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Understanding Bonds – Demystifying Yield
Before getting caught up in the maze of fixed income investing, it's important to have a clear understanding of things like the difference between a bond's yield and its price. Because they're not the same.
Simply stated, yield expresses your percentage return on the your investment. Yield is most useful as a method of comparing fixed income investments for planning purposes, rather than as an exact measure of the return you will receive from an investment.
Yield can be calculated in several ways:
- Current yield
- Yield to maturity
- Yield to call
Current yield is the easiest but most often misunderstood yield calculation. To calculate current yield, you simply divide the bond's coupon interest - the amount of interest it will pay you each year - by the price of the bond. For example, if a bond is priced at $1,000 and it pays 8% or $80 a year in interest, your current yield is 8%. Current yield provides a reasonably good measure of return if a bond sells at or very close to its par value. However, current yield overstates the true return if you buy a bond selling at more than its par value (a premium bond), and it understates the true return if you buy a bond selling at less than its par value (a discount bond). This measure is not used by bond market professionals, but is commonly used by equity traders to compare preferred shares.
Yield to maturity
Yield to maturity provides a more accurate measure of return than current yield, and it is the yield used to compare bonds in the marketplace. Yield to maturity is a fairly complex calculation based on a bond's coupon interest rate, current price, length of time to maturity and reinvestment of the coupon income. It differs from current yield because it takes into account any difference between the price you pay for the bond and the par value you will receive at maturity, as well as the reinvestment of interest income over time.
Yield to call
Yield to call is an important measure of return for an investor who buys a bond selling for more than its par value that may be called away or redeemed by the issuer before final maturity. Because many fixed income securities have call features, it's important to know the yield to call before you buy a bond priced above par value.
Annual YTM (or money market yield) is used for money market instruments, conventional bonds and zero coupons that have less than one year remaining to maturity. Eurobonds are also quoted on an annual basis.
To find out more about bonds and fixed income investing, make sure to speak with a CIBC Wood Gundy Investment Advisor. Together you can determine the suitability of including fixed income investments in your portfolio.
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