What is the difference between a bond’s coupon rate and yield to maturity?
- Created on Sunday, 03 May 2015 19:00
Quick Take on Fixed Income
April 2015
Q: What is the difference between a bond’s coupon rate and yield to maturity?
A: The coupon rate tells you the annual amount of interest paid by a fixed income 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. The coupon rate, however, tells you very little about the yield. For most securities, the yield is a good proxy for the return of the fixed income security (that is, how much you can expect your wealth to increase if you purchase the security) and is far more meaningful than the coupon rate. To illustrate, consider these two Treasury bonds:
- 8.875 percent coupon, February 2019 maturity
- 2.75 percent coupon, February 2019 maturity
Both bonds mature around the same time, but they have enormous differences in coupon. One is paying coupon interest of $88.75 per year per $1,000 of face value and the other is paying $27.50, yet one trades at a yield to maturity of 2.40 percent and the other at 2.41 percent. This means they are priced in a way to provide essentially the same return. You have to pay significantly more to buy the bond with the relatively high coupon than the bond with the lower coupon. The net result is that either purchase has essentially the same yield to maturity, or expected return.
Another measure of yield that sometimes can be referenced is current yield, which is calculated by dividing a bond’s annual cash flow by its current price. This measure is not an accurate reflection of the actual return that you will receive because it only takes into account the coupon and current price as opposed to yield to maturity, which takes into account those two factors as well as the par value and time to maturity, providing a more complete picture. There are some brokers who will quote current yield as opposed to yield to maturity because the current yield is typically higher.
For example, let’s say a Texas water bond with a coupon of 6.25 percent and a maturity date of June 2021 is currently trading at 126.686. At that price, the current yield is 4.93 percent while the actual yield to maturity is only 1.63 percent.
Summary
When considering fixed income options, it is important to understand the differences among coupon rate, yield and expected return. While each piece does tell an important story, the best indicator of return on the security is yield to maturity.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
How Much Are You Paying for Your Size and Value Tilt?
- Created on Sunday, 03 May 2015 19:00
By Jared Kizer
It’s becoming clear that the price for overall U.S. equity market exposure is close to zero. Many market-cap weighted index funds and exchange-traded funds from Vanguard and others are charging expense ratios of five basis points (bps) or less. An interesting, and more difficult, question to answer: How much are you paying to gain exposure to small-cap and value stocks across the funds in the marketplace? This is more difficult to answer because a fund that calls itself “small cap” may own stocks that are materially smaller than another fund that also has “small cap” in its title. The same is true for funds with the word “value” in their names.
I explore one methodology here by running Fama-French three-factor regressions for a large number of Vanguard and DFA funds and using the output to tease out how much additional expense ratio investors are paying on average for small-cap and value exposure, respectively. (Anyone who is interested in the exact methodology can email me. The details are too laborious to include in the blog post.)
Using data from the 48 Vanguard and DFA U.S. equity funds included in the analysis, Figure 1 presents the bps expenses investors are paying on average for small-cap and value exposure through Vanguard and DFA (for Vanguard, I use only Admiral and Institutional open-ended index mutual fund share classes).
With the entire set of funds used in the analysis, we see investors are paying on average about seven bps for one unit of size exposure and about 27 bps for one unit of value exposure. Since a strong argument can be made that different fund companies price fund expense ratios using different methodologies, I think it’s more interesting to examine Vanguard and DFA separately. Figure 2 presents the same analysis using the 31 Vanguard funds includes in the data set.
Very interestingly, we see that Vanguard does not appear to price its small-cap and value funds any differently from its large-cap and growth funds. I say this because both bars in Figure 2 are very close to zero (notice that the scale is different from Figure 1). Here’s the same analysis using the 17 DFA funds.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
We see that DFA tends to price one unit of small-cap exposure at about 31 bps and one unit of value exposure at about six bps (although the value result is statistically insignificant). Given the statistical strength of the small-cap result, DFA clearly appears to be factoring in whether a fund is small-cap versus large-cap oriented in setting the expense ratio.
This commentary originally appeared April 2 on MultifactorWorld.com
Simple Financial Solutions Often Beat the Complex Ones
- Created on Sunday, 26 April 2015 19:00
By Carl Richards
“Can it really be that simple?”
Over my career, I’ve heard these words from so many people. Clients, friends and family all just assumed that the process of financial planning needed to be complex. This assumption doesn’t surprise me. The traditional financial industry is built, in large part, on the notion that complexity equals quality. In fact, the more complex the solution, the more someone should pay to access it.
But there’s a problem with this argument: It’s wrong.
Seekers of financial advice overlook simple prescriptions because when they hear simple, they make the leap to easy. But sticking with good money decisions isn’t easy. So how do we bridge this gap? Here are two things to consider.
Stop confusing simple with easy. People often ask me, “What’s one thing I can do that will have a big financial impact?” I almost universally suggest they spend less and save more. You can imagine the looks I get. That’s too simple. It couldn’t possibly work.
But if it’s so simple, why doesn’t everyone do it? Think about all the simple financial advice we’ve heard over the years. Create and stick to a budget. Avoid unnecessary debt. Save money in an emergency fund.
All of these things are simple, but that doesn’t mean they’re easy. So to avoid the hard choices, we pretend that simple won’t get the job done and go looking for complexity, often in our investments, in order to make up for high spending and low savings.
Stop confusing concepts with application. If we all had unlimited resources, life would be easy. But almost every financial decision comes with complicated trade-offs. So when we hear, “Spend less, save more,” we’re likely to ignore it. We have a mortgage. We haven’t had a raise in five years. We have children who always seem to need something. Clearly we need more than, “Spend less, save more.”
Not really. We do, however, need to ask ourselves some difficult questions. Simple solutions put the weight on us to act. Only we know the “why” behind our money decisions. To spend less and save more, we have to dig deeper. That can get messy.
Remember those complicated trade-offs? Suddenly, they’re everywhere. We bought a house that was at the upper end of our budget. We haven’t really done anything at work to merit a raise. We have a hard time saying “no” to our children. So what are we going to do to correct those things or change course?
Whatever the answers, simple solutions bring us face to face with some painful truths about what we are or are not doing, and why. Oddly enough, I’ve found that a lot of people just aren’t comfortable with this process. They’re much more comfortable spending time and money on complicated solutions that don’t require much, if any, self-reflection.
We could keep going down this path or we could try something different. So for one week, I want you to try following a single piece of simple financial advice that until now you’ve always ignored. It will likely be harder than you think, and you may even be tempted to give up by Wednesday. Don’t.
Give yourself one week to ask questions and weigh your decisions without assuming that simple won’t be enough. Along the way, you may discover that simple does more for you than complex could ever dream of.
This commentary originally appeared April 6 on NYTimes.com
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.