Concepts of Measurement
Now that you understand what returns are and how dividends work, you need to know how to measure investment performance. The Securities Industry Essentials (SIE) exam tests several yield measures, total return, and basis points.
Current Yield
Current yield measures annual income relative to the current market price. It tells you the income return you're getting right now.
- Formula: Annual Income / Current Market Price
- For bonds: Annual Coupon Payment / Current Market Price
- For stocks: Annual Dividend / Current Market Price
- Yield moves inversely to price: as price rises, yield falls (and vice versa)
Example (Bond):
- A bond with a $50 annual coupon is trading at $900
- Current yield = $50 / $900 = 5.56%
Example (Stock):
- A stock paying $3.00/year in dividends is trading at $75
- Current yield = $3.00 / $75 = 4.0%
Exam Tip: Gotchas
- Current yield ONLY measures income. It ignores capital gains or losses entirely. If a question asks about "total performance," current yield is the wrong answer.
Yield to Maturity (YTM)
Yield to maturity is the total annual return on a bond if held to maturity. It's the most comprehensive yield measure for bonds because it accounts for:
- Coupon payments (income)
- Purchase price vs. par value (capital gain or loss at maturity)
- Time remaining until maturity
Key relationships based on purchase price:
| Purchase Price | Yield Ranking (non-callable) | Yield Ranking (callable, called at par) |
|---|---|---|
| At a discount (below par) | YTM > Current Yield > Coupon Rate | YTC > YTM > Current Yield > Coupon Rate |
| At par (face value) | YTM = Current Yield = Coupon Rate | All four yields equal |
| At a premium (above par) | Coupon Rate > Current Yield > YTM | Coupon Rate > Current Yield > YTM > YTC |
Why?
- Discount bond: You paid less than par, so you'll receive a capital gain at maturity, boosting your total return above the coupon
- Premium bond: You paid more than par, so you'll take a capital loss at maturity, reducing your total return below the coupon
Think of it this way: A discount bond is a bargain; you get a bonus at maturity (capital gain), so your total return exceeds the coupon. A premium bond costs extra; you lose that extra at maturity (capital loss), so your total return falls below the coupon.
Exam Tip: Gotchas
- For a non-callable discount bond: YTM is the highest (YTM > Current Yield > Coupon Rate).
- For a callable discount bond called at par: YTC is the highest (YTC > YTM > Current Yield > Coupon Rate). The capital gain is realized over a shorter period if called, which raises the annualized return above YTM.
- For a premium bond: Coupon Rate is the highest. If it is callable and gets called at par, YTC is the lowest (Coupon > Current Yield > YTM > YTC) because the capital loss is realized sooner.
- Yield and price move in OPPOSITE directions. As a bond's price rises, its yield falls (and vice versa).
Yield to Call (YTC)
Yield to call uses the same concept as YTM but assumes the bond is called (redeemed early) at the earliest call date rather than held to maturity.
- Issuers typically call bonds when interest rates fall; they can refinance at lower rates
- For a callable premium bond: YTC < YTM. The investor loses the premium over a shorter time period, so YTC is the worst-case (lowest) yield.
- For a callable discount bond: YTC > YTM. The investor realizes the capital gain sooner, so YTC is the highest yield.
- Exam convention: when asked which yield to quote on the exam, use the lower of YTM or YTC (the worst-case yield). This is typically YTC for premium bonds and YTM for discount bonds.
When to use which yield:
| Scenario | Use This Yield | Why |
|---|---|---|
| Non-callable bond | YTM | No call feature exists |
| Callable bond at a discount | YTM | Issuer unlikely to call (rates haven't fallen enough) |
| Callable bond at a premium | YTC | Issuer likely to call (rates have fallen); gives the lowest (worst-case) yield |
Exam Tip: Gotchas
- For a premium callable bond, the LOWEST yield is yield to call (YTC). The investor loses the premium over a shorter time frame, making YTC the worst-case scenario.
Total Return
Total return is the most comprehensive measure of investment performance. It captures everything: income plus capital changes.
- Formula: (Income + Capital Gain or Loss) / Initial Investment
- Includes interest, dividends, and any price appreciation or depreciation
- Can be expressed as a dollar amount or a percentage
Example:
- Buy a stock for $1,000
- Receive $40 in dividends over the year
- Sell the stock for $1,100
- Total return = ($40 + $100) / $1,000 = 14%
Think of it this way: Total return answers the question "How much did I actually make?" It counts the dividends in your pocket plus the profit (or loss) when you sell, all relative to what you originally paid.
Basis Points
Basis points (bps, pronounced "bips") are a precise way to express small changes in yield or interest rates.
- 1 basis point = 0.01% (one-hundredth of one percent)
- 100 basis points = 1%
- Used because percentage changes can be ambiguous
Quick conversion:
| Basis Points | Percentage |
|---|---|
| 1 bp | 0.01% |
| 25 bps | 0.25% |
| 50 bps | 0.50% |
| 75 bps | 0.75% |
| 100 bps | 1.00% |
| 150 bps | 1.50% |
Example: A yield increase from 3.50% to 3.75% is a change of 25 basis points.
Why does this matter? Saying "interest rates rose by 1%" is ambiguous. Does that mean from 5% to 6% (100 bps) or from 5% to 5.05% (5 bps, which is 1% of 5%)? Basis points eliminate this confusion.