The Issue at Hand by Madison Investments
At any given time, the bonds in a portfolio may have coupon rates above or below current market rates. When interest rates move, clients may question why their bonds have coupons that are lower, sometimes significantly lower, than the market rate. But coupon is only one part of the return equation. The price you pay for a bond, the income it generates, and how its price moves all matter when evaluating its total return.
In this episode, Chris Aleman and Mike Sanders break down the different ways to evaluate a bond’s return, including current yield, yield to maturity (YTM), yield to call (YTC), and yield to worst (YTW). They explain why YTM can provide a more useful apples-to-apples comparison between bonds with different coupons and prices, and why a higher coupon does not always mean a better investment.
They also discuss how fixed income managers think about low- and high- coupon bonds and the role they play in portfolio construction.
Key Takeaways
- Coupon tells you the cash an issuer pays, but the price you pay for that cash flow matters.
- A bond purchased at a discount can generate return through both coupon income and appreciation toward par, while a premium bond can lose value as it moves toward par.
- Unlike current yield, yield to maturity incorporates both the coupon payments and the price paid for the bond, making it a useful starting point for comparing securities.
- Different bonds can have different roles depending on a client’s need for income, risk tolerance, and overall portfolio objectives.
The Discussion
Chris Aleman: Welcome back to The Issue at Hand. I’m Chris Aleman, and with me as always is Mike Sanders. As you know, our goal for this podcast is to provide relevant and timely information regarding bonds and bond characteristics. One of the most basic characteristics is the bond coupon. And over the last five months, Treasury yields have increased approximately 19%. Over the last four years, they’ve gone up about 166%.
With all that movement, though, the same question continues to come up. At least the question that I’m getting is: why is my coupon lower than the current rate?
Clients see their statements, and they see a coupon lower – and oftentimes significantly lower. So, what do we need to do about this? When they look at their bonds and/or their bond portfolio, coupon is only one way to look at things. A low coupon can be an attractive investment, and a high coupon doesn’t always mean the best return.
What we’d like to share in this episode is an understanding of the balance between price, income, and coupon, and how it impacts total return.
So, Mike, let’s begin. Let’s start with the basics before we dig a little deeper. What is a bond’s coupon?
Mike Sanders: Thanks, Chris. The bond’s coupon is what the stated return of cash is on your investment. That’s not necessarily the total return of your investment, but it’s how much cash the issuer is going to pay you back. And obviously, your return is going to be based on how much you pay for that cash getting returned to you.
So, two different things: the return and the coupon. But obviously very, very important, and you can look at it different ways.
Chris Aleman: That makes sense. And I think people have trouble comprehending the difference between current yield, price-yield relationship – that sort of thing. Can you go into a little bit of detail between those two?
Mike Sanders: At a basic level, your current yield is the coupon divided by the price you pay for it. So in simple terms, you pay a hundred cents on the dollar for a bond, it pays a five percent coupon, it’s a five percent current yield. Now, again, as interest rates move down and move up, and the prices move up and down, your current yield is going to shift around. And then your yield to maturity, yield to what you earn, equates the price you pay with the coupons you receive. So, you can look at it a couple of different ways when you’re trying to assess a fixed income security. Current yields give you maybe the upfront cash you’re going to receive in the near term, but then the yield is what’s going to show what you’re going to get over the longer periods of time.
Chris Aleman: I think for those who are just listening in, we have a chart that’s essentially explaining the seesaw effect of what Mike is trying to illustrate. If interest rates rise, the bond price is going to be at a discount, or it’s going to go down. If interest rates fall, you’re going to pay a little bit of a premium. Is that fair to say in my simplistic terms, Mike?
Mike Sanders: Correct. And just to be clear, it’s the interest rates rise and fall, and it’s a premium or discount relative to the coupon payment on the bond. So that’s the key. The coupon doesn’t change. It’s the price that you pay for it that changes.
Chris Aleman: I think this goes back to one of the first things that you had said way back when, “there are no bad bonds, just bad bond prices.”
Mike Sanders: Correct. It’s lots of different ways to look at fixed income. There’s no right or wrong way. I guess it’s just personal preference, but you do have to know the differences between what your current yield’s going to be and your yield to maturity. Those are going to tell you much different measures of performance and total return over various periods of time.
Chris Aleman: I think that’s actually an important part that you said was one of the things that I think you need to focus on a little bit more: yield to maturity. Why is this important in terms of how a client or how financial advisors should talk to their clients with regard to bonds?
Mike Sanders: It’s important because it’s taking what you pay for it and then the actual pulling to par, going the bonds always are going to go to par, 100 cents for the dollar, if you will. It’s equating that pull to par, and the coupon you’re receiving, into one number that shows you the total return.
And so again, versus what the current yield is, which is just the amount of income versus what you pay. That changes over time as the bond pulls to par, in essence, because if it’s higher than a hundred, then it’s going to go towards a hundred, if it’s below, it’s going to go up. So those numbers change a little bit, but in my opinion, and as somebody that’s in fixed income, I guess the truer sense of what you’re going to get on as a return in your fixed income security is going to be your yield to maturity, yield to worst, kind of the same context. It’s equating what you pay for it and the coupon payments you receive into one number versus the other numbers kind of changing.
Chris Aleman: So one of the important things you’re saying there, and I hope everybody paid attention to that part, was that not just looking at coupon, but looking at yield to maturity, so that way you can compare apples to apples, I guess, when you’re looking at different bonds. Is that fair?
Mike Sanders: Correct. It’s a much easier way to compare two securities to the same measure that has a more long-term reflection of what performance will be.
Chris Aleman: I think when I’m having conversations with advisors, one of the things that helps me to illustrate this, and I think we’re going to throw a slide up – is the difference between what a price is for a higher coupon versus a lower coupon, even though they have the same maturity. Do you think you can go through that example, please?
Mike Sanders: If you look at this chart, we have three different securities, and it just kind of gives you a context of what happens when you buy a bond at a premium and then what happens as you buy a bond at a discount and what happens if you buy a bond that’s at par – a hundred cents in the dollar. And how the price changes over time when you have different coupons. So if you buy a five-year bond with a seven and a half percent coupon and the interest rate in the market is five, you’ll be paying a premium for that. And conversely, if it’s two and a half, you don’t have to pay as much for that.
But as you can see, because you’ve paid that premium for the 7.5% coupon, that bond’s price is going to eventually be a hundred in five years. It’s the same way as the bond that’s at 89 is going to be at 100. So to calculate the total return, you have to take the income that you’re receiving for both, but then you have to adjust it for price over time.
And so again, that’s why yield to maturity is the preferred measure in fixed income to look at. Because it equates buying something for eighty-nine cents or buying something for a hundred and eleven cents, almost, and how that balances itself out over time as you approach the bond’s maturity.
Chris Aleman: For those just listening in, one of the things that we’re trying to illustrate is that even though you paid for a higher coupon bond, you paid 110. That’s eventually going to fall back down to 100 versus the two and a half percent coupon that’s at 89, that’s eventually going to rise to 100 as it approaches maturity. That’s what we need to factor in when we’re talking about this total return. And I hope everybody can understand that because one of the other issues that I think Mike just mentioned is, I think we’re always overwhelmed with a lot of the terminology that’s thrown out there. So, one of the things that you mentioned, Mike, was a yield to call, a yield to worst, a yield to maturity. How should an advisor know when to utilize those, when to look at those?
Mike Sanders: I think, in general, it’s yield to maturity and yield to worst. The yield to worst – there are bonds that sometimes have an option to get called away early, and so you really need to understand it’s kind of the worst-case return for a security that can get called away from you. So I think, in general, yield to call, yield to worst is kind of the same thing, and yield to maturity should be your main focus when you’re analyzing the return profile for fixed income. Current yield is useful if you want to get a sense of how much income might be generated from a portfolio in the near term. But if you’re looking at a total return over multiple periods, the yield to call, yield to worst, and yield to maturity would all be the preferred methods. Again, it takes into consideration the other factors that are important when you’re investing in a fixed income security.
Now that’s not everything to focus on in fixed income. Because bond prices and yields – it’s just math. And so, there are slightly different risks in terms of the sensitivity to interest rates if you own a low-coupon bond or a high-coupon bond. And as a manager of a fixed income portfolio, it’s our job to take that into consideration when building a portfolio.
Chris Aleman: Well, let me stop you there. Let’s flip this on you and not go theoretical. When you are buying a bond, how do you decide whether to look at a low coupon, high coupon with the same maturity? What are the things that you’re considering? What else are you looking for? I like this conversation.
Mike Sanders: So it’s issuer-specific risks. Obviously, if you have the same issuer that has a low coupon and a high coupon, I’m looking at it from an investment perspective. Ideally, I’d like to be paid more yield, have more spread if you have the same maturities. And you can manage the other risks in terms of duration of your overall portfolio or interest rate sensitivity with other securities in the portfolio.
So, we’re trying to maximize the yield for the portfolio, making sure we’re doing that in a very risk-aware kind of framework. So, from our perspective, it’s about maximizing the yield. And so sometimes, in certain scenarios, a higher coupon bond might have a slightly different yield than a low coupon bond. But as long as we’re comfortable from the credit quality perspective, either one of them could be a good fit in an overall portfolio. It might be slightly different if you’re buying individual bonds for somebody, but I think when you think about it in a portfolio context, both of them have a place in a portfolio.
Another thing to consider would be if the client wants more cash flow up front, maybe you’d be focusing on bonds that are near par or slightly higher versus discounted bonds that get more of their performance from the price change. Because the yield to maturity is both the coupon and the price. If you’re holding the bonds to maturity or holding them for a while, you really can’t spend the price increase, if you will. So you want the cash from the coupon. Not to make it too complicated, but both of them have their place. I think it’s really about maximizing yield for the client.
Chris Aleman: I think the other thing is this ties back to the importance of portfolio construction, wouldn’t you say?
Mike Sanders: Correct. Investing in general, in my opinion, is as much about understanding the risks that you’re taking as it is finding attractive bonds. If all you do is chase yield, and we’ve discussed this in the past, that’s where you can get into trouble, and so you really have to understand the risks involved when you’re purchasing any security, but especially bonds, because there are multiple different ways to look at it.
Chris Aleman: So let me see if I can bring it all back. Coupon – not the same as return. Price matters. And when comparing bonds, compare yield to maturity as a starting point. Is that all fair?
Mike Sanders: I would agree with that.
Chris Aleman: Well, I think that sums it up. I think we’re still going to get a lot of questions on that, but I think that’s a general base for where everybody should start. So thank you, Mike, for joining. As you may or may not know, we do actually here at Madison have a brief paper on this topic as part of our bond concept series. We’ll put a link in the show notes along with any of the charts that we referenced in this episode. Please feel free to use it with your clients when you’re having your discussions. And for more insights and additional disclosures, visit MadisonInvestments.com.
Don’t forget to subscribe, and thanks for tuning in. Take care.