Market Beat: Understanding bond yields can be tricky
August 29, 2017
The key to making good investment decisions is through education. People who are already retired should have some of their portfolio allocated to fixed income investments. One decision that you need to make is whether to use mutual funds or individual bonds for your fixed income investments.
An advantage to using mutual funds is the diversification they offer, which can be especially beneficial with high yield or junk bonds because you can spread out the default risk. With investment grade bonds the default risk is much lower or essentially zero with United States Treasury bonds, so buying individual issues can have some advantages with higher credit quality bonds.
With a portfolio of individual bonds, the investor has the ability to control the maturity dates of their bonds, so it's possible to employ strategies to help manage interest rate risk, like bullets, barbells, and ladders.
When you're putting together a bond portfolio, it's important to understand how much income you'll receive each year. The terminology about yield can get somewhat confusing. There are several different yield calculations, which are based on how long you own the bond and how much you pay for it.
The yield to maturity, or YTM, is the yield you’ll get from your bond based on your purchase price if you hold it until it matures. If you’re planning on holding your bond until maturity, you’ll need to know if it’s callable before you purchase it.
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One is the coupon rate or nominal yield. The coupon rate is the interest rate the bond pays based on it's par price, the price it was issued at. Once bonds begin trading in the secondary market they will trade at either a premium or discount to the par price.
The yield to maturity, or YTM, is the yield you'll get from your bond based on your purchase price if you hold it until it matures. If you're planning on holding your bond until maturity, you'll need to know if it's callable before you purchase it.
If the bond is callable, you can find the yield to call or YTC. If the issue has multiple call dates or is continuously callable, you can determine the yield to worst call or YTW. This is very important to understand because you could find a bond with a nice yield to maturity only to have it called away from you at an inopportune time and you won't get a good return. Issuers call bonds when it's beneficial to them, not you.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.