But sometimes you need to make sure you are looking at the right kind of yield...
Here's a question: would you buy a corporate bond with an income yield of over 9%?
I guess most people would say: yes please, assuming they can be reasonably sure that their money will be safe. However (as you have already probably guessed) this might not be the best decision - more information is required.
The problem arises with fixed-rate securities that involve 'redemption' or the return of the nominal value of the investment at a fixed date. These investments include most corporate bonds, gilts (government bonds), some preference shares and similar securities.
And here's the thing: what is the relationship between the redemption value, the 'face value' of the security and the price you paid for it?
The answer, of course, is the redemption yield, which takes into account:
- purchase price
- coupon (i.e. the fixed yield on the nominal or 'par' value)
- the redemption value (i.e. 'par')
- the number of years until redemption
Usually you won't have to calculate this yourself - most platforms (e.g. Bondscape) giving security prices will give this value.
Taking a case in point: HSBC Holdings 9.875% 2018 corporate bond (i.e. maturing in 2018 and paying a coupon of £9.875 on each £100 nominal value) is currently showing the following yields (in mid-March 2012):
- income yield: 9.1%
- redemption yield: 2.1%
A nice income yield but a low redemption yield. Should you buy or not?
Too easy isn't it? Why would you want to invest your money at a return that is way less than current UK inflation? Essentially you would be buying the future annual returns with some of your capital.
So, look at the different yields when there is a redemption involved. Many 'funds' will offer high yields achieve this with a high income yield - but by eating your capital.
Now, this difference between income and redemption yield is, of course, quite unusual. In the case of the HSBC 2018 corporate bond the reason is that, although the redemption is in 2018, this bond is callable in April 2013, at the discretion of the bank. (I discussed the topic of early callable securities in a previous post, in relation to PIBS.)
Well, do you think that the bank will replace this relatively expensive loan with some of the cheap money that the government has been flooding the market with? Clearly the market does.
And, by the way, mea culpa - I've been holding this very security for a while and have finally realised I need to sell it! D'oh!
I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.