Personal Finance & Money Asked on October 19, 2020
Consider two bonds that have the same issuer, seniority, credit rating, and maturity date. My question is about the comparability of their yield to maturity (YTM): if one bond has a higher YTM the other, is the higher yield bond always a better investment than the lower yield one?
My current understanding says "no", but I’m not exactly sure. My reasoning:
Consider two bonds, with one paying less coupons than the other. To make a more extreme example, suppose bond Z is a zero-coupon bond, while bond B is a coupon-paying bond.
When bond Z matures, the compounded annual growth rate (CAGR) of the investment will be equal to the bond’s initial YTM (i.e. the YTM when the bond was purchased).
However, for bond B, subsequently falling interest rates will mean that the coupons get reinvested at a rate lower than the initial YTM, which causes the CAGR of the whole investment (including coupon reinvestment) to be less than the initial YTM. Conversely, subsequently rising interest rates will mean that the coupons get reinvested at a rate higher than the initial YTM, which causes the CAGR of the whole investment (including coupon reinvestment) to be greater than the initial YTM.
Reason to prefer bond Z even if it has a lower YTM than bond B
If an investor always holds bonds to maturity, bond B is higher-risk than than bond Z in the sense that the CAGR for bond B (including coupon reinvestment) could be lower than anticipated, whereas the CAGR for bond Z is fixed at the initial YTM. Therefore, even if bond B has a higher YTM than bond Z, bond Z will still be favored by investors who believe that future interests rates will be lower.
Reason to prefer bond B even if it has a lower YTM than bond Z
On the other hand, investors may be worried about credit risks and prefer bond B for paying coupons even if its YTM is lower than that of bond Z.
Am I correct that bonds having different coupon amounts cannot be compared using YTM?
Am I correct that bonds having different coupon amounts cannot be compared using YTM?
No, you are wrong. YTM is a standard way of comparing the yield of bonds that pay different coupons. But, it is not the only measure that is applicable. Duration (sensitivity to interest rates) is another way to quantitatively distinguish them, and would highlight the difference in your example of a coupon-paying bond and a zero-coupon bond (the latter will have a much lower sensitivity to interest rate changes).
But you are right in the sense that a higher YTM is not necessarily a "better" investment. It depends on the reason for the higher yield. Your scenario of wanting income sooner is certainly reasonable, but there may be other reasons for a higher YTM, such as optionality or credit risk, that must be considered. For example, you could have two bonds that have the same YTM, but one is callable, which would offset differences in credit risk.
Correct answer by D Stanley on October 19, 2020
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