What is the current yield?
The current yield is the annual income from an investment (interest or dividends) divided by the current price of the security. This measure examines the current price of a bond, rather than looking at its face value. The current yield represents the yield that an investor would expect to earn if the owner bought the bond and held it for one year. However, the current yield is not the actual yield that an investor receives if he holds a bond to maturity.
Bond yield: current yield and YTM
Break down the current yield
The current yield is most often applied to bond investments, which are securities that are issued to an investor at a nominal value (nominal value) of $ 1,000. A bond carries an interest coupon which is indicated on the front of the bond certificate, and bonds are exchanged between investors. Because the market price of a bond changes, an investor can buy a bond at a discount (less than the face value) or at a premium (above the face value), and the purchase price of one bond affects current performance.
Key points to remember
- In fixed income investing, the current yield on a bond is the annual income from an investment, including interest payments and dividends, which are then divided by the current price of the security.
- Since the market price of a bond can change, investors can buy bonds at a discount or premium, when the purchase price of a bond affects current yield.
- With stocks, the current yield can also be calculated by taking the dividends received for a share and dividing this amount by the current market price of the share.
How the current yield is calculated
If an investor purchases a 6% coupon bond for a $ 900 discount, the investor earns annual interest income of ($ 1,000 X 6%), or $ 60. The current yield is ($ 60) / ($ 900), or 6.67%. The annual interest of $ 60 is fixed, regardless of the price paid for the bond. On the other hand, if an investor buys a bond with a premium of $ 1,100, the current yield is ($ 60) / ($ 1,100), or 5.45%. The investor has paid more for the premium bond which pays the same amount in interest dollars, so the current yield is lower.
The current yield can also be calculated for the shares by taking the dividends received for a share and dividing the amount by the current market price of the share.
Consideration of yield to maturity
Yield to Maturity (YTM) is the total return earned on a bond, assuming the owner of the bond holds the bond until the maturity date. For example, suppose the 6% coupon bond purchased for a $ 900 rebate matures within 10 years. To calculate YTM, an investor assumes a discount rate, so that future principal and interest payments are discounted to their present value.
In this example, the investor receives $ 60 in annual interest for 10 years. At maturity, the owner receives the nominal value of $ 1,000 and the investor recognizes a capital gain of $ 100. The present value of interest payments and the capital gain is added to calculate the YTM of the bond. If the bond is purchased at a premium, the YTM calculation includes a capital loss when the bond matures at nominal value. (For a related reading, see “Current Yield vs. Yield to Maturity”)
Generally, investors should expect higher returns for riskier investments. Therefore, if two bonds have similar risk profiles, investors should opt for the higher yielding offer.