BY HAFIZAN HAMZAH
Your credit union has probably seen or heard the debate: What is a better measure of fixed-income performance, book yield or total return? And the answer is it depends. They both have their benefits and limitations. Find out what these strengths and weaknesses are in terms of your CU’s portfolio performance.
a popular debate in the banking world considers the question: What is a better measure of fixed-income performance, book yield or total return? However, book yield is more of an accounting measure than a performance measure. Further, attempting to measure performance using book yield fails to account for the dynamic nature of market risk factors that affect an asset’s ongoing performance. Another method of measuring financial performance is total return. It is important to note that any reference to total return in this article is related to actual realized returns, not a forward-looking horizon analysis. Total return is a more powerful measure of fixed-income performance because it more accurately reflects risk and return over a specified time period. Thus, it is the preferred performance measure in the asset management community. In this article, we’ll define each measure and break down the benefits and limitations of each, as well as discuss how performance is commonly measured and used.
Yield to Maturity
A bond’s yield to maturity (YTM) is the anticipated annual rate of return, assuming the security is purchased at a specific price and held until final redemption, with all coupon payments being reinvested at the bond’s original YTM and all payments occurring on time (i.e., no defaults or credit losses). YTM also can be thought of as the bond’s internal rate of return (IRR). YTM calculations require a price, par value, coupon rate and term to maturity. As the terms imply, a market YTM will use the current market price, and a book yield will use the book price. Both measures (market and book) rely on the assumptions of the YTM calculation. These assumptions present major limitations to yield-based performance analysis, particularly for book yield. To that effect, a bond’s real return can vary greatly from its purchase YTM, given changes in reinvestment rates and holding period. Therefore, book yield has limitations as a performance measure even for the simplest of security types, such as Treasury notes