Have the low interest rates available lately tempted you to reach for higher rates in new places? Low interest rate environments always make it difficult for those who rely on the income from their investments to support their lifestyle. But before you start searching for sources that provide a greater return, it is vital that you understand that it’s not the yield that matters.
I have a client who recently retired with well over a million dollars. He needs to earn roughly 6% a year on his investments to allow him to maintain his lifestyle without using his principal. With rates on short-term Certificates of Deposit paying only around 2% and the 10-year Treasury Note only paying 4.25%, it is a challenge for him to get the income he desires. In his frustration with these low rates he has been tempted to reach for higher yields.
“Jeff, there’s got to be something better. What about these bonds I see in the Wall Street Journal? There are some that are yielding over 7%. "
These rates only tell a part of the story. When analyzing income oriented-investments, the yield quoted in the newspaper may be considerably different than the return you actually receive.
Understanding the relationship of the quoted yield and the price of the bond is the first step in calculating your actual return. The yield often quoted in newspapers is referred to as the coupon rate. If a bond has a coupon rate of 7%, the issuing company will pay whoever owns each $1,000 bond $70 per year in interest. But your return is based on how much you paid for that bond. For instance, right now you would have to pay $1,400 for that bond, which means that your yield would actually be 5%, not 7%. This is called your yield to maturity.
But you must also consider the yield to call. Many bonds are callable, which means they can be paid off early. Some can be called as early as a few months after issue, others years later. If you pay more than $1,000 per bond and it is taken away from you early, your return can be substantially less than the yield to maturity. For instance, if you buy a 7% 10-year corporate bond, callable at face value in 5 years, it would cost you $1,200 per thousand dollar bond. This would give you a yield to maturity of 4.5% but a yield to call of only 2.7%.
The reason the yield to call is so much less than the yield to maturity is because you ‘lose’ the premium you paid for the bond over a shorter period of time. So, in this example, you ‘lose’ the $200 extra per bond over 5 years instead of over 10 years. That’s a reduction of $400 per year as opposed to $200 per year. The yield to call takes these factors into account.
Our example discussed the effect of paying more than $1,000 per bond. When paying a ‘premium’ the yield to call will always be lower than the yield to maturity. If you pay less than $1,000 per bond you still receive $1,000 when it comes due. So instead of ‘losing’ that difference you are actually earning it. So on ‘discount’ bonds, the yield to call will always be higher than the yield to maturity.
Instead of looking at the coupon rate, it is better to look at the yield to worst. Yield to worst is the lowest return you would have in the event the bond either lasted until maturity or was called early. The yield to worst only includes the effects of paying more or less than the face value of the bond and the call provisions. It does not include other factors that could affect the overall value of the bond or the issuers ability to repay it at maturity.
When my client found out that the yield to worst on those 7% bonds in the newspaper was actually 4%, he realized they weren’t as good of a deal as he thought. So when looking for income-oriented investments, remember it’s not the yield that matters.
Nationally-syndicated financial columnist and Certified Financial Planner® Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He’ll answer your financial question – FREE at http://www.guardingyourwealth.com