Measuring Yield
While the stated (nominal) interest rate on a bond might appear to be the only measure of a bond yield, it is only accurate if you buy a bond at
par (or its face value) and hold it until the bond matures. However, many investors buy bond
s at price
s above or below par, and many sell prior to maturity.
The following measures are used to reflect these circumstances:
- Yield to Maturity - YTM
- The return based on the actual purchase price of the bond
- Takes any premium or discount over par into account and uses the actual time to maturity for the number of compounding periods
- If an investor buys a bond at a price below its par value (at a discount), then its YTM will be greater than its stated interest rate (also known as its coupon rate).
- If an investor buys a bond above its par value (at a premium), then its YTM will be lower than its coupon rate.
- If the bond was purchased at par, the yield to maturity will equal the stated coupon rate.
Example:
For $976 James Smith buys a bond with a face value of $1,000 and a 6% coupon rate. What will his yield to maturity be?
- 6%
- Less than 6%
- More than 6%
- Unable to calculate based on given information
Answer: The correct answer is "c". When an investor buys a bond at a discount to its face value, the yield to maturity will exceed the coupon rate.
- Yield to Call
- Similar to YTM but uses the call date for the number of compounding periods and incorporates any call premium into the future value
- A callable bond is one that allows the issuer the right to demand the bond back from an investor prior to maturity. The investor is paid the bond's face value plus a premium to partly compensate the investor for the loss of the future coupon payments on the bond. Typically, the investor must reinvest the proceeds at a lower rate of return than the rate of return earned prior to the call.
- The YTC on a particular bond usually will be less than its yield to maturity because there are fewer coupon payments and fewer compounding periods.
Current Yield
- Simply, the annual income divided by the market value of the bond
- If the bond is trading at a premium, the current yield will be less than the nominal yield.
- If the bond is trading at a discount, the current yield will be greater than the nominal yield.
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| Current Yield = Annual Income ÷ Market Value |
Example:
A bond with a $1,000 face value and a 5.5% coupon rate currently trades at $984. What is its current yield?
Current yield = $55/$984 = .056 or 5.6%.
- Real interest rate
- The rate the investor receives after inflation is taken into account; in essence, the real interest rate equals the nominal interest rate minus the inflation rate. (This equation will give you an approximate real interest rate; the precise equation is more complicated but is not needed for the Series 65 exam.)
- The inflation premium is typically higher for bonds with longer maturities.
