EnvisionCap.com: Forbes Article - The Yield That Counts

The Yield That Counts

Marilyn Cohen, Forbes Magazine, 06.02.97

WHEN YOU BUY a callable corporate or municipal bond, which yield matters most? Current yield? Yield to maturity? Yield to the first call?

None of the above. The right thing to pay attention to is the yield to worst. This is the total return you will get if the bond is called away from you at the least convenient time.

Example: the Mattel 10 1/8s of Aug. 15, 2002, recently trading at 104.50 (meaning that you pay $1,045 for every $1,000 of face value). Current yield, which is the one reported in the newspaper, is 9.7%, not at all bad for a bond rated BBB+. This is calculated by dividing the coupon by the price.;

In this case the current yield is misleading. What the newspaper listing doesn't reveal is that these bonds are callable this Aug. 15 at 103.80. If Mattel does call these high-coupon bonds;which is exactly what I would do if I were Mattel's treasurer;then you don't earn 9.7%. Instead, you earn your premium 101/8 coupon for just three months, at which point you are forced to sell the bond back to the issuer for a 0.7% capital loss. The net result is an annualized yield of only 7.4%. So avoid this one, even though the apparent yield looks good.

The typical callable bond (a majority of corporate and municipal bonds are callable) has a series of call options for the issuer. It can redeem the bonds ten years early at such-and-such a price or five years early at another price and so on. Your total return is subject to the whim of the issuer and the ups and downs of interest rates.

The yield to maturity is the number to look at for a noncallable U.S. Treasury bond, but it takes on a nebulous meaning for a corporate bond. Even "yield to call" is ambiguous. Which call?

Call me a pessimist for fixating on the worst possible outcome, but it makes plenty of sense for a bond buyer to concentrate on the worst possible outcome. In my experience, whether your rate of return is better is a toss-up. Remember, the corporate or municipal treasurer has a lot of options and his job is to pick the one that keeps his employer's interest costs the lowest. That's likely to be the very choice that gives you the worst possible outcome.;

Call me a pessimist, but it makes sense for a bond buyer to focus on the worst possible outcome.;

Note that the worst call for the investor is not necessarily the quickest one. Look at the 91/8s of 2003 issued by World Color Press, which printed the page you are reading. The bond, rated BB-, has calls beginning in 1998 and set at a different price every year through 2002. It recently traded at par.

The soonest that World Color can redeem the bond is next March, at 104.56. I don't expect that to happen, but if it did, you would earn a generous annualized return of 14%. More likely: The bond stays outstanding for its original maturity six years from now and is redeemed at par. In that case your total return is 9.1% a year, compounded semiannually. This is the yield to worst. I like the bond; some clients are in it. But I am counting on the lower of these possible yields.

There's nothing wrong with multiple call features as long as you understand the arithmetic. Consider the San Antonio (Tex.) Water Revenue 6.4s due May 15, 2006, rated AAA. In the event that the city leaves these bonds outstanding for the full nine years, your yield to maturity is 5.6%. Probable outcome: The bonds get hauled in only six years from now at a price of 101. In this case your total return is 5.4% a year, and as it happens, this is your yield to worst.
One more caution on callable bonds: A call gives the issuer the right, but not the obligation, to call the bond in. The bond will not be called if interest rates shoot up or if the issuer gets into financial trouble. Thus a certain amount of uncertainty is built into any callable bond, even one with a coupon that is well above current interest rates. As an investor, you should make sure that you are compensated for this uncertainty.

Look again at the San Antonio water bond. It will probably be called in 2003, but it does not have to be. There is a certain risk that circumstances will change so dramatically that you will find it unpleasant to hold this security between 2003 and 2006. How does the 5.4% expected return compare? Noncallable Texas munis due in six years yield only 5.2%, a bit less. Here, you are being compensated for uncertainty. I consider the bond a buy, but it's not a screaming bargain.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.