For income-seeking investors, a bond investment's yield—that is, how much income it produces—is a key consideration. However, there are many ways to calculate yield. Here are eight such calculations, along with which matter most depending on the type of bond and the environment in which you're investing.
Newly issued bonds are purchased directly from the issuer, and you'll generally pay the face—or par—value, which is the amount you'll receive at maturity.
The price of a bond purchased on the secondary market, on the other hand, changes based on its interest payment relative to current rates. If it pays more than newly issued bonds, its price tends to increase; if it pays less than newly issued bonds, its price generally drops.
For bonds purchased on both the primary and secondary markets, there are typically six types of yield:
Also referred to as a bond's coupon rate, the nominal yield is the annual income divided by the bond's face value. For example, a bond with a $1,000 face value that pays $50 annually has a nominal yield of 5% (50 ÷ 1,000 = 0.05). For fixed-rate bonds, the nominal yield always remains consistent. For floating-rate or index-linked bonds, the nominal yield fluctuates with changes in the referenced rate of interest (such as the federal funds rate) or underlying index (such as the Consumer Price Index), respectively.
What to know: Nominal yield is most relevant to newly issued bonds. If you purchase a bond on the secondary market, its nominal yield may not reflect its current price and therefore its current yield.
Because a bond's price on the secondary market may be more or less than its face value, you can calculate its current yield by dividing its annual income payments by its current price. If a bond with a $1,000 face value paying $50 in annual income is trading at $950 on the secondary market, its current yield would be 5.26% (50 ÷ 950 = 0.0526).
What to know: Current yield is helpful when assessing a bond's cash flow against other bonds in the market. However, it offers a limited look into a bond's potential total returns since it doesn't account for the return of principal, whether at maturity or through a potential call (see "Yield to call").
Yield to maturity (YTM)
YTM measures a bond's annual rate of return if held to maturity, including all coupon payments and the return of principal when it matures, whether you purchased it on the primary market or on the secondary market at a discount or a premium.
What to know: Unlike current yield, YTM measures a bond's total return and therefore may be more useful in assessing not just expected cash flow but also total payouts over the life of the bond.
Yield to call (YTC)
Callable bonds can be repurchased—or "called in"—by the issuer on predetermined dates prior to maturity, so YTC measures the annual rate of return at the bond's next call date. This usually happens when interest rates fall and the issuer feels it can reissue the debt at a lower rate. Some bonds can be called at their face value, but others may be callable at a premium.
What to know: When considering callable bonds—such as municipal bonds—YTC is the best way to determine the minimum cash flow you can expect to receive in the event the bond is called before maturity.
Yield to worst (YTW)
Its ominous name aside, YTW indicates a callable bond's lowest potential return, barring default. If the bond is trading at or below its face value, its YTW will be the same as its YTM; if it's trading at a premium, its YTW will be the same as its YTC.
What to know: YTW is most helpful for investors who have specific income requirements and need to determine the lowest possible payouts they can expect to receive from a bond.
Taxable bonds often offer higher yields than their tax-exempt peers, but the tax you'll owe on the generated income will reduce the total return. Thus, tax-equivalent yield determines what a taxable bond would need to yield to match a comparable tax-exempt bond. To calculate it, divide the tax-exempt bond's current yield by (1 – your federal tax bracket). For example, if you're in the 32% tax bracket, to match the tax benefits of a tax-exempt bond yielding 3.50%, you would need a taxable bond yielding 5.15%, or 3.5 ÷ (1 – 0.32).
What to know: Tax-equivalent yield is the easiest way for investors to compare a tax-exempt bond against a taxable alternative.
Unlike individual bonds, bond funds generate income in perpetuity (barring a fund's closure). As a result, bond funds generally report yield in one of two ways:
Also called the "trailing 12-month yield" or "TTM yield," this metric is calculated by dividing a fund's cumulative distributions over the previous 12 months by its net asset value (NAV)—its total assets minus liabilities, divided by total outstanding shares—at the end of the period.
What to know: Because this indicator is backward-looking, it doesn't reflect recent portfolio adjustments or price changes that could affect the fund's future yield, especially if interest rates have changed significantly over the past 12 months. As a result, distribution yield is best employed as a point of comparison for similar funds rather than as a planning tool for future income.
SEC 30-day yield
In an effort to standardize yield reporting, the Securities and Exchange Commission (SEC) developed this 30-day yield metric, which all bond funds are required to disclose. To calculate it, a fund divides its net income per share during the past 30 days by the best price per share on the last day of that same period (regardless of closing price in the case of exchange-traded funds). The resulting yield tells investors how much income they could expect to earn over the next 12 months, assuming the fund continues to earn the same income rate for the rest of the year.
What to know: All funds are required to use the same methodology when calculating their SEC yields, so it's the best metric to use when comparing future income potential.
As you can see, yield is a lot more complicated than one simple calculation. Understanding the different ways to measure yield is key to assessing a bond investment's income potential now and in the future.