In my article entitled "Your Retirement investments: Addressing the Bonds Dilemma", I quoted 12-month yields for a list of bond ETFs. However, 12-month yields do not best reflect the true yield of a bond investment. No single measure consistently best reflects the true yield of a bond investment, but yield to maturity (YTM), yield to worst (YTW), and option-adjusted yield (OAY) can provide a better measure than the 12-month yields, distribution yields, and 30-day SEC yields often quoted.
Also, you need to be careful because, sometimes, yield statistics are misleading or simply misquoted. You need to compare the yield statistic that is the best measure for the bond investment you are considering to other data to ensure it is fairly accurate.
Yield to Maturity
YTM is a measure of your annualized return if a bond, or all the bonds in a fund, are held to maturity. It accounts for interest and the fact that, at maturity, the principal of the bond or bonds will have returned to par value. It, at least, tends to be the best measure of yield, if none of the bonds involved can be prepaid or the like. (Bonds that can be prepaid are often referred to as bonds that can be called.)
YTM calculation is complicated. For an individual bond, though, you can calculate a figure very much like YTM with little effort. For example:
Par value: $1,000 | Current market price: $1,147.10 | Annual interest: $45.79 | Years to maturity: 5
Theoretical Interest Payment
Theoretical Interest Rate
(Note: I constructed this example using 10-year Treasury note rates. I do not recommend that anybody buys this bond.)
In theory, the principal is reduced by $29.42 each year, so that it equals $1,000 upon maturity; and the annual interest is, effectively, $29.42 less due to the reductions in principal. 1.51% is simply an average of the theoretical interest rates for each year. This is not how YTM is calculated; but it gives you an understanding of what the calculation is achieving, and the results are close to the same. Here is a tool for calculating YTM for an individual bond.
Yield to Worst
YTW is a measure of your annualized return if a bond, or all of the bonds in a fund, are held to their prepayment date(s) or maturity, whichever is least profitable for you given the current market price of the bond or bonds. It accounts for interest and the fact that, upon prepayment or maturity, the principal of the bond or bonds will have returned to prepayment or par value. YTW is a better measure of yield than YTM if the bond or bonds can be prepaid. YTW and YTM are the same if none of the bonds involved can be prepaid or it is not more profitable for the borrowers to prepay any of the bonds involved.
Theoretically, OAY is a better measure than YTW (if the bond or bonds can be prepaid). OAY is calculated using the current value of the bond prepayment options, versus using a return to prepayment values. OAY is often unavailable. When OAY is available, different entities may quote you different results because they are calculating using different models and/or data. In practice, OAY may not be a better measure than YTW.
Example: iShares Barclays MBS Bond Fund (MBB)
The iShares website has four different yields quoted for MBB. As of 9/27/12, they were:
- 30-day SEC yield: 3.03%
- Average yield to maturity: 0.35%
- Distribution yield: 1.30%
- 12-month yield: 2.49%
([Weighted] average yield to maturity means that bond holdings of greater value were given appropriately more weight, and bond holdings of lesser value were given appropriately less weight, in calculating. YTM, YTW, and OAY calculations should always be weighted averages.)
YTM should be the best measure of MBB's yield, as none of the bonds in the fund seem to be prepayable; but the YTM provided seems grossly low. In looking at the distribution history for the fund, we can see that the monthly distributions have, generally, been strongly shrinking in size. This explains why the distribution yield, based on the current NAV and the last monthly distribution (times twelve), and the 12-month yield, based on the current NAV and the last twelve monthly distributions, are so divergent. The 30-day yield, based on the most recent 30-day period and for which the calculation is more involved, seems grossly high. So what is the true yield of MBB?
I exported data from the iShares MBB Holdings page into an Excel spreadsheet. The data included YTM and YTW figures for each of the 358 bonds in the fund. The data also included a market value for each of the bonds. (The data was as of 9/26/12.) With this data, I was able to calculate that the weighted average YTM and YTW for MBB's bonds were 2.18%. MBB's bonds only accounted for about 96.89% of MBB's total value. The remaining 3.11% may have been in cash, providing little return. I assumed that the remaining 3.11% returns 0.50%, and MBB's YTM and YTW calculated as 2.14%.
I believe that MBB's true yield is close to 2.14%. The Vanguard website showed YTM of 2.1% for the Vanguard Mortgage-Backed Securities ETF (VMBS) and Barclays U.S. MBS Index. As MBB and VMBS are both based on the Barclays U.S. MBS Index, this indicates that my assessment of MBB's true yield is correct.
You should not have to be so elaborate to determine what you believe to be the true yield of a fund. Usually, you will not have to be. You can simply go to the fund provider's website, find the YTM or YTW, and compare it to the YTM or YTW for similar funds to sanity check it. In so doing, you should make an adjustment if the YTM or YTW to which you are comparing is for a fund with significantly longer or shorter average maturity, higher or lower average credit quality, etc.
(Thank you to cpa28761 for inspiring this article.)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I manage a portfolio which includes an investment in a mutual fund with holdings similar to those of MBB and VMBS. This investment is being exited.