|
DIFFERENT YIELD MEASURES
<br />Yield is a commonly used measure of a fixed income
<br />portfolio's growth. Yield appears to be a simple,
<br />straightforward measure that is easyto understand and
<br />easy to describe to interested parties. However, when
<br />we take a closer look atyield measurement, we observe
<br />that, itmaynotbe assimpleas itseemsatfirst.
<br />The biggest problem that users encounter when
<br />discussing yield is simply determining what measure of
<br />yield we are talking about. There are a variety of yield
<br />measures, based on different calculations, which may
<br />result in different yields. Imagine the following
<br />exchange.
<br />Our bond portfolio has been performing well, says the
<br />countytreasurer. Ityields 5,35%. No it doesn't says the
<br />city manager, it yields 5.28%. No, you're both wrong
<br />says the investment officer, our portfolio yield is
<br />5.39%.
<br />Who is right? Do two of the people not knowwhatthey
<br />are talking about? In fact, all three of the people are
<br />correct. The same bond portfolio can show yields of
<br />5.35%, 5.28%, and 5.39%, depending upon the yield
<br />measure thatyou are using.
<br />All of these yield measu res can be useful, as long as theyare
<br />used properlyand in the correctcontext.Unfortunately, it is
<br />often difficult to keep track of the proper yield measures.
<br />That is why yield, while useful, is not always the best
<br />measure of a bond portfolio's return. Let's take a closer
<br />look at when yield might be useful, as well as situations in
<br />which it is not the best tool to use.
<br />When isy_ield useful?
<br />Yield is useful when trying to predict future cash flows. An
<br />excellent example of this is the budget process. If you need
<br />to figure out how much cash your investment portfolio is
<br />going to generate, yield to maturity is an excellent
<br />measure.
<br />When isn'tyield useful?
<br />Yield is less useful in measuring a portfolio's performance.
<br />In part, this is because of possible confusion as to which
<br />yield measure is appropriate for assessing portfolio return.
<br />For instance, if you are comparing your portfolio's yield to a
<br />benchmark, and you use purchase yield while the
<br />benchmark uses currentyield, you no longer have an apples
<br />to apples comparison and therefore do not have an
<br />accuratemeasureofyourtrueperformance.
<br />The preceding discussion should make it abundantly
<br />clear that when using yield as a measure of portfolio
<br />performance (or a bond's value) it is extremely
<br />important to use the proper yield measure. The chart
<br />below includes several popular yield measures and
<br />their definitions:
<br />Current Yield =the annual coupon payments divided by
<br />the market price ofthe band.
<br />Yield to Maturity =the internal rate of return of a bond or
<br />portfolio, based upon either the current market price or the
<br />initial cost assuming all coupon payments are reinvested at
<br />exactly the same rate. Two problems here: First assuming all
<br />coupon payments will be invested at the same rate is
<br />unrealistic. Second, the yield to maturity calculated at cost is
<br />likely to be very different from the yield calculated at market
<br />distinction that interested parties may not understand.
<br />Book Yield =this is another term for the yield to maturity
<br />based upon the price actually paid for the bond when
<br />purchased
<br />Yield to Call =the yield that will be received if the bond is
<br />called at the next call date. When purchasing callable bonds
<br />at a premium it is very important to note the yield to call,
<br />which will be lower than the yield to maturity, and is your
<br />"worst case" return.
<br />Bond Equivalent Yield =the yield on a bond when
<br />semiannual, quarterly, or monthly payments are converted
<br />into annual payments. This allows bonds with different
<br />payment schedules to be compared to each other.
<br />Money Market Yield = a bond yield calculation based
<br />upon semiannual payments, and a 360 day year (as
<br />opposed to a 365 dayyear)
<br />In addition to the confusion over its proper measurement,
<br />yield also has another shortcoming. A portfolio's return
<br />consists of three components: interest, reinvestment of
<br />principal and interest, and gains/losses from security
<br />purchases and sales. When using yield as a measure of
<br />portfolio performance, you are only measuring the first
<br />part of portfol io return.
<br />Abetter practice is to use total rate of return calculations in
<br />order to measure portfolio performance. Total rate of
<br />return calculations overcome the two shortcomings of
<br />yield. First of all, there is only a single, agreed upon
<br />definition and measurement of total return. Second of all,
<br />total rate of return measures all three of the components of
<br />a portfolio's performance.
<br />Yield measures are excellent tools when used properly.
<br />Always remember to specify which yield measure you are
<br />using when calculatingyield. Alsoyield should be used only
<br />when appropriate, such as for forecasting cash flows or
<br />preparing a budget. Do not use yield measurements when
<br />they are not appropriate, such as when measuring a
<br />portfolio's return. When evaluating the performance of
<br />your internal or external money managers, total return is
<br />the appropriate measurementtool.
<br />Note: Yield and total return can be confusing topics. If this
<br />article has prompted additional questions, contact your
<br />investment providers (investment advisor or broker) or
<br />search the web for more information (www.
<br />investinginbonds.com is an excellentsite).
<br />Brian Perry, Vice President, Portfolio Specialist
<br />Fage 2
<br />®2007. Chandler Asset Management, Inc, A Registered MvestmentAdvisec
<br />
|