A Closer Look at Key Bond Yields

Download the PDF version of this article

The rapid rise in interest rates, as the U.S. Federal Reserve has aggressively hiked the fed funds rate, has brought bond market dynamics to the front of investor awareness. Bond yields are higher, and year-to-date returns across most fixed-income market segments are generally negative, driven by the largest move in bond prices in decades.

As a rule of thumb, bond returns can be broken down into two components: the yield of the bonds, and price movements. Held to maturity, bonds will return their starting yield. But the prices of bonds can vary before they mature, as prevailing interest rates move. And those prices move, as we are regularly informed by financial publications, in the opposite direction from yields.

But which yields are we talking about? Investors are barraged with a variety of different yield calculations, further complicating an already frustrating year. Here, we explain the difference between frequently used yield calculations, and what they mean in the context of a bond investment

What Bond Yields Tell Investors

Broadly, there are two types of yield calculations—one involves only income, and one involves the expected return of a bond investment. The difference between the two types has caused significant confusion for many bond investors, particularly as those yields have diverged during this period of extraordinary interest-rate volatility. Unfortunately, the existence of these different types of yield calculations can distort the picture when investors are considering what to do next.

For clarity, we will discuss two types of yield calculations:

1) Current yield, which tells investors about annual income

2) Yield to worst (YTW), which is a conservative estimate of the annualized total return of the investment (similar to yield to maturity, or YTM)

How Do These Bond Yields Work?

The first type of calculation tells investors only about annual income. There are several variations on this theme, including distribution yield, current yield and 30-day SEC yield. Current yield simply looks at the pre-determined annual interest payments of a bond (or bonds if the calculation is for a fund), and divides by the dollar price (the cost of the initial investment relative to the final payment).

For example, if an investor buys $1,000 of a bond with a 2% coupon, the annual income would be $20 a year for the life of the bond investment. Calculating the current yield would require adjusting for actual dollars invested (the price paid for the bond) to receive that $20. If the bond were trading at a discount, meaning that, for example, only $900 was required to purchase the $1000 face value, then the current yield would be 20/0.9 = 2.22%. Calculations for distribution yield are similar to those for current yield but look at prior payments for a fund, instead of expected future payments. Both (and other similar) methodologies focus exclusively on expected income while not entirely taking other aspects of a bond’s return profile into account.

Among other things, this calculation tells us nothing about how the overall hypothetical investment would perform. Other yield calculations, of which YTW is among the most conservative, take the price and maturity of the bond into account as part of the expected return. For example, in the prior calculation, an investor who buys $1000 of a bond for $900 will also gain $100 when the bond matures, in addition to the annual coupon payments. A coupon-based calculation like current yield ignores this aspect of the return of the bond. Industry conventions for quoting bond yields are in terms of YTM—the expected annual total return of a bond from purchase to its maturity date. YTW is simply a more conservative calculation than YTM, which can be relevant for callable bonds, when the final maturity date is uncertain.

When do these different types of calculations differ most? When the dollar prices of bonds are farther from par (the price at maturity), and when maturities are fairly short. That is, when there are larger price gains (or losses) versus maturity, and when they are realized more quickly. Figure 1 shows two hypothetical bond examples to illustrate the distinction.

Fund Yields

Yield calculations for bond mutual funds take the aggregate characteristics of the underlying bonds in the portfolio. The specifics of fund accounting can vary, but the current yield of a fund is the current yield of all the underlying bonds. It’s the same with yield to worst or yield to maturity. Returns for a fund in a given year will generally be the starting yield to worst—plus or minus the price changes of all of the underlying bonds.

Figure 1. The Impact of Time-to-Maturity

Yields based on hypothetical bonds

Source: Lord Abbett. YTM=Yield to maturity. The chart above does not represent the results that any particular investor actually attained. The information presented is based on hypothetical assumptions and data and is for illustrative purposes only and does not reflect the performance of any specific portfolio managed by Lord Abbett or any particular investment. The hypothetical results have many inherent limitations, and no representation is made that any account will or is likely to profit similar to those shown in the chart. Actual performance results may differ substantially. Changes in the scenario assumptions may have a material impact on the hypothetical results presented. The chart is purely a hypothetical illustration of a mathematical principle. All returns and yields are gross of fees and taxes. Bonds are assumed to be held to maturity. Past performance is not a reliable indicator or guarantee of future results.

The long-term hypothetical bond—Example 2—has a much higher current yield because it has a higher annual payment, but it has a lower expected return over the life of the bond. This means that despite the higher annual income of the second bond, investors would make more money each year of the investment with the first bond. In this case, the annual income from the short-term bond—Example 1— would be 1% of every dollar invested, but an investor would also receive an additional $1 because the principal repaid at maturity is higher than the initial investment. The expected return, or YTM (also YTW), is double the current yield that only considers the coupon but ignores the price change.

Another hypothetical example that may be more relevant for today’s market would be a generic two-year corporate bond, with a coupon of 3.5% and a price of $96.00—a rough average of where such bonds are today. This bond would have a current yield of 3.65% (3.5/0.96). But the current yield calculation ignores the fact that an investor would also receive $4 of additional principal over the next two years.

That discount turns out to be important. The YTW or expected return of the bond investment in this hypothetical example is 5.67%, which is higher than the current yield. When compared to a two-year U.S. Treasury with a quoted yield of more than 4.5%, the current yield of the corporate bond looks very unattractive. However, the YTW might look appealing!

Again, this is because current yield does not factor in other key aspects of a bond’s return. Different two-year Treasuries will generally have the same YTM, because markets are efficient, even if they have very different coupons (and thus different current yields).

Treasuries versus Corporate Bonds

Comparing the current yield of a two-year corporate bond to the yield of a two-year U.S. Treasury note may be misleading, as the two-year U.S. Treasury is always quoted in terms of yield to maturity. Such distinctions are important to remember when considering the potential return of each investment.

Key Takeaways

So which yield is correct? They tell us different things. Distribution yield is more appropriate for considering long-term or perpetual investments. Note that the value of such an investment may change as prevailing interest rates change, but that may matter less to an investor looking to simply use the income from a long-term investment. When comparing to a two-year U.S. Treasury or to any other short-term fixed-income investment, distribution yield or current yield can be misleading.

On the other hand, YTM and YTW are more appropriate for investors who are thinking about return expectations. Of course, yield/price changes before maturity will add or subtract total return from a YTM in a given year, but YTM gives investors a good baseline of what to expect over time.

Important Information

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

References to fund yields are for informational purposes only and are not meant to represent any specific Lord Abbett bond fund or portfolio.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

Equity Investing Risks

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price.

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

Glossary & Index Definitions

A basis point is one one-hundredth of a percentage point.

Coupon represents the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.

Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield to maturity (YTM) represents the expected return (expressed as an annualized rate) from the bond’s future cash flows, including coupon payments over the life of the bond and the bond’s principal value received at maturity. Yield to worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Please consult your investment professional for additional information concerning your specific situation.

Important Information for U.S. Investors

Lord Abbett mutual funds are distributed by Lord Abbett Distributor LLC.

FOR MORE INFORMATION ON ANY LORD ABBETT FUNDS, CONTACT YOUR INVESTMENT PROFESSIONAL OR LORD ABBETT DISTRIBUTOR LLC AT 888-522-2388, OR VISIT US AT LORDABBETT.COM FOR A PROSPECTUS, WHICH CONTAINS IMPORTANT INFORMATION ABOUT A FUND'S INVESTMENT GOALS, SALES CHARGES, EXPENSES AND RISKS THAT AN INVESTOR SHOULD CONSIDER AND READ CAREFULLY BEFORE INVESTING.

The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Important Information for non-U.S. Investors

Note to Switzerland Investors: This is an advertising document. The state of the origin of the fund is Luxembourg. In Switzerland, this document may only be provided to qualified investors within the meaning of art. 10 para. 3 and 3ter CISA. In Switzerland, the representative is ACOLIN Fund Services AG, Leutschenbachstrasse 50, CH-8050 Zurich, whilst the paying agent is Bank Vontobel Ltd, Gotthardstrasse 43, CH-8002 Zurich. The basic documents of the fund as well as the annual and, if applicable, semi-annual report may be obtained free of charge from the representative. Past performance is no indication of current or future performance. The performance data do not take account of the commissions and costs incurred on the issue and redemption of units.

Note to European Investors: This communication is issued in the United Kingdom and distributed throughout Europe by Lord Abbett UK Ltd., a Private Limited Company registered in England and Wales under company number 10804287 with its registered office at Tallis House, 2 Tallis Street, Temple, London, United Kingdom, EC4Y 0AB. Lord Abbett UK Ltd (FRN 783356) is an Appointed Representative of Kroll Securities Limited (FRN 466588), which is authorised and regulated by the Financial Conduct Authority.

Lord Abbett (Middle East) Limited is authorised and regulated by the Dubai Financial Services Authority (“DFSA”). The entire content of this document is subject to copyright with all rights reserved. This research and the information contained herein may not be reproduced, distributed or transmitted in any jurisdiction or to any other person or incorporated in any way into another document or other material without our prior written consent. This document is directed at Professional Clients and not Retail Clients. Any other persons in receipt of this document must not rely upon or otherwise act upon it. This document is provided for informational purposes only. Nothing in this document should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction. Nothing contained in this document constitutes an investment, an offer to invest, legal, tax or other advice or guidance and should be disregarded when considering or making investment decisions.