Current Yield in Bond Investments: Understanding and Calculating

12.2.1 Current Yield

Understanding the concept of current yield is crucial for anyone involved in bond investments, whether you’re preparing for the Series 6 Exam or managing a portfolio. Current yield provides investors with a snapshot of the income-generating capability of a bond relative to its market price. This section will delve into the definition, calculation, and application of current yield, offering practical examples and insights into its role in bond valuation.

Definition of Current Yield

Current Yield is a financial metric used to evaluate the income return on a bond relative to its current market price. It is expressed as a percentage and represents the bond’s annual interest payment divided by its current market price. Unlike other yield measures, the current yield does not consider the bond’s maturity date or any potential capital gains or losses that may occur if the bond is held to maturity.

Formula for Current Yield

The formula for calculating the current yield of a bond is straightforward:

• Annual Coupon Payment: This is the total interest paid by the bond issuer to the bondholder over a year. It is determined by the bond’s coupon rate and its face value.
• Current Market Price: This is the price at which the bond is currently trading in the market.

Example Calculations of Current Yield

To illustrate the application of the current yield formula, let’s consider three scenarios where a bond is selling at par, at a premium, and at a discount.

Example 1: Bond Selling at Par

Assume a bond with a face value of $1,000, a coupon rate of 5%, and it is currently trading at par ($1,000).

• Annual Coupon Payment: 5% of $1,000 = $50
• Current Market Price: $1,000

Using the formula:

In this case, the current yield equals the coupon rate because the bond is selling at par.

Example 2: Bond Selling at a Premium

Consider a bond with a face value of $1,000, a coupon rate of 5%, but it is currently trading at a premium of $1,100.

• Annual Coupon Payment: 5% of $1,000 = $50
• Current Market Price: $1,100

Using the formula:

Here, the current yield is lower than the coupon rate because the bond is selling at a premium.

Example 3: Bond Selling at a Discount

Now, consider a bond with a face value of $1,000, a coupon rate of 5%, but it is currently trading at a discount of $900.

• Annual Coupon Payment: 5% of $1,000 = $50
• Current Market Price: $900

Using the formula:

In this scenario, the current yield is higher than the coupon rate because the bond is selling at a discount.

Difference Between Current Yield and Yield to Maturity

While the current yield is a useful measure of a bond’s income-generating ability, it is important to distinguish it from Yield to Maturity (YTM). YTM is a more comprehensive measure that considers the total expected return of a bond if held until maturity, including all coupon payments and any capital gain or loss that results from the difference between the purchase price and the face value.

• Current Yield: Focuses solely on the income aspect, ignoring the time value of money and any capital gains or losses.
• Yield to Maturity: Accounts for the entire life of the bond, incorporating the time value of money and the bond’s price changes over time.

Usefulness of Current Yield

Current yield is particularly useful for investors who are primarily interested in the income aspect of a bond. It provides a quick and easy way to compare the income potential of different bonds, especially when evaluating bonds with similar maturities but different coupon rates and market prices. However, it should not be the sole criterion for investment decisions, as it does not provide a complete picture of the bond’s total return potential.

Practical Applications and Considerations

• Income-Focused Investors: Current yield is a key metric for investors seeking regular income from their bond investments. It helps in selecting bonds that offer the best income relative to their market price.
• Market Conditions: In a rising interest rate environment, bond prices typically fall, which can increase the current yield for new investors. Conversely, falling interest rates can lead to higher bond prices and lower current yields.
• Bond Comparisons: When comparing bonds, look at both current yield and YTM to get a balanced view of income potential and total return.

Glossary

• Current Yield: The annual income (interest or dividends) divided by the current price of the security.
• Coupon Payment: The periodic interest payment made to bondholders during the life of the bond.

Further Reading and Resources

For more in-depth information on bond investing and yield calculations, consider exploring the following resources:

• Financial Industry Regulatory Authority (FINRA) Bond Center
• Bond investing guides available through financial institutions and online educational platforms.

Series 6 Exam Practice Questions: Current Yield