Key Bond Investment Considerations, part 2
Yield is the return you actually earn on the bond—based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call. Current yield is the annual return on the amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought at €1,000 and the interest rate is 8% (€80), the current yield is 8% (€80 ÷€1,000). If you bought at €900 (the discounted price) for the same €1,000 bond (i.e. its par or face value) and the interest rate is 8% (€80), the current yield is 8.89% (€80 ÷ €900). You obviously would only be able to purchase the €1,000 face value bond at a discounted price if interest rates had risen since the bond was issued.
Yield to maturity and yield to call, which are considered more meaningful, tell you the total return you will receive by holding the bond until it matures or is called. These concepts also enable you to compare bonds with different maturities and coupons.
Yield to maturity = all the interest you receive from the time you purchase the bond until maturity (including interest on the interest at the original purchasing yield), + any gain (if you purchased the bond below its par, or face, value) or – any loss (if you purchased it above its par value).
Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive face value back at the call date. With a securitisation transaction such as a mortgage-backed security, where calls/prepayments can be unpredictable, you should ask about the assumptions used when calculating the yield to maturity. You should ask your financial advisor for the yield to maturity or yield to call on any bond you are considering purchasing. (See the Aids to Understanding Bonds section for tips on Using Math to Understand Bonds). Buying a bond based only on current yield may not be sufficient, since it may not represent the bond’s real value to your portfolio.