Many investors judge the value of a bond by its current yield – i.e. the annual income paid by the bond divided by the bond price. Unfortunately, current yield can be a very misleading indicator of value. Let me explain.
Why Current Yield Can Deceive Investors
The par value of a bond is generally priced at $100. The problem is that unless a bond is trading very close to $100, current yield can be a deceptive indicator of the total return offered by the bond.
Current yield understates the total return on a bond when the bond is trading below $100. By the same token, current yield overstates total return when a bond trades above $100.
In the current low interest rate environment (^TNX ^TYX) the risk to investors comes from bonds trading above $100. The reason is simple: Bonds that were issued in the past when interest rates were significantly higher will tend to have increased in price. The decline of interest rates has tended to push the current yields on all bonds down. However, this also implies that the price of the bonds have been pushed up – in many cases, above $100.
Let us look at an example for illustrative purposes. Take a bond with a 7.5% coupon issued five years ago. Let us assume that the bond currently has a value of $125 due to interest rate declines after the bond was issued – and/or perhaps credit quality improvements by the issuer. The current yield of the above bond is 6.0% (7.5/125). However, this 6.00% yield is illusory.
Let’s say that this bond matures in five years. You will collect 6% per year ($7.5/$125) or about $37.5 worth of nominal coupon income over that period. Furthermore, when the bonds mature, and assuming no default, you will get exactly $100 in return of principal. However – and here’s the catch - since you paid $125 for the bond, you will actually be taking a capital loss of $25 on the initial investment of $125. In sum, the total return on this investment amounts to roughly 2% per annum – $37.5 of nominal income minus a $25 capital loss divided by the $125 initial investment in over a five-year holding period.
The moral of the story: Current yield becomes a value trap when looking at bonds trading above $100.
In the above example, a current yield of $6.0%, which looks highly attractive in the current low interest rate environment, can ensnare an unwitting individual to make an investment that will actually only yield 2% over the life of the investment. After inflation is factored in, this investment that looks like a winner on the basis of current yield is actually a loser when total return is calculated.
This story works inversely as well, by the way. When you buy a bond below $100, not only will you receive the current yield until maturity, you will benefit from capital appreciation.
I have emphasized the dangers of using current yield as an indicator of the value of bonds because in a low interest rate environment, many bonds will trade above $100. When bonds trade above $100, quotation of current yield can become a value trap that can ensnare unsuspecting investors.
Many investors that are new to bonds do not understand this risk and are making poor decisions as a result.
This warning applies equally to investors that purchase individual bond issues or bond mutual funds and/or ETFs (LQD, JNK, HYG, IEF, TLT, AGG, BND, PHB, HYLD, IBND, EBND, TLO). The warning is especially relevant to investors in convertible bonds due to the fact that the bond price can be inflated by price appreciation of the stock that the convertible bond is attached to.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short TLT.