Market Beat: Understanding bond yields
In today’s interest rate environment, the yield curve is very flat and recently inverted.
In a normal interest rate environment, the yield curve slopes upward so bonds with longer maturities pay a higher rate of return than bonds with shorter maturities.
When the yield curve is flat, as it is now, short term bonds pay almost as much as long term bonds. When the yield curve inverts, as it did recently, short term bonds pay a higher rate of return than long term bonds.
As of last Friday, May 25, the long-term 30-year U.S. Treasury bond was paying 2.75%. The 10-year U.S. Treasury was paying 2.33% and the two-year note was paying a rate of 2.16%. As you can see, there is not much difference between the yields. The very short term one-month Treasury bill was paying 2.37%, which is more than the 10-year and the two-year.
The yield that is quoted is what’s known as the yield to maturity, or YTM. In other words, that rate is the yield that you’ll receive each year if you hold the bond until maturity, when you’ll be re-paid the par value of the bond. Bonds also have what’s called a coupon rate which is the rate paid if the bond is trading at par. Bonds that trade in the aftermarket typically trade at premiums or discounts based on current interest rates. Bond prices rise when interest rates fall and drop when interest rates rise.
Some bonds are callable, meaning that the issuer can pay you back for the bond prior to maturity if they want to. Some issues are perpetually callable, and others have set dates that they can be called. If you are considering buying a callable bond, you need to know what the yield to call, or YTC, will be. The yield to call can be very different than the yield to maturity. In many cases, the yield to call is considerably lower than the yield to maturity.
If the bond is perpetually callable or has more than one call date, you need to determine what is the yield to worst call, or YTW. If you were to get called at the worst possible time, that number will tell you what your yield will be.
Another measure of yield is the taxable equivalent yield or TEY. The TEY is used for tax free municipal bonds and is used to compare tax free to taxable yields.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.
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