The ABCs of bond yields
Retirees who want fixed income as part of their asset allocation have several options to choose from. You can use bond funds, buy individual issues, or a combination of both.
If you prefer funds, you can use exchange traded funds or traditional mutual funds. You can also choose to use managed funds or passive funds that track a bond index. One of the advantages of mutual funds is that you can diversify a relatively small amount of money. Another advantage of managed funds is that you have a professional fund manager who makes the investment decisions, you just need to determine which fund (s) are best suited for your portfolio.
If you plan to purchase individual numbers for your account, you need to understand some basic terminology. Most investors are familiar with the term “yield”. Investopedia defines return like “The return on investment of an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the cost of the investment, its current market value or face value. different types of yield.
The return to maturity, or YTM, is the total return you will receive if you hold your bond to maturity and the issuer does not default. The coupon rate is the interest rate paid by the bond. There is a difference between YTM and the coupon rate. If the bond you are valuing is trading in the secondary market, it can trade either at a premium or at a discount to its face value. If it is trading at a premium, the YTM will be lower than the coupon rate and if it is trading at a discount, the YTM will be higher than the coupon rate.
Some bonds are callable, which means that the issuer has the right to redeem your bond from you before the maturity date. If the bond is callable, you can also calculate the yield to redeem, or YTC. For example, you could buy a 20-year bond with a YTM of 4.5%, but it could be callable in five years and the YTC could be only 1%. The bonds can have several call dates or also be callable continuously. If there are multiple call dates, you can calculate the yield for the worst possible call date known as YTW, or yield to the worst call date.
Another term to understand if you are considering non-taxable bonds is the Taxable Equivalent Yield, or TEY. The TEY is the return that a taxable bond must have in order for you to get the same after-tax amount as the tax-free bond. Municipal bonds may be exempt from federal and state income tax depending on your state of residence and state of issuance. If you live in a state with no income tax, you can buy municipal bonds from all 50 states. Currently, there are seven states without income tax; Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. If you live in one of the states that have state income tax and want income free from federal and state income tax, you will be limited to purchasing bonds issued by your state of residence.
The TEY is calculated by taking the tax-free return and dividing it by (1- your tax bracket). If you are in the 35% tax bracket and are considering a bond with a YTM of 3%, the TEY would be 4.62% and would be calculated by taking the yield to maturity (YTM) and dividing by (1-your tax rate). 3.00% YTM / (1-0.35) = 4.62%.
The past few years have been very difficult for fixed income investors with the record interest rates we have seen and fixed income can be tricky. Please consult your advisor before making any investment decision.
More from RetireMentors:
Investors in bond funds should reduce the duration
Need income? Try a balanced fund
How to Use Equipped Bonds in Your Retirement Portfolio