by John P. Hussman, Ph.D.
Imagine someone offers you a 10-year bond with a coupon yield (annual interest payment / face value) of 3.0%, and a current yield (annual interest payment / current price) of 2.3%. Let’s assume zero probability of default. Comparing this opportunity with the 1.5% yield-to-maturity available on 10-year Treasury bonds, would you prefer the bond “yielding” 2.3%?
I’ve offered a hint by using quote marks, but if you chose the 2.3% bond anyway, you’ve joined the company of countless other investors who are making effectively the same mistake as they reach for yield across every financial asset. In order for a 10-year 3% coupon bond to provide a 2.3% current yield, one must pay $130 today in return for the following set of future cash flows: $3 a year for 10 years, plus $100 at the end. Paying $130 today in return for $130 in future cash flows, buyers of that bond will inadvertently discover that they’ve locked in a total return of zero.