Bloomberg’s “Odd Lots” podcast, co-hosted by Joe Weisenthal and Tracy Alloway, recently produced a five-part series on LIBOR. It covered the retirement of the benchmark index, a long-time cornerstone in the capital markets. The series provided some great background and perspective.
To make it easier for you, here’s a list with links to each of the episodes in the series:
1 – Meet the Man Who Blew the Whistle on LIBOR: Features an interview with Richard Robb, who first raised concerns about LIBOR back in the mid-1990s.
2 – This is the Index That’s Supposed to Replace LIBOR: Discussion on the Secured Overnight Funding Rate (SOFR) with Joe Abate from Barclays.
3 – The Case for AMERIBOR as the Replacement for LIBOR: An interview with Richard Sandor from the American Financial Exchange about an alternative index to LIBOR.
4 – How the Transition from LIBOR is Actually Going: Features a discussion with Tom Wipf from Morgan Stanley about the transition process that’s underway.
5 – What Happened to LIBOR During the COVID Crisis: An interview with Josh Younger from JPMorgan, reviewing how LIBOR has behaved during the COVID crisis.
The podcast series is full of interesting history, context, and info, so check it out!
Early in my career, I learned that the most important consideration for bond investments was a bond’s yield. After all, if we don’t know the potential return on a bond, how do we select the investment that might be best for our needs?
In fact, when speaking with brokers or reviewing Bloomberg screens, most of what you will see is based on the bond’s yield. However, there are three important factors about the bond yield calculation that may make it a misleading measurement.
Exactly What Does “Yield” Mean?
Most of the time, when we talk about yield, we’re referring to the yield-to-maturity (YTM). YTM is the annual return that an investor can expect to earn on a bond investment over its lifetime. It takes into account the interest income earned, the principal cash flow when the bond matures, and any premium or discount paid. For those that are more statistically-minded, YTM represents the internal rate of return (IRR) necessary to discount all future cash flows so that the sum of their present values is equal to the bond’s current price.
YTM provides a summary measurement of all the bond’s cash flows, including principal received at maturity. Many investors believe that YTM offers a clear indication of the return they will earn. However, to truly realize a bond’s YTM, several key assumptions need to be met:
- The bond is held to its final maturity.
- All income is reinvested at the same rate as the YTM.
- You receive all interest and principal payments on schedule.
Because of these assumptions, you’ll face three reasons why you might not earn the YTM on a bond investment:
Reason #1: You Don’t Hold the Bond Until It Matures
While your intent may be to hold your bonds until final maturity, that may not always be the case. Bonds can be sold before maturity for several reasons. These can include liquidity needs, changing risk factors, or adjustments to the portfolio investment mix. Depending on the original price paid, if you sell a bond before it matures, you may realize a gain or loss on the sale, and your return will vary from the YTM.
Reason #2: You Don’t Reinvest the Income You Earn
As mentioned above, one of the assumptions is that any income received is reinvested at the YTM interest rate. While this is difficult to do (though not impossible if you invest in zero-coupon bonds), the reality is that your return will vary from the expected YTM as coupon income is reinvested at rates that vary from the original YTM (if it is reinvested at all).
Reason #3: Optionality Changes the Payment Schedule
Since YTM assumes that you receive all payments as scheduled, it also assumes the absence of any embedded options. Once optionality is introduced, as in the case of callable bonds or securities with prepayment risk like mortgage-backed securities, it has a direct influence on the actual yield. It also results in a difference when compared to the YTM.
Some metrics, such as yield-to-call (YTC), help to quantify some of the effects of optionality. However, what about when the bond contains multiple embedded calls? How do you know what your yield will be then? Below is a snapshot from a Bloomberg screen for a callable step-up agency bond. As you can see, your yield can vary depending on whether (or when) the bond is called.
It is more challenging to determine the possible yield on a security with prepayment risk, such as an MBS. As the Bloomberg screenshot below shows, the yield to maturity can change throughout the investment’s life as principal payments vary due to optionality.
The bottom line is that basing an investment decision solely on the yield at the time of the purchase isn’t necessarily telling you the whole story.
Is Using Yield a Worthless Exercise?
So with all the reasons that the YTM calculation doesn’t provide an entirely accurate result, does that mean it is a useless measurement or a waste of time? No, not really.
While it may not be a perfect metric, YTM allows you to make a direct comparison between different securities, taking into account different coupons and prices. It combines all the different cash flows into a single statistic and allows a quick apples-to-apples comparison of the potential return you could earn on your investment based on “what might be.”
However, it is probably best not to use YTM as your sole measurement for evaluating fixed income securities. It is better to blend YTM with other factors such as duration, weighted average life, and total return when analyzing bonds. These measurements, along with your specific balance sheet needs and risk tolerances, will help shape the overall picture required to make a sound investment decision.