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Current Yield vs. Yield to Maturity: An Overview
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. 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 market. For example, a bond with a $1,000 par value and a 7% coupon rate pays $70 in interest annually.
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 total return anticipated on a bond if the bond is held until its maturation date.
Current Yield
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.
Current Yield=Bond PriceAnnual Coupon Payment
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
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.
Which Is Better, Current Yield or Yield to Maturity?
Both current yield and yield to maturity provide a different analysis of a bond for investors. Current yield is tied to the market price of a bond, which can fluctuate over time, and is a better indicator of short-term profitability. Yield to maturity provides investors with the total expected return of a bond if it is held to maturity.
It takes into consideration compounding, the time value of money, the frequency of coupon payments, the maturity date, and interest reinvestment. Yield to maturity provides a long-term outlook as well as being a better method of comparing bonds.
What Does It Indicate When Yield to Maturity Is Greater Than Current Yield?
When the yield to maturity is greater than the current yield, it indicates the bond is selling at a discount (its price is less than par value). On the other hand, if the yield to maturity is lower than the current yield, it is selling at a premium (its price is higher than par value). If a bond is selling at a discount, it can be a good investment if held to maturity; this is so because you’re paying less than the face value to buy it but will receive the face value at maturity.
What Are the Limitations of Current Yield?
Current yield can be viewed as a snapshot in time, showing a bond’s annual return in relation to its market price. It’s a good metric for a short investment horizon but has critical limitations when analyzing a bond investment for the long term. Current yield does not take into consideration the time value of money; the idea that a dollar today is worth less than a dollar tomorrow, so it forgoes the concepts of compounding and reinvestment.
The Bottom Line
Current yield and yield to maturity are two aspects of bonds that investors need to understand when making investments in this asset class. Current yield provides investors with a picture of a bond’s annual return based on its market price. This is valuable in gauging a bond’s short-term profitability.
Yield to maturity indicates the total expected return of a bond over its lifespan, taking into account compounding and reinvested interest. Understanding both metrics will help investors make informed decisions on their investment choices.
