Interpreting Yields for Bond Funds

The common measures of value for equities include price to earnings and price to book ratios but these are not applicable for bonds. For bonds, the yields to maturity (or YTM) are used and compared with the risk free rates or other bonds. Of course, there are many different types of yields used in different ways but let's look at the simplest way first.

Yield to Maturity

An investor can think of YTM as the annualized return per annum for holding the bond under some assumptions. Let's go through how YTM is calculated and some of the assumptions that have to be in place for this yield figure to work.

First, YTM takes into consideration the cash flows you receive over the life of the bond, the price that you paid for the bond and the principal amount that you get back upon the maturity of the bond.

We can use the formula below to calculate yield to maturity:

P = c (1 + r)-1 + c(1 + r) -2 + . . . + c(1 + r) -n + B(1 + r) -n

r = yield to maturity
c = annual coupon payment (in dollars)
n = number of years to maturity
B = par value
P = purchase price

Take an example of a bond with par value of $100 and has a coupon rate of 4%. The price of the bond is $105 now. We can put in the information in the formula:

105 = 4(1 + r) -1 + 4(1 + r) -2 + . . . + 4(1 + r) -10 + 100(1 + r) -10

r = yield to maturity
c =$4
n =10
B =$100
P =$105

Looks complicated? It is. The yield cannot be easily derived using a normal calculator and it has to be calculated using a financial calculator because if it is done manually, we have to input many different "r" values and it would be quite time consuming.

The "r" calculated using this formula will be the return that you will be getting when the bond is held until it matures and assuming that the periodic coupon payments are reinvested at the same yield. We can use a financial calculator to derive the "r". In this example, the "r" is 3.4%.

Does that mean if a bond is yielding 3.4% based on this formula, would it be the absolute figure that the investor gets? The answer is a yes but only when three conditions are met.

Three Conditions for YTM to hold

For the YTM to accurately represent the annualized returns there are three conditions that need to be met.

1) The investor must hold the bond to maturity.

2) The company that issued the bond must not default on the bond.

3) The coupons received every year must be invested at the rate of YTM (in practice, this is hard to fulfill).

The first condition is one that we would like to elaborate on because many a time investors could actually choose to sell the bonds prior to maturity - especially when the price of the bond has already gone up and he or she feels that it is time to take profits. One major variable that the YTM depends on would be if the bond is purchased on par, at a discount or premium.

Relationship between Yields and Bond Prices

The price of a bond is inversely related to its YTM. YTM is high when the price of the bond is low. A low price or high YTM would signify value, provided the company does not default on any payment. The relationship would be best illustrated in the flowing example.

The bond's par value is $100,000, the coupon rate is 5% with the coupon being paid out once a year and the bond matures in 5 years time in 2013. The difference in the prices quoted results in varying levels of YTM.

Table 1: Relation between price of bond and YTM

Source: iFast Compilations

Table 1 shows three scenarios of the same bond trading at different prices and thus showing differences in YTM. The base scenario is the Bond (at Par) shows that the YTM equals the coupon rate. The quoted price is at par, which means that the investor will get back exactly the initial amount he has invested upon maturity. However, the investor must be able to reinvest the coupon at 5% interest rate (recall third condition).

The second scenario shows the Bond (at Discount) trading at $90,000 which is a discount to par value of $100,000. This means that besides the coupon payment that the investor would be collecting; he would collect $100,000 upon maturity or enjoy a capital gain of $10,000. Including this capital gain in the computation of YTM pushes the yield higher than Bond (at Par) to 7.5%.

The third scenario shows the Bond (at Premium) trading at $110,000, which is a premium to the par value. Upon maturity of the bond, the investor would experience a $10,000 capital loss, resulting in a lower YTM compared with the base scenario.

As an annualized return, higher yield to maturity would mean better returns for investors. However, the yield on the bond could have risen because investors think that the company is more likely to default on the bond and are therefore shunning the bond.Investors can look at YTM and compare the changes across time. If company fundamentals remain sound but YTM goes higher, it suggests value in the bond issue.

Besides looking at the YTM only, investors often compare the YTM with other fixed income assets of the same maturity (or duration).Duration measures the sensitivity of price of bond to changes in prevailing interest rates.

One common comparison would be between the YTM of a Singapore Dollar (SGD) denominated bond with the YTM of an almost risk free asset, for e.g. the Singapore Government Securities (SGS). The difference between the yields of both assets reflects the perceived risks of the corporate bond relative to a risk free asset. A bigger difference reflects higher perceived risks of the corporate bond.

Gross Yields to Maturity For Bond funds

When investors buy a typical bond, they would want to know what the YTM of the bond is. Similarly, when investors buy into a bond fund, they would be interested know the YTM of the bonds being held by the fund. If a fund has invested in bonds of different maturities and yields, the yield from the fund will be the weighted average of the yields on different securities, weighted by the proportion of invested sum. This is how the weighted gross YTM a portfolio of bonds or a bond fund is being calculated. Do note that in Table 2, there is no actual YTM for the bond portfolio, but there is a weighted YTM based on the underlying bond holdings.

Table 2: Calculating Weighted YTM for Portfolio of bonds

Source: iFAST Compilations

While the YTM on an individual bond represents an accurate estimation of the annual returns till maturity of the bond, investors must be careful in interpreting the YTM of a bond fund.

Weighted YTM A Reference Point Not a Forecast of Future Returns

As mentioned earlier, there are conditions to be met before the YTM can reflect an annualized return. It is quite likely that for bond funds the weighted yield of the bond fund would not be realized - the actual return could be lower or higher than the weighted YTM.

The fund managers may not hold the individual bonds to maturity. Trading on the underlying bonds often happens when a company's fundamentals changed or a more attractive opportunity arises. Selling before the bond's maturity means that the par value is not received and the capital gain/loss will not be the same as captured by the YTM calculation. If a bond appreciates in value, there would be a capital gain which means that the actual returns can be higher than the weighted YTM. On the other hand, if bond depreciates in value, the weighted YTM shown would not be achieved.

Also, the bonds within the funds are subjected to interest rate risks. As the funds are valued on a marked-to-market basis, when interest rate increases, the price of the bonds would fall and that would have a negative impact on the value of the fund. The converse is true.

The risks of defaults on bonds remain although the impact of defaults on the fund's value would be mitigated by diversification across a number of bonds. Any default in the bonds funds would means that the fund manager is very likely to claim an amount lower than the principal value of the bond, would also result in returns that are lower then weighted YTM.

Lastly, any reinvestments would be subjected to interest volatility which is affected by many other factors like economic conditions, market sentiments etc.

All these mean that investors should not take weighted YTM as an absolute return per annum that they would expect to receive.

While weighted YTM of a fund is not absolute measure of future performance, it is a piece of useful information that provides to investors a snapshot of the weighted yield of the bonds within the bond portfolio. Moreover, we believe that YTM data over time can help investors make decisions in whether investments should be made in bond funds. When markets are risk averse and are avoiding risky bond assets, we will see that it is likely to be reflected in a falling NAV figures and rising YTM figures. Rising YTM figures suggests that the prices of the bonds are getting depressed. For investors looking for value in bonds, it is an interesting time to look at the higher yielding bonds.

Aside from YTM, let's now go through some of the variations including Yield to call and Yield to worse.

Yield to Call and Yield to Worse

Some bonds are callable, which means that they can be redeemed prior to maturity date. When interest rates have fallen to a level lower than the coupon rate, the companies that issued those bonds would find it cheaper to pay lower prevailing interest rates. This is similar to the way that a homeowner might choose to refinance (call) a mortgage when interest rates decline.

The companies would then redeem the callable bonds and issue new bonds at lower interest rates. As a bond holder of a callable bond, you run the risk of having your bond called before maturity and in such cases, fund managers calculate the Yields to Call (YTC). The calculation method is the same as calculating the YTM, except that the par value would be replaced by call price (par value plus call premium) YTC would typically be lower than YTM if the bond is expected to be called. Yield to Worst (YTW) represent lower of YTM or YTC, a more conservative way of displaying yields figures and YTW may be the same as YTM figure but never higher.

Net Weighted Yield to Maturity Updated on a Weekly Basis

With the information fed from selected fund houses, we would be presenting weighted YTM figures on a weekly basis. We have estimated a net weighted YTM figures by subtracting the expense ratio reflected in the latest annual reports of these funds. We hope investors would be able to make use of the information to aid their investment decisions on bond funds. Table 3 shows the weighted YTM for four different funds. Schroder Global High Yield fund provides YTW figure as the fund invests a significant amount in bonds with callable features.

Table 3: Gross and Net Weighted Yields to Maturity

^Nett yields are estimates provided by iFAST Financial taking into accounts the latest expense ratios listed on the annual report. Source: Various fund houses & iFAST Compilations

Making investment decisions on fixed income funds

Investors may wonder about the difference in YTM of various funds presented. The funds have different YTM mainly because of the different regions and credit ratings grades of the underlying fixed income instruments. For example, the Schroder Global High Yield invests 70% or more into credits with less than investment grade ratings (investment grade of below BBB-, S&P Credit Rating) as compared with DBS Shenton Income who invests mainly into investment grade rated sovereign and corporate bonds. Durations of the bonds held can also affect the YTM figures, with longer duration bonds being compensated with higher yields typically.

As a general rule of thumb, higher returns reflect higher risks although sometimes brilliant fund managers become the anomaly. We hope that investors will find the YTM figures to be helpful in as a reference to the yields in various kinds of bond funds and benefit from being able to start deploying bond funds in their asset class allocation decisions.

Wong Weiyi, Analyst, is part of the Research Team at iFAST Financial Pte Ltd.

iFAST and/or its licensed financial adviser representatives may own or have positions in the funds of any of the asset management firms or fund houses mentioned or referred to in the article, or any unit trusts or Singapore Government Securities bonds related thereto, and may from time to time add or dispose of, or may be materially interested in any such unit trusts or Singapore Government Securities bonds. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any fund. No investment decision should be taken without first viewing a fund's prospectus. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Past performance and any forecast is not necessarily indicative of the future or likely performance of the fund. The value of units and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.