Understanding Bond Equivalent Yield: A Key to Smart Fixed-Income Investing
In financial terms, bond equivalent yield (BEY) is a vital metric that enables investors to calculate the annual percentage yield for fixed-income securities, even if they are discounted short-term investments that pay out monthly, quarterly, or semi-annually.
Having BEY figures at their fingertips allows investors to assess the performance of these investments in conjunction with traditional fixed-income securities that span a year or more and produce annual yields. This empowers investors to make more informed choices when constructing their overall fixed-income portfolios.
A Primer on Bond Equivalent Yield
To fully grasp how the bond equivalent yield formula operates, it’s crucial to understand the fundamentals of bonds and how they differ from stocks.
Companies seeking to raise capital may either issue stocks (equities) or bonds (fixed income). Equities, distributed to investors as common shares, have the potential to generate higher returns than bonds, but they also carry greater risk. Specifically, if a company files for bankruptcy and subsequently liquidates its assets, bondholders are first in line to collect any available cash. Only if there are assets left over do shareholders receive any money.
Key Points to Remember
- Fixed-income securities come in various forms.
- Zero-coupon (discounted) bonds have shorter durations compared to traditional fixed-income securities, making it challenging to calculate their annual yields.
- The bond equivalent yield (BEY) formula can approximate what a discounted bond would pay annually, thereby enabling investors to compare their returns with those of traditional bonds.
Even if a company remains solvent, its earnings could still fall short of expectations, potentially depressing share prices and causing shareholders to incur losses. However, that same company is legally obligated to pay back its debt to bondholders, regardless of its profitability.
Not all bonds are created equal. Most bonds pay investors annual or semi-annual interest, but zero-coupon bonds do not pay interest at all. Instead, they are issued at a steep discount to par, and investors collect returns upon the bond’s maturity. Analysts use the bond equivalent yield formula to compare the returns on discounted fixed-income securities with those of traditional bonds.
Delving into the Bond Equivalent Yield Formula
The bond equivalent yield formula is calculated by dividing the difference between the face value of the bond and its purchase price by the purchase price. This result is then multiplied by 365 divided by the number of days remaining until the bond’s maturity. Essentially, the first part of the formula is the standard return calculation used for traditional bond yields, while the second part annualizes this return to determine the equivalent figure for discounted bonds.
Although calculating the bond equivalent yield can be complex, most modern spreadsheet software includes built-in BEY calculators to simplify the process.
Still unsure? Consider this example:
Assume an investor buys a $1,000 zero-coupon bond for $900 and expects to receive the par value in six months. In this scenario, the investor would make $100. To determine BEY, follow these steps:
- Subtract the actual price paid for the bond from its face value:
- $1,000 - $900 = $100
- Divide $100 by $900 to get the return on investment, which is approximately 11%.
- Annualize 11% by multiplying it by 365 divided by the number of days until the bond matures, which is half of 365.
The bond equivalent yield, therefore, is 11% multiplied by two, equating to 22%.
This method allows investors to effectively compare the yield on a zero-coupon bond with traditional bonds, ensuring more strategic portfolio management.
Related Terms: Zero-Coupon Bonds, Equities, Fixed-Income Securities, Investment Portfolio, Bond Yields.
