An understanding of yield values is essential to investing in bonds and is also helpful for stock investors. If your definition of yield ends with big yellow signs on the highway, let us help you with some clarification of how yields apply to bonds.
The three yield definitions below all have a useful purpose, depending on whether you are considering an individual stock, comparing different types of bonds, or comparing the relative value of stocks and bonds.
- Current Yield – This number is a snapshot value of a bond at any given time. Current yield in general is defined by this equation
Yield = cash received per year/current market price
For stocks, current yield is the annual dividends paid relative to the current share price (dividend yield); for bonds, it is the annual interest, or coupon, payment relative to the current bond price (bond yield). In the case of bonds, this reflects what the return would be if someone bought the bond at current market price and held it for one year. Since market prices change constantly, so does the current yield.
This is useful for comparison between bonds if you are buying, but not for determining return on bonds that you own. For example, if you purchased a $100 bond with an annual coupon (interest) of $5, the current yield is 5%. If your bond price dropped to $90 at the end of the year and you decided to sell it, the yield is now 5.55%.
This does not help you, because the overall price dropped. Your return is -$5 ($5 in interest you received minus $10 you lost on the overall price). That is bad news for you, but good news for the buyer.
- Yield-To-Maturity (YTM) – YTM is a measure of the overall return. This is an estimate of what you will receive if you hold your bonds to the maturity date. It takes into account the loss or gain you took if you bought the bond sometime after it was issued.
Since YTM estimates a future value, the time value of money has to be taken into account. YTM totals all the future values (interest payments plus value at maturity), converts them to present value, and sets them to the current market price, expressed as an interest rate.
In other words: what constant interest rate would it take for all the interest you receive plus the redemption value of the bond to equal what the bond costs right now? If that number is more than the coupon rate, it is selling at a premium, if less, then it is selling at a discount. Calculators are available online to help you find YTM as long as you know the market price, par value (face value), time to maturity and the coupon rate.
YTM has less meaning with callable bonds or bonds with options – since you can never be certain what the maturity date will be. There are variations of calculating this value that try to take this into account.
- Earnings Yield – This is the annual earnings divided the market price. For stocks, this is the inverse of the useful P/E (price/earnings) ratio. For bonds, there is not any difference between earnings yield and current yield, since there is no difference between earnings and dividends – the main use of earnings yield is to compare stocks to bonds, and determine whether they are relatively over- or undervalued. Usually the comparison is broad, such as comparing the S&P 500 yield to a 10-year Treasury yield.
We hope this clears up yield definitions with respect to bonds and stocks. We also trust that you know what yield means when we meet on the highway!