The weighted average yield represents the average yield to maturity (YTM) of all bonds within a bond fund or portfolio, factoring in the proportional size of each bond holding. In simpler terms, it's not just a simple average of all the yields; instead, it gives more weight to the yields of larger holdings.
Understanding the Concept
What is Yield to Maturity?
Before diving into weighted average yield, it is important to understand yield to maturity (YTM). YTM is the total return anticipated on a bond if it is held until it matures. It is considered a long-term yield and is expressed as an annual rate.
How Weighted Average Yield Works
The weighted average yield, unlike a simple average yield, takes into account the size or proportion each bond makes up in the portfolio. This gives a more accurate representation of the overall yield of the portfolio. The coupon rate, as highlighted by the reference, is the annual interest paid by the bond but is not directly used in calculating weighted average yield.
Key Components
- Yield to Maturity (YTM) of Each Bond: The expected return of each individual bond held until maturity.
- Weight (Proportion): The relative size or proportion of each bond's holding in the portfolio.
- Calculation: It involves multiplying the YTM of each bond by its weight and then summing the results.
Formula
The weighted average yield can be expressed by this simple formula:
Weighted Average Yield = Σ (YTM of Bond * Weight of Bond)
Where:
- Σ represents summation (adding all the results).
- YTM of Bond is the yield to maturity of the individual bond.
- Weight of Bond is the proportional size of the bond in the portfolio.
Example
Imagine a bond portfolio with three bonds:
| Bond | YTM | Value | Proportion of Portfolio |
|---|---|---|---|
| A | 5.0% | \$200,000 | 20% |
| B | 6.0% | \$500,000 | 50% |
| C | 7.0% | \$300,000 | 30% |
The weighted average yield would be calculated as follows:
(0.05 0.20) + (0.06 0.50) + (0.07 * 0.30) = 0.01 + 0.03 + 0.021 = 0.061 or 6.1%
Thus, the weighted average yield for this portfolio is 6.1%.
Why is Weighted Average Yield Important?
- Portfolio Performance: Investors can use this calculation to better understand the performance of their total bond portfolio.
- Comparison: It provides a more accurate measure for comparing different bond portfolios.
- Decision-Making: It aids in making better investment decisions by providing a clearer view of the expected return on the portfolio.
Key Takeaway
The weighted average yield is a critical measure for anyone holding a bond portfolio, as it gives a realistic overview of the total yield, considering the impact of the weight of each holding.
