BY ROBERT PERRY
A popular debate in the banking world considers the question, what is a better measure of fixed-income performance: book yield or total return? For many, this issue is rooted in a traditional accounting framework, where yield is a preferred measure; but as this article discusses in more detail, measuring performance using book yield fails to account for the dynamic nature of market risk factors affecting an asset’s ongoing performance. Another method of measuring financial performance is total return, and it is important to note that any reference in this article to total return 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 will define each measure and break down the benefits and limitations of each.
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 reinvestment 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.
As we move into more complex assets, such as mortgage-backed securities (MBS) and other option-embedded assets, yield becomes an even less reliable performance measurement tool because of the uncertainty of cash flow timing. As noted above, yields are anticipated annual rates of return, and periodic prepayments or other early redemption can greatly affect the actual performance of those securities. This is particularly true in the case of agency debentures with short call options (callable agencies). Many times, we see investors puzzled when the actual returns of their callable portfolio do not match up with the purchase yields. Callable agencies typically exhibit high levels of negative convexity. If rates fall, these securities can be called, and the proceeds must then be reinvested at lower rates.