Which Yield Calculation is the “Right” One?
Per Investopdia.com, the term “yield” is defined as the earnings generated on an investment over a particular period of time, expressed as a percentage. Fixed-income investors, in particular, will use a bond’s yield to compare it to other bonds or will use the yield to determine their expected income or return from the bond. Yields can vary based on the type of security, its duration and other factors. To make matters confusing for investors, there is no shortage of yield calculations available, each with their own purpose.
Below we attempt to define the various yield calculations you are likely to encounter, explain what they each mean and how/when to use them, and then illustrate some of the unique cases where caution should be exercised.
Often-Cited Bond Yield Calculations
The following yield calculations pertain to individual bonds. We will discuss information pertinent to mutual funds, ETFs, and other portfolio-level yield calculations further down in this review. Please note that this is meant to be a high-level tutorial, not a comprehensive analysis of these calculations. Some concepts have been left out, such as assumptions about coupon/distribution reinvestment, etc.
Coupon Yield, also known as the coupon rate, is the percent of par value that is paid out each year.
- A 5% coupon yield means a $1000 par bond is paying out $50/year
- This is important for discussing the characteristics of the bond but is incomplete information because it does not factor in the price you paid for the bond.
Current Yield is the coupon divided by the current price.
- A 5% coupon bond that you buy for $1210 has a current yield of 4.1%
- This calculation is imperfect because it assumes you will receive the price you paid for the bond if you sell it and/or if held to maturity. In reality, it is very unlikely that you will receive the price you paid, because the bond will likely return to par value if held to maturity; if you sell the bond prior to maturity, you may receive more or less back than you paid.
Yield to Maturity (YTM) factors in the price paid and assumes the return of par value at maturity. It essentially provides a total return estimate assuming the bond is held to maturity.
- Back to the example above, the YTM is 3.0% because you paid a premium for the bond but only received par at maturity.1
Yield to Call (YTC) is the yield of the bond until the time of its call date. It should be stated that the YTC is only valid if the bond is actually called.
Yield to Worst (YTW) calculates the YTM to every possible call date (or other similar bond provisions) and to final maturity and chooses the lowest option. YTW represents the investor’s lowest possible yield outside of the bond defaulting.
Portfolio Yield Calculations
Yield to Maturity – an approximation of a fund’s projected annual return over its Weighted Average Maturity (WAM)
- WAM (aka Average Effective Maturity) takes into account the weight of each bond as a percentage of the portfolio.
- YTM is often cited as an estimate of expected return for bond funds at any point in time, but due to factors like shifting markets, portfolio cash flows, and changes to the portfolio, it is far from being a precise measure or prediction of future returns.
Yield to Worst – essentially this is the same calculation as YTM, but it accounts for alternate “maturity” dates
- When call provisions exist for any of the bonds included in the fund, YTW will be preferred over YTM, if it’s available.
Distribution Yield - sometimes referred to as “dividend yield”
- This is a backward-looking calculation which typically takes the most recent fund distribution, annualizes it, and divides by the NAV.
- You may also encounter a similar “12-Month Distribution Yield” which uses the actual distributions over the previous 12 months rather than annualizing the most recent distribution.
SEC Yield – another backward-looking metric designed to improve upon the distribution yield and provide a standardized way of comparing similar mutual funds.
- The calculation is based on dividends and interest earned during the most recent period, net of expenses, annualized.
- Bond funds use the most recent 30-day period and assumes bonds are held to maturity
- Money market funds use the most recent 7 days.
- Stock funds also use 30 days
- The catch here is that most stocks pay quarterly dividends, so if a fund has an uneven spacing of dividends, it will likely alternate between over- and understating the calculation every 30 days.
As you can see, there are several yield calculations for an investor to choose from. Depending on what you are trying to solve for, there is likely one yield calculation that will be more appropriate versus the others.
Challenges in Reviewing Yield Data
Outside of understanding and choosing the “right” yield calculation, there is the other challenge in how asset managers publish their data on their website or distribute it to data providers like Morningstar. We suggest using caution before using this data and doing your best to make sure you understand the output and verify it is an apples-to-apples comparison.
On top of there being many different calculations for “yield”, which can be confusing by itself, there are several other caveats to look out for:
Hedged Global/non-US Bonds – Investors need to be careful when looking at the stated YTM of non-US or global fixed income when the product is hedged USD. This is because the YTM can be stated in either or both unhedged and hedged terms. Specifically, we know that index providers like Bloomberg will calculate the YTM of their indexes using the YTM of the underlying bonds without regard to the USD hedge. We also know that fixed-income managers may use a different calculation where the hedge is included in the YTM calculation. This difference in calculation methodology can cause investors to see a wide difference in stated YTM.
TIPS Funds and ETFs - According to Vanguard, for inflation-protected bond funds and ETFs, YTM is calculated by adding the trailing 12‐month inflation adjustment to the current 'real' (i.e., before inflation) YTM of the fund. This means that if inflation persists at the same rate as the previous 12 months, as represented by the trailing 12‐month inflation adjustment, the YTM of the fund going forward (which also assumes income will be reinvested at that rate) would be the same as the published YTM. It’s worth noting that CPI figures are delayed by two months, so there’s a bit of an additional lag in terms of the calculations and adjustments as well.
The SEC yield for TIPS products is essentially the real yield, or the yield before adjusting for inflation. The actual yield on a TIPS fund will be a combination of the SEC yield plus the inflation adjustment. A complete estimate of the fund's forward-looking yield requires that an estimate of future inflation be added to the real yield.
SEC Yield and Global/non-US fixed income – the calculation for SEC yield for global/non-US fixed income hedged USD does not include the hedged component. In other words, the SEC yield is an unhedged yield and won’t accurately reflect the actual experience of the investor when the product is hedged USD.
Data providers (e.g. Morningstar) – In a perfect world, investors would be able to quickly see the YTM of their entire fixed income portfolio and utilize a tool like Morningstar or others to accomplish this.
Unfortunately, we know that not every asset manager publishes a YTM for their products. For investors calculating a portfolio YTM, it is critical to make sure each underlying fund/ETF has the appropriate YTM included.
Separately, investors also need to be aware that Morningstar receives the YTM data from the asset managers themselves, and not all asset managers provide the same exact data or use the same methodologies. For example, some asset managers will publish a YTW in the YTM field believing it is the more accurate/appropriate data point, while others will publish the YTM. In short, this simply means that a comparison of the YTM field in Morningstar may not be an apples to apples comparison. Unfortunately, we have also found instances where the data in Morningstar is not the same as the data published on the firm’s website.
Finally, it is important to be sure to make sure you are comparing data from the same date. For example, data can be current, shown for previous month end, or for some other time period. In particular when rates are changing rapidly, comparing yields from two different periods can result in large differences in results.
In other words, regardless of the yield calculation being used or the source of the data, it is important to review the data for reasonableness.
East Bay Investment Solutions, a Registered Investment Advisory firm, supplies investment research services under contract.
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