Yields: Conventional Yield Measures

A Guide to Conventional Yield Measures

Conventional yield measures are important tools used in bond and investment analysis to assess the return and risk characteristics of fixed-income securities. These measures provide insights into the income generated by a bond relative to its price, the total return expected until maturity or call/put option, and the yield of a portfolio. This section will provide a detailed explanation of various conventional yield measures commonly used in debt and money markets.

1. Current Yield

The current yield is a straightforward measure that calculates the annual income generated by a bond relative to its market price. It is computed by dividing the bond's annual coupon payment by its market price.

Current Yield = Annual Coupon Payment / Market Price

Example:
Consider a bond with a $1,000 face value, a 5% coupon rate, and a market price of $950. The current yield would be:

Current Yield = ($50 / $950) ≈ 5.26%

2. Yield to Maturity (YTM)

Yield to maturity is a comprehensive measure that takes into account the bond's cash flows, time to maturity, and market price. It represents the annualized rate of return an investor would earn if the bond is held until maturity. YTM considers both the coupon payments and the difference between the purchase price and the face value of the bond.

The bond's selling status can be categorized as follows:
- Par: If the bond's YTM is equal to the coupon rate, the bond is selling at par value.
- Discount: If the YTM is higher than the coupon rate, the bond is selling at a discount below its face value.
- Premium: If the YTM is lower than the coupon rate, the bond is selling at a premium above its face value.

3. Yield to Call (YTC)

Yield to call is similar to YTM, but it focuses on the potential call option of a bond. It represents the annualized rate of return an investor would earn if the bond is called by the issuer before its maturity date. YTC considers the coupon payments, the difference between the purchase price and the call price, and the time until the potential call date.

4. Yield to Put (YTP)

Yield to put measures the annualized rate of return an investor would earn if they exercise the put option on a bond. The put option allows the bondholder to sell the bond back to the issuer at a predetermined price before the bond's maturity date. YTP considers the coupon payments, the difference between the purchase price and the put price, and the time until the potential put date.

5. Cash Flow Yield

Cash flow yield is a measure of a bond's total return, considering both coupon payments and capital gains or losses upon the sale of the bond. It calculates the annualized rate of return that an investor would receive over the holding period, including all cash flows received.

6. Yield for a Portfolio

Yield for a portfolio represents the average yield of a collection of bonds or securities held in a portfolio. It is calculated by weighting the yields of individual securities based on their respective holdings in the portfolio.

Conclusion

Conventional yield measures provide valuable insights into the return and risk characteristics of fixed-income securities. Current yield provides a simple measure of income relative to price, while yield to maturity, yield to call, and yield to put consider the full cash flow stream and potential options. Cash flow yield and portfolio yield offer broader perspectives on total returns. Understanding these conventional yield measures enables investors to assess the attractiveness of bond investments, evaluate risk and return profiles, and make informed decisions in debt and money markets.

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.