by Archie M. Richards, Jr., CFP^®
June 10, 2002

When someone talks about the yield of a bond or a bond fund, pin down exactly what the person means.

On an individual bond, assume that the annual interest payments total $70. (Most bonds pay interest twice a year.) The bond is priced at "par," meaning $1,000 per bond. Par is also the price at which the bond matures. The "current yield" is the interest payments ($70) divided by the price ($1,000), or 7 percent.

The interest payments remain level, but because people are buying and selling the bond throughout the day, the price changes constantly. The current yield therefore changes too.

Assume you bought the bond a year ago at 10 percent above par ($1,100 per bond). The current yield then ($70 divided by $1,100) was 6.4 percent.

But during the year, bond prices took a licking. Investors might have expected higher inflation, or they might have become concerned about whether bonds would be paid off. For whatever reason, the price of your bond fell from 10 percent above par to par.

You received $70 interest during the year, but because of the price decline, you lost $100. Your total return for the year was a loss of approximately 2.7 percent. (The exact loss depends on when the semiannual interest payments were paid.)

A bond's total return is altogether different from its current yield. The total return on your bond last year was a loss of 2.7 percent. But the current yield rose from 6.4 percent to 7 percent. As the price declined, the total return went down and the current yield went up.

A third kind of yield on bonds is yield-to-maturity. This requires a calculator to compute and takes into account the interest payments, the current price, the time to maturity, and the amount of repayment at maturity ($1,000 per bond).

Return to the bond you bought a year ago at 10 percent above par ($1,100). The current yield was 6.4 percent.

The bond matures at $1,000, causing a 10 percent loss on the price. The loss will pull the yield-to-maturity down below the 6.4 percent current yield it had at the time of purchase. When you buy a bond above par, the yield-to-maturity at purchase is always lower than the current yield.

The opposite is also true. Assume you bought the bond a year ago at 10 percent below par ($900). The current yield then was 7.8 percent ($70 divided by $900). The bond will gain 10 percent when it matures at par. When you buy a bond below par, the yield-to-maturity at purchase is higher than the current yield.

We now come to bond mutual funds. The portfolio of a bond mutual fund changes constantly. Some of the bonds mature or are sold, and others are acquired. The fund's interest payments therefore do not remain level.

In fact, none of the values of a bond fund remain level. A bond fund has no time of maturity and no maturity value (unless it's a unit investment trust, which is another story.) The interest payments, current yield, total return, and yield-to-maturity all remain in flux.

Of the three kinds of yields (current yield, total return, and yield-to-maturity), the least important is total return.

Let's say your bond's price fell last year. Despite the payments of interest, you lost money on it.

Losses are no fun, but they have no bearing on the future. Historic changes in price predict nothing. A loss last year does not mean there will be a loss this year. In deciding whether to buy or sell this year, forget about last year. The only thing that counts is what's going to happen next year.

When a person talks about the "yield" of a bond or a bond fund, ask whether he means the current yield, the total return, or the yield-to-maturity. If the person doesn't the know the difference, deal with someone who does.