Many equity investors would be very familiar with the term ‘Dividend Yield’. They would most likely consider dividend yields when buying shares. The same concept exists for bonds, where it’s called ‘Running Yield’. They’re both similar in concept – how much cash flow (dividend or coupon) am I going to get back for every dollar I invest?
When looking at equities, this is not a terrible measure to use – mainly because of the lack of a better alternative. The future dividends and sale price of an equity can, of course, change at any moment and cannot be determined. And as shares don’t mature, you don’t have a known capital repayment (or looked at another way, a known ‘future price’) to consider.
The future cash flows of hybrids are unknown as well. Coupons are both optional and variable, and the timing of the maturity payment is the choice of the issuer – or the issuer can convert the security into equity. Since cash flows are relatively unknown, it is also common to look at Running Yield when considering hybrid securities.
When looking at true fixed-rate bonds, or XTBs over them, Running Yield is not the best metric to consider when you’re making an investment. This is due to the certainty in their cash flows – the exact cash flows are determined on the issuance date, by contractual agreement, and cannot change. Since we know exactly what cash flows we are going to get, and exactly when, we can use more complete measures to determine what an investor’s return will be. The measure is known as Yield to Maturity (YTM).
Let’s use an example to explain more clearly the difference between YTM and Running Yield.
On the maturity date of all XTBs, investors will be paid the principal amount ($100.00) plus the final coupon of the XTB. For YTMTLS (a Telstra XTB), that number is $100.00 + $3.875 = $103.875 and it will be paid on 15-July-2020. If not, Telstra is in breach of its contract and in default – there is no flexibility or optionality.
In June this year:
- YTMTLS was trading at $120.00, which comprises a Clean Price of $116.64 and Accrued Interest of $3.36. Clean Price and Accrued Interest are explained here.
- The annual coupon for YTMTLS is $7.75, which gives a Running Yield of 6.46% ($7.75 / $120).
- But investors will not earn this – not even if they hold the XTB for one day.
This isn’t intuitive to many investors. If you are receiving $7.75 p.a. and paid $120.00, as a percentage you are earning 6.46%. It is the certainty around the future price of the XTB that drives this to be an incomplete approach. For equities the ‘future price’ is unknown so it makes sense to ignore it, but when you know this information with certainty, why should you ignore it? We know that the Clean Price on 15-July-2020 will be $100, and this should be taken into account when investing.
To demonstrate this, assume that the Clean Price straight-lines to maturity. So the clean price goes from $116.64 to $100.00 in equal portions every one of the next 1,120 days. This isn’t a perfect replica of what happens in practice, but it’s not far from the truth.
If this is the case, the path of both Clean and XTB Price will look like this:
Chart 1: Clean bond and XTB Prices
If this assumption holds true then tomorrow the Clean Price will be:
The Accrued Interest tomorrow would be $3.38. If we take out any rounding, the full XTB Price would be $120.0066. Over the course of the one day period, an investor has earnt 0.00546% ($120.0066 / $120). Annualised with simple multiplication, this is 0.00546% * (365) = 1.99%.
1.99% is a lot lower than 6.46%. Taking into account the known ‘future price’ of the XTB significantly changes the analysis, even with a simple straight-line assumption.
Of course, the actual result achieved by an investor might vary due to daily price fluctuations (up and down) of the market. As a side note, the extremely low volatility of XTB’s is discussed here. However, this analysis shows that we cannot use Running Yield as a measure for return on products with certain cash flows, even over short time periods.
The same result falls out if we use 2 days, 7 days, 30, 90 or 150 days. The analysis’ returns are 1.99%, significantly lower than the Running Yield.
The YTM calculation takes all of the future cash flows into account. The YTM on YTMTLS using the XTB data above is 2.12%, which is quite close to what we calculated in our slightly simplified example. The difference is largely driven by YTM taking into account the reinvestment of coupons along the way. This is why the market convention is to use YTM when looking at an investment in fixed-rate Bonds and XTBs.
We have more information when we assess an investment in bonds, or XTBs, than we do with equities or hybrids (being the known future cash flows). Therefore, it would be remiss to make an investment decision without taking this information into account. The Running Yield calculation does not take this additional information into account, whereas the Yield to Maturity calculation does. It takes into account every future cash flow. It is this defining difference which makes Yield to Maturity a better, more informed, metric to use when assessing an investment.
Data: 19th June 2017