One of our roles as a financial advisor is to help educate our clients on different risks in the market and in their portfolios and to help them minimize those risks. But often when we discuss those risks and the options we are recommending, without realizing it, we can use terminology that some of our clients might not fully understand, especially when discussing fixed income or bonds. In this blog we will go some basic functions of bonds, terminology and how they complement your portfolio.
Many people look to bonds for portfolio diversification and to add stable income, especially in retirement. The basic idea of a bond investment is easy to understand. You simply buy a debt obligation, or bond, from an issuer, collect regular interest payments over the life of the bond, and then get your principal back when the bond matures.
Although bonds give a predictable income stream and usually come with lower risks and volatility than stocks, in certain environments, such as rising interest rates (for example 2022), bond values can also go down. The bond is still paying the same income but because someone can now purchase a bond paying a higher interest rate your bond can go down in value if you choose to sell it in the open market. But if you are holding the bond to maturity for the income that it provides that shouldn’t matter because you are still receiving the same income or coupon until the bond matures.
When looking to purchase a bond, most investors consider the yield. But there are many ways of quoting the yield on an investment, and they can vary based on a number of factors. For investors looking for income, knowing which yield measure to consider doesn’t need to be complicated. Below are some descriptions of different types of yield and the function and importance of each.1
Distribution Yield (Trailing 12-month yield/TTM yield): It is based on the yield when the bond was purchased. This is a backward-looking measure that represents what investors have received in actual income. It is a less volatile measure of yield and a lagging indicator during periods of volatility. It is useful for comparing past performance of investments.
Yield to Maturity (YTM): Based on the current market valuations, it’s a measure that includes the return of principal and coupon payments, if a bond is held to maturity. It is forward-looking measure that can be used to compare bonds. If you intend to hold the bond or even a certificate of deposit and not sell it - it measures a bond’s potential for total return based only on its income. This measure may be used as an income planning tool.
Yield to Worst (YTW): The most conservative yield measure. It considers the current price of the bond and the potential impact of prepayments or call provisions. Generally, if a bond has a call feature you will see this in the description of the bond besides the maturity date. Also the call date generally is earlier than the maturity date. This calculation essentially compares all the potential call dates and maturity dates to see which outcome produces the worst annualized rate of return.
SEC Yield: Intended to create a net-of-fees, apples-to-apples comparison across yield oriented strategies, using both current and historical pricing. It is a useful tool for comparing between investments. Certain assumptions can limit comparability because it excludes yield contribution from non-cash securities and doesn’t account for prepayments in securitized assets.
Fixed rate vs. floating rate. This may indicate a reset of the rate of interest the bond pays to the holder or investor.
Bond rating. This can indicate the financial strength of the payor. For example, Government bonds may generally have higher rating than corporate bonds based on a rating agency opinion. This is an opinion and not a guarantee of payment however as historically some rating agencies have misguided on their ratings of certain issuers. Also in the case of government bonds of the US Treasury may be viewed differently than government agency bonds such as FNMA (Federal National Mortgage Association) etc.
Bonds are an important part of an overall diversified investment strategy. Hopefully this helps to understand them a little better. And remember, as the Fed looks to start cutting interest rates in the near future the current value of the bonds in your portfolio will be an even more attractive because when interest rates go down, bond values go up!
We hope that you and your family have a safe and healthy summer.
Jean, Kurt, Anders, Maggie & Molly
1 Columbia Threadneedle Investments, How well do you understand yield? A guide for investors. May 14, 2024
Note: All investments involve risk, including loss of principal. Some of the potential risks associated with fixed income investments include call risk, reinvestment risk, interest rate risk, credit risk, default risk, liquidity risk and inflation risk. Additionally, it is important that an investor is familiar with the inverse relationship between a bond’s price and its yield. Bond prices will fall as interest rates rise and vice versa. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates. Ratings are measured on a scale that ranges from AAA or Aaa (highest) to D or C (lowest). Investment grade investments are those rated from highest down to BBB- or Baa3.
JG2024-0618*