Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Cash flow and income (yield) represent two important features for bond investors shaping their long-term investment strategies. However, cash flow and income sometimes get commingled, potentially creating confusion. Cash flow and yield typically represent two different components which can be utilized to accomplish different objectives.
Ultimately, investors seek as much income (yield) as possible. Yield is what you earn on your total investment. Cash flow represents the dollars received based on the coupon of the bond. If $1,000 is invested and $1,050 is returned after one year, an investor yielded $50 in income or earned a 5% return (50/1000). If $1,000 is invested and $1,050 is returned after two years, an investor still earned $50 in income. However, they earned a yield of 2.5% ((50/1000)/2). Yields are quoted in annual figures. If you earn the same amount of money in half the time, your yield is higher since your capital is being used for a shorter period. Yield calculations are computed on an annualized basis so that investors can fairly compare options side-by-side.
When investing, investors expect a yield to be quoted as calculated above. The cash flow, which is usually a simple function of coupon times the number of bonds is uniform; however, the yield is not often as simple and may be more or less than the cash flow. The arranged return of the initial capital invested plus the income earned may vary but the premise remains intact. On day one, an investor outlays capital or “loans” out money to have that capital returned at maturity plus added interest at some point or many points along the loaned timeline.
In our example above, there are several ways that an investor could be paid interest. Interest could be paid semi-annually, giving an investor $25 after six months and another $25 plus the $1,000 investment at the one-year maturity. Interest could be monthly, paying $4.16 each month until maturity. Cash flow could also be zero, which is referred to as a zero-coupon bond. In this case, an investor would receive all their interest at maturity, paying a discount to the face value of the investment. An investor may also pay a premium for additional cash flow. If the coupon (cash flow) is 5%, and the current market yield for that type of bond is 4%, paying a premium over $1,000 per bond provides an investor with elevated cash flows above market rates. In this case, the coupon on a bond would generate $50 per bond annually, but the premium price paid would reduce the yield because part of the cash flow is a return of the premium paid.
Why would cash flow matter if the initial investment is $1,000 and, at the end of one year, the total received is $1,050 in each theoretical situation? There are several reasons, and when the example is scaled up to millions of invested dollars and much longer time periods, these reasons are amplified. “When” you receive your money can become advantageous or disadvantageous as interest rates change over time. If interest rates are falling, reinvesting money will lower future returns. Conversely, receiving money and reinvesting in the higher-rate environment will provide better returns if interest rates rise.
