For Bonds, Yield Doesn't Always Equal Return
When discussing bonds with investors, I find that many confuse yield, coupon rate and expected return. I asked my Buckingham Asset Management colleague Jared Kizer to provide an explanation of the differences. (Jared co-authored The Only Guide to Alternative Investments You'll Ever Need with me.) Here's what he had to say.
Coupon Rate vs. Yield
The coupon rate of a bond tells you the annual amount of interest paid by that security. For example, a Treasury bond with a coupon rate of 5 percent will pay you $50 per year per $1,000 of face value of the bond. However, this tells you very little about the yield of the fixed income security. For most bonds, the yield is a good proxy for their return and is far more meaningful than the coupon rate. To illustrate this, consider the following two Treasury bonds:
- 8.875 percent coupon, 2/2019 maturity
- 2.75 percent coupon, 2/2019 maturity
2.51 percent. This means they're priced in a way to provide essentially the same return. That is, you have to pay significantly more to buy the bond with the relatively high coupon than you do to buy the bond with the low coupon. The net result is that either purchase has essentially the same yield, or expected return.
Yield vs. Expected Return For securities such as CDs, agency bonds and high-grade municipal bonds, yield is a good approximation of their expected return. This isn't true of all types of fixed income securities, however.
In particular, yield isn't a good measure of the expected return for securities that have meaningful default risk, such as high-yield bonds. The standard yield calculation assumes you'll receive all principal and interest payments. The actual expected return for these securities will always be significantly lower than the yield. This also means the yields of securities with significant default risk can't be meaningfully compared with the yields of securities with minimal default risk.
Let's look at an example of why you shouldn't confuse yield and expected return. From 1979 through 2009, the Vanguard High-Yield Corporate Fund (VWEHX) earned an annualized return of 7.2 percent underperforming the 8.7 percent annualized return of the Barclays Capital Intermediate Credit Index, an index of investment-grade bonds. Despite high-yield bonds always having much higher yields than investment-grade bonds, they didn't provide higher returns.