The current yield is the return investors can expect from a bond investment in the next year. Using this, one can tell whether the bond trades at a discount or premium.
What is Current Yield?
Current yield is a measure of an investor’s return from the bond investment in the next year. Also, it is a ratio of the coupon rate and the bond’s current price. Hence it tells how much return an investor can earn from the coupon payments given the bond’s market price.
It takes into account the current price of the security rather than the face value. Thus, it is a better performance measure for investors who want to invest in bonds for the short term and not hold it until their maturity.
How is the Current Yield Calculated?
It is calculated by dividing the coupon payments by the bond’s current price. Following is the formula:
Current yield = Annual coupon payment / Current bond price
It can be calculated in three simple steps.
- First, determine the annual cashflows from coupon payments. The coupon rate is available on the bond certificate.
- Second, determine the price of the bond. It is the price at which the bond is currently trading in the market. It can be trading at par, or a premium or discount.
- Finally, divide the coupon payment by the current price.
Let’s understand this with the help of an example.
Suppose a bond’s face value is Rs 1,000 and has an annual coupon rate of 7%. The coupon payment would be Rs 70. If the bond’s current price is Rs 950, then it would be calculated as follows.
Current yield = 70/95 = 7.3%
This means that you can expect a 7.3% return from the bond investment you want to invest in it at the current price.
How to Interpret the Current Yield?
The current yield is a very good indicator for identifying short term investments. This is because it measures the returns from a bond investment for a year, and as a potential investor, you can choose the bonds with the potential to give high returns, given the current market situation.
It is very useful when the bonds deviate from their par value. A bond can either be trading at a discount or premium relative to its par value. When the bond price is below par value (discount), the current yield is greater than the coupon rate. If the bond trades at par value, the current yield and coupon rate are the same. In contrast, if the bond trades above its par value (premium), the current yield is less than the coupon rate.
Hence by knowing if the bond is trading at a discount or premium, you can tell whether its current yield is higher or lower than its coupon rate and make an investing decision.
In the above example, since the bond trades at a discount, the current yield is above the coupon rate. If the bond trades at Rs 1,050 (premium), the current yield would be 6.66%. In this situation, investing in the bond might not be a good decision as the return is lower.
You can compare the yields of different bonds against different asset classes to decide on investment for your portfolio. Along with yields, you must also consider other factors like risk tolerance, goals, and investment horizon before investing in any asset.
Limitations of Current Yield
Despite being a very useful indicator, there is one drawback. It doesn’t factor in the price at which you will sell the bond. You can sell it at a gain or loss, impacting the total return on investment. This is where yield to maturity comes into the picture.
Factoring in Yield to Maturity
Yield to maturity (YTM) is the total return you will earn from your bond investment if you hold it until maturity. It considers the total return i.e., coupon payments and the gain/ loss from the bond investment. YTM is also the bond’s internal rate of return (IRR). It assumes the coupon payments are reinvested at the same return, thereby increasing the total interest earned.
However, calculating YTM is far more complicated than calculating the current yield. This is because, in YTM, you have to assume the discount rate, so the future cash flows are discounted to present value.
Assume you invest in a bond with a coupon payment of 5%, a face value of Rs 100, and a maturity of 5 years. Suppose you purchase it at a discount of Rs 10. At the end of 5 years, you will receive Rs 5 per annum as a coupon payment, and Rs 10 as capital gains. To compute the YTM, you have to add the capital gains to coupon payments. In case you purchase the bond at a premium, then you have to subtract the capital loss from coupon payments to compute YTM.
Current Yield vs Yield to Maturity
Current yield and yield to maturity are two different metrics used by investors to gauge and compare bonds against each other. The current yield measures the income from the bond, whereas YTM is a more comprehensive metric that measures the bond’s total return. Both metrics are very different from each other, and the following table summarises the differences between the two.
|Point of Difference||Current Yield||Yield to Maturity|
|Measures||Income from the bond||Total return from the bond|
|Horizon||One year||Until maturity|
|Calculation||Simple and easy||Difficult|
|Investor focus||Income||Overall performance|
|Suits investors||With short-term goals and want to earn additional income||Who wants to invest for a long term|
|Assumption||Investor sells the bond after one year||All coupon payments are reinvested at the same rate, and bondholders hold it until maturity|
|Drawback||Doesn’t factor in the price at which the bond is sold||All coupon payments cannot be reinvested at the same rate|
Frequently Asked Questions
It helps determine the actual return from a bond if you hold it for one year. It measures profitability, helps you compare different investments, and choose the one with the highest yield.
The current yield and YTM are equal when the bond trades at a par value. In this case, the coupon rate also equals the current yield and YTM. In contrast, when the bond trades at a discount, the YTM is greater than the current yield. Alternatively, if the bond is trading at a premium, the yield to maturity is lower than the current yield.
Yes, the current yield can be greater than YTM. This is when the bond trades at a premium or above its par value. A bond trades at a premium when its interest rate is higher than the market interest rate. In other words, when the interest rate in the market falls, the bond’s interest rate is higher than the market. Hence investors are willing to pay more for such bonds. As a result, its price increases, and the bond trades at a premium. Suppose the bond trades at a premium, the return which you can earn if you hold it until maturity falls. In other words, the YTM falls below the current yield.
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