As an asset class, fixed income generates longer-term returns that are largely predictable. So why are those returns not always a reasonably sure thing, and why is there controversy around the methodology being used for making predictions for one sector in particular?


We can calculate a bond’s yield (or a portfolio’s yield) because we can predict future cash flows with a fair amount of certainty. And yet, not with complete certainty.

To handle the uncertainty about the size or timing of future cash flows—for instance, that a bond may be called before maturity—fixed-income markets have traditionally taken a conservative approach and applied what is known as the yield-to-worst calculation. This metric solves for the yield to all possible future cash-flow scenarios for a bond and then chooses the lowest yield as the likeliest outcome.

This is consistent with the premise that bond issuers, who often own the right to call or put a bond, will choose what is most beneficial to their own interest. And what’s most beneficial to the issuer is typically least beneficial to the investor.

As a result, yield to worst tends to be a very good indication of expected return over the duration of a bond or bond portfolio.


The major exception to this conservative approach is found in the world of bank loans.

Calculating the yield on a loan is, conceptually, identical to calculating the yield on a bond. The yield is the discount rate at which the present value of future cash flows equals the current price of the loan. And prices of loans are easily observed.

But future cash flows are quite uncertain. Loans can be called by the issuer at par with no prepayment penalty. In addition, loan coupons float and adjust based on movements in LIBOR rates. Thus, future cash flows must be estimated. The accuracy of such estimates varies with market conditions—and with the assumptions used.