There is a great deal of interest in bonds right now. I thought it was time to talk a little bit about bond yields. Bonds are different from a bank CD. The bank tells you they have 1% one year CD, and that’s the rate. But bonds are trickier for a few reasons. First, bonds trade in the open market, and so you can buy them for more than full price, or for a discount. That changes the yield. Second, the company that issues a bond may give themselves the option to buy the bond back or ‘call’ it, often below the current market price. Much like you can refinance your mortgage, the company may want to pay off the bond holders and issue new bonds at lower rates.
So when you are talking about bonds there are actually four yields that you need to be aware of. They are:
Current yield – that’s the yield on the bond at the current price, ignoring call options and the cost of buying the bond at a premium.
Yield to maturity – this is the yield that you’ll get if you hold the bond until it’s time is up. If you buy the bond for a premium (i.e. you pay $1050 for a $1000 bond) this yield will be less than the current yield, as it will take the premium cost into account.
Yield to call – if the bond is callable, this will be the yield you’ll get if the bond is called by the issuer. If you buy the bond at a premium, this will be a lower yield than the current yield and lower than the yield to maturity.
Yield to worst – this is the yield you’ll get in the worst case scenario, which could be the yield to call or yield to maturity.
In general you’ll want to find out the yield to worst for any bond that you buy. You may do better, but you have to assume that the issuer will want to pay as little interest as possible and that’s the rate you’ll get when all is said and done.