- 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 an investment's annual income, including both interest payments and dividends payments, which are then 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.
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 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 annual interest income of ($1,000 X 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.
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.
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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