re quoted may be deceptive. That brings us to the second problem: A bond may be trading above its par value, which is usually set at $1,000. That means that at maturity you’ll receive less for the bond than its current price. You often end up with bonds trading above their par value when the general level of interest rates falls, driving up the price of existing bonds that pay more interest.

An added complication: A bond’s maturity date may turn out to be earlier than you expect, because the bond has a “call provision” that allows the issuer to call in the bond early and thus pay off investors before maturity. That means that a bond, which you had hoped would kick off fat interest payments for many years, is suddenly gone from your portfolio. To help investors understand these various risks, bonds are often quoted with a variety of different yields:

• Nominal yield. This is the bond’s stated coupon rate, which is the annual interest payments divided by the bond’s par value (or value at maturity). You would only get this yield if you bought the bond as a new issue at par value or you managed to buy the bond in the secondary market at par.
• Current yield. The annual interest payments you should collect divided by the bond’s current price.
• Yield to call. The return you would earn if the bond is redeemed early, because the issuer takes advantage of the bond’s call provision. Keep in mind that some bonds can be called at prices that differ from their par value. Since 1985, Treasury bonds have been issued without call provisions.
• Yield to maturity. The return you would earn if you held the bond to maturity.
• Yield to worst. This is either the yield to call or the yield to maturity, whichever is lower.

Next: Ten-Year Treasurys

Previous: New Bond Issues

Articles: Clipping Coupons, Matters of Maturity and Yielding Clarity