While the current yield and yield-to-maturity (YTM) formulas may be used to calculate the yield of a bond, each method has a different application—depending on an investor’s specific goals.
Key Takeaways
- Bonds are debt instruments that pay interest to investors, who essentially function as creditors to issuers. These interest payments constitute a bond’s yield.
- A bond’s current yield is the investment’s annual income, the interest it pays, divided by the current price of the security.
- Yield to maturity (YTM) is the totalreturnanticipated on a bond if the bond is held until its maturation date.
Bond Basics
When a bond is issued, the issuing entity determines its duration, face value (also called its par value), and the rate of interest it pays, known as its coupon rate. These characteristics are fixed, remaining unaffected by changes in the bond’s market. For example, a bond with a $1,000 par value and a 7% coupon rate pays $70 in interest annually.
Current Yield of Bonds
The current yield of a bond is calculated by dividing the annual coupon payment by the bond’s current market value. Because this formula is based on the market value or purchase price rather than the par value of a bond, it more accurately reflects the profitability of a bond, relative to other bonds on the market. The current yield calculation helps investors drill down on bonds that generate the greatest returns on investment each year. This is especially helpful for short-term investments.
For example, if an investor buys a 6% coupon rate bond (with a par value of $1,000) for a discount of $900, the investor earns an annual interest income of ($1,000 × 6%), or $60. The current yield is ($60) / ($900), or 6.67%. The $60 in annual interest is fixed, regardless of the price paid for the bond.
If, on the other hand, an investor purchases a bond at a premium of $1,100, the current yield is ($60) / ($1,100), or 5.45%. The investor paid more for the premium bond that pays the same dollar amount of interest, so the current yield is lower.
CurrentYield=BondPriceAnnualCouponPayment
Current yield may also be calculated for stocks by taking the dividends received for a stock and dividing that amount by the stock’s current market price.
Yield to Maturity of Bonds
The YTM formula is a more complicated calculation that renders the total amount of return generated by a bond based on its par value, purchase price, duration, coupon rate, and the power of compound interest.
This calculation is useful for investors looking to maximize profits by holding a bond until maturity because it includes the interest that could be earned if annual coupon payments were reinvested, thereby earning additional interest on investment income.
Yield to Maturity = [C + (FV-PV)/n] / [(FV+PV)/2]
where:
C is the coupon rate, FV is the face value, PV is the market price, and n is the number of compounding periods.
Bond Yield as a Function of Price
When a bond’s market price is above par, which is known as a premium bond, its current yield and YTM are lower than its coupon rate. Conversely, when a bond sells for less than par, which is known as a discount bond, its current yield and YTM are higher than the coupon rate. Only on occasions when a bond sells for its exact par value are all three rates identical.
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FAQs
A bond's current yield is the investment's annual income, the interest it pays, divided by the current price of the security. Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until its maturation date.
Which is better, current yield or yield to maturity? ›
In this way, the yield to maturity is the more comprehensive measuring stick. It can help investors compare bonds over time and make a more informed decision. A bond's face value, or par value, is its value when the bond is first issued. It's also the amount you'll get back when the bond matures.
How do you calculate current yield from yield to maturity? ›
The yield to maturity (YTM) is calculated by the following formula: [Annual Coupon + (FV – PV) ÷ Number of Compounding Periods] ÷ [(FV + PV) ÷ 2]. The YTM metric offers bondholders with the option to estimate the return on a bond instrument, as well as measure the impact on the portfolio return.
What does current yield tell you? ›
Current yield is a financial measure used to calculate the current value of bonds, or other investments that provide a fixed interest, meaning the interest rate will not change. Current yield may also be called bond yield or dividend yield.
What is the difference between current yield and dividend yield? ›
dividend yield is the annual dividend paid by a company divided by its current stock price. It represents the percentage return on investment an investor can expect from the company's dividend payments. Current yield, on the other hand, is the annual interest paid by a bond divided by its current market price.
What are the limitations of the current yield? ›
What is a limitation of current yield? A limitation of this calculation is that your total return also depends on the price you sell the bond one year in the future. Market prices can change within that time, so you can experience a gain or loss on the sale. This affects your total return on the investment.
Should I look at sec yield or 12 month yield? ›
In general, 12-Month Yield gives a good picture of the current yield investors are receiving from their funds. (SEC Yield, in contrast, is a good measure of the income return currently priced into a fund's bonds.)
Is the current yield an accurate approximation for YTM? ›
Current yield is a common approximation for abond's yield to maturity. The approximation becomes less accurate as the bond price moves away from par value.
What is the yield to maturity for dummies? ›
Yield to maturity is the total rate of return earned when a bond makes all interest payments and repays the original principal. YTM is essentially a bond's internal rate of return if held to maturity.
What is the yield to worst CD? ›
Yield to worst is a measure of the lowest possible yield that can be received on a bond with an early retirement provision. Yield to worst is often the same as yield to call. Yield to worst must always be less than yield to maturity because it represents a return for a shortened investment period.
In short, current yield is derived by taking the bond's coupon yield and dividing it by the bond's price. Suppose you had a $1,000 face value bond with a coupon rate of 5 percent, which would equate to $50 a year in your pocket.
What is another name for current yield? ›
The current yield, interest yield, income yield, flat yield, market yield, mark to market yield or running yield is a financial term used in reference to bonds and other fixed-interest securities such as gilts.
Do you want a high current yield? ›
It may be tempting to buy a bond based on a high current yield. Just consider how a particular bond fits into your investment strategy. For example, if you plan to hold a bond until its maturity date, you may focus on the bond's face value or coupon yield rather than its current yield.
Is current market yield the same as yield to maturity? ›
A bond's current yield is the investment's annual income, the interest it pays, divided by the current price of the security. Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until its maturation date.
What is a good current dividend yield? ›
What Is a Good Dividend Yield? Yields from 2% to 6% are generally considered to be a good dividend yield, but there are plenty of factors to consider when deciding if a stock's yield makes it a good investment. Your own investment goals should also play a big role in deciding what a good dividend yield is for you.
Is current yield the same as interest rate? ›
Coupon yield, also known as the coupon rate, is the annual interest rate established when the bond is issued that does not change during the lifespan of the bond. Current yield is the bond's coupon yield divided by its current market price. If the current market price changes, the current yield will also change.
Is yield to maturity the higher the better? ›
The higher the yield to maturity, the less susceptible a bond is to interest rate risk. There are other risks, besides interest rate risk, that can increase yield to maturity: the risk of default or the risk of a bond getting called before maturity.
What is the difference between coupon rate current yield and yield to maturity? ›
The primary difference between coupon rate and yield to maturity is that the coupon rate stays the same throughout the tenure of the bond. However, the yield to maturity undergoes a change depending on various factors such as the years remaining till maturity and the current price at which the bond is being traded.
Is yield to maturity an effective rate? ›
The YTM calculation is structured to show – based on compounding – the effective yield a security should have once it reaches maturity. It is different from simple yield, which determines the yield a security should have upon maturity, but is based on dividends and not compounded interest.
Is yield to call better than yield to maturity? ›
Yield to maturity is the total return that will be paid out from the time of a bond's purchase to its expiration date. Yield to call is the price that will be paid if the issuer of a callable bond opts to pay it off early. Callable bonds generally offer a slightly higher yield to maturity.
