Evaluating fixed-income performance according to book yield or total return is a common question received by ALM First, investment adviser to the Trust for Credit Unions Portfolios and trusted partner to more than 250 financial institutions. To answer it, we’ll break down and define each term, analyze the advantages and limitations of each, and look at how both are used to measure performance.
Book yield, also called yield to maturity (YTM), applies more to accounting than portfolio performance because it doesn’t reflect the volatile nature of market risk factors that affect the return on an asset. In contrast, total return is a more accurate measure of fixed-income performance, reflecting risk and return over a specified time frame. Thus, total return is the preferred measurement tool for asset managers. For the purposes of this article, total return refers to actual realized returns, not a forward-looking horizon analysis.
A bond’s book YTM is the anticipated annual rate of return, assuming the security is purchased at a specific price and held until maturity, with all coupon payments reinvested at the bond’s original rate and all payments occurring on time with no defaults or credit losses. Another way to think of YTM is as the bond’s internal rate of return (IRR). To calculate YTM, one needs only the bond’s price, par value, coupon rate, and term to maturity. While a market YTM uses the current market price and the book yield uses the book price, both measures are based on the assumptions of the YTM calculation. This offers major limitations to a yield-based performance analysis, particularly for book yield. A bond’s real return can vary greatly from its purchase YTM because of changes in reinvestment rates and the holding period. So, the efficacy of book yield as a performance measure is limited, even for the simplest security types, such as Treasury notes.