Fixed Income Valuation: Yield Measures
Understanding the various yield measures is crucial for valuing fixed income securities. These measures help investors assess the return they can expect from a bond, considering different aspects of its cash flows and price.
Current Yield
The current yield is the simplest measure of a bond's return. It represents the annual coupon payment divided by the bond's current market price. It provides a snapshot of the income generated relative to the current investment cost, but it doesn't account for the bond's maturity or any capital gains or losses.
Current Yield = Annual Coupon Payment / Current Market Price
Yield to Maturity (YTM)
Yield to Maturity (YTM) is the most comprehensive measure of a bond's return. It is the total return anticipated on a bond if the bond is held until it matures. YTM is expressed as an annual rate and is essentially the internal rate of return (IRR) of the bond's cash flows. It accounts for the current market price, par value, coupon interest rate, and time to maturity.
YTM assumes that all coupon payments are reinvested at the YTM rate. This is a key assumption that may not hold true in reality.
Yield to Call (YTC)
Many bonds are callable, meaning the issuer has the right to redeem the bond before its maturity date. Yield to Call (YTC) is the total return anticipated on a bond if it is held until the call date. It's calculated similarly to YTM, but the cash flows are considered only up to the call date, and the principal repayment is assumed to be the call price (often par value).
| Measure | Focus | Key Assumption |
|---|---|---|
| Current Yield | Annual coupon payment relative to current price | Ignores maturity and capital gains/losses |
| Yield to Maturity (YTM) | Total return if held to maturity | All coupons reinvested at YTM; held to maturity |
| Yield to Call (YTC) | Total return if held to call date | All coupons reinvested at YTC; redeemed on call date |
Yield to Worst (YTW)
For callable bonds, investors are often concerned with the 'worst-case' scenario. Yield to Worst (YTW) is the lowest of the YTM and all possible YTCs. It represents the minimum yield an investor can expect to receive on a callable bond, assuming the issuer acts in their own best interest to minimize the investor's return.
Effective Yield
When coupon payments are made more frequently than annually (e.g., semi-annually), the effective annual yield (EAY) provides a more accurate representation of the bond's annual return than simply multiplying the periodic yield by the number of periods. It accounts for the compounding of interest.
The relationship between bond price and yield is inverse. When market interest rates rise, the price of existing bonds with lower coupon rates falls, and vice versa. This is because investors demand a higher yield to compensate for the lower coupon payments relative to prevailing market rates. The sensitivity of a bond's price to changes in interest rates is known as duration.
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Key Takeaways
Each yield measure provides a different perspective on a bond's return. Current yield is a quick estimate, YTM is the standard for non-callable bonds, YTC and YTW are crucial for callable bonds, and effective yield accounts for compounding. Understanding these measures is fundamental to fixed income analysis and valuation.
Learning Resources
Official curriculum material from the CFA Institute covering various yield measures for fixed income securities, essential for exam preparation.
A comprehensive explanation of different bond yield measures, including YTM, current yield, and their implications for investors.
A video tutorial explaining Yield to Maturity (YTM) with practical examples, suitable for CFA Level I candidates.
Charles Schwab's guide to understanding bond yields, offering practical insights for investors.
A video tutorial focusing on Yield to Call (YTC) and its calculation, relevant for CFA Level II preparation.
A tutorial from Wall Street Prep that breaks down various yield measures used in fixed income analysis.
Khan Academy's video series on bond valuation and yields, providing foundational knowledge.
Investopedia's definition and explanation of Yield to Worst (YTW), a critical measure for callable bonds.
Investopedia's explanation of Effective Annual Yield (EAY), detailing how it accounts for compounding.
A lecture from a Coursera course on Fixed Income Analysis, specifically covering yield measures.