Yields: One Term, Many Meanings
First, let’s talk about yields. This is where the discussion often starts because the word yield is where confusion often develops. People throw the word around in many phrases: “this is what my bond fund yields,” or this is the “yield-to-maturity we see right now.” Between the multiple ways investors use the word and the many different yield measures that exist (yield-to-worst, yield to maturity, 30-day SEC yield, etc.), it’s easy to see how the potential for mixed signals can create pain points in client conversations (see yield definitions in FIGURE 1).
So, consider starting at the beginning. Yield is defined as the return you get based on the capital you invest. It’s as simple as that—or, at least, it should be.
In bond-land, the terminology gets tricky because clients often refer to a bond’s regular coupon payments as their bond yield. They may not realize that fluctuating interest rates and spreads2 will change the value of bonds at any given moment. You can explain that bonds trade at a premium when the bond’s coupon is higher than the prevailing level of rates; and they trade at a discount when the bond’s coupon is lower than the prevailing level of rates. You can further explain that, depending on the price you paid for your bond (i.e., at a premium or a discount), the yield will be a combination of that difference from par combined with the coupon.
So, what does it look like today? Since coupons are higher, your clients might think they should be getting higher monthly payments from their bond fund. Should they? Well, yes—but maybe not as high as some measures of yield are quoting.
For instance, yield-to-worst (YTW) is the lowest potential yield that can be received on a bond without the issuer defaulting. It’s calculated by making worst-case scenario assumptions on the issue by calculating the returns that would be received if provisions, including prepayment, call, or sinking fund, are used by the issuer.
The YTW on the Bloomberg US Aggregate Bond Index (the “Agg”)3 was 4.81% as of 2/28/23. However, the average coupon of the more than 13,000 bond issues that make up the Agg was 2.76%. Furthermore, the five largest passive core-bond ETFs managed to that Index paid, on average, a 2.93% distribution, which is more representative of the average coupon than YTW on average for February 2023. Fees were not an issue as each only charge 3 basis points.4 So, where is the other 1.9%?