What is Current Yield of Bond ?
The current yield of a bond calculates the rate of return on a bond by using the market price of the bond instead of its face value. It is calculated as the annual coupon payment divided by the current market price The current yield is an accurate measure of bond yield as it reflects the market sentiment and investor expectations from the bond in terms of return.
Current Yield of a Bond Formula
Current Yield of Bond Formula = Annual Coupon Payment / Current Market Price
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Source: Current Yield of a Bond (wallstreetmojo.com)
Understanding Current Yield of Bond
The relevance of the Current yield can be seen in the evaluation of multiple bonds of the same risk & maturity. The coupon rate of a bond usually remains the same; however, the changes in interest rate markets encourage investors to constantly change their required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more (Current yield). As a result, bond pricesBond PricesThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more fluctuate, and prices increase/decrease as per the required rate of return of the investors.
The current yield of a discount bondA Discount BondA discount bond is one that is issued for less than its face value. It also refers to bonds whose coupon rates are lower than the market interest rate and thus trade for less than their face value in the secondary market.read more is greater than the annual coupon rate because of the inverse relationship that exists between the yield of a bond and its market price. Similarly, the yield on a premium bond is lower than its annual coupon rate and equal for a par bond. The reason why current yield fluctuates and deviates from the annual coupon rate is because of the changes in interest rate market dynamics based on Inflation expectations of the investors.
Current yield, when used with other measures such as YTM, Yield to the first call, etc. helps the investor in making the well-informed investment decision.
Examples
Example #1
Suppose there are two Bonds. Bond A & B. The details are as follows:
| Particulars | Bond A | Bond B |
|---|---|---|
| Face Value | 1000 | 1000 |
| Current Market Price | 1200 | 900 |
| Annual Coupon Rate | 10% | 10% |
The current yield of A & B Bond will be calculated as follows:
For Bond A
Step 1: Calculate Annual coupon payment
- Face value * Annual coupon rate
- 1000 * 10%
- = 100
Step 2: Calculate Current Yield
- = Annual coupon payment / Current market price
- = 100 / 1200
- = 8.33%
For Bond B
Step 1: Calculate Annual coupon payment
- = Face value * Annual coupon rate
- = 1000 * 10%
- = 100
Step 2: Calculate Current Yield
- = Annual coupon payment / Current market price
- = 100 / 900
- = 11.11%
Example #2
Let us now analyze how current yield differs under various scenarios for a bond.
| Particulars | Discount Bond | Premium bond | Par bond |
|---|---|---|---|
| Face Value | 1000 | 1000 | 1000 |
| Current market price | 950 | 1050 | 1000 |
| Annual coupon rate | 10% | 10% | 10% |
| Annual coupon payment | 100 | 100 | 100 |
Scenario #1: Discount Bond
Suppose the Bond is trading at a discount, meaning the current market price is lesser than the face value.
In this case, the current yield will be;
- = Annual coupon payment / Current market price
- = 100/ 950
- = 10.53%
Scenario #2: Premium bondPremium BondA premium bond refers to a financial instrument that trades in the secondary market at a price exceeding its face value. This occurs when a bond’s coupon rate surpasses its prevailing market rate of interest. For instance, a bond with a face value (par value) of $750, trading at $780, will reflect that the bond is trading at a premium of $30 ($780-750). read more
Suppose B is trading at a premium, meaning the current market price is greater than the face value.
In this case, the current yield on a Premium bond will be;
- = Annual coupon payment / Current market price
- = 100/ 1200
- = 9.52%
Scenario #3: Par bond
Here the current market price is equal to the face value.
In this case, the current yield on a par bond will be;
- = Annual coupon payment / Current market price
- = 100/ 1000
- = 10%
The above relationship can be understood in the below table:
A well-informed investor relies on various types of calculations to better analyze the multiple investment opportunities and decide which opportunity to pursue. Some of the calculations that are relevant for the bond market are Yield to maturityYield To MaturityYield to Maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's expected returns after making all the payments on time throughout the life of a bond.read more, Current Yield, Yield to the first call, etc.
Example #3
Suppose an investor wants to invest in the Bond market and shortlists two bonds according to his risk toleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more. Both bonds have the same level of risk & maturity. Based on the details provided below, which bond should the investor consider investing in?
| Bond | Annual coupon payment | Face value | Current market price |
|---|---|---|---|
| ABC | 100 | 1000 | 1500 |
| XYZ | 100 | 1000 | 1200 |
Let us calculate the current yield of both bonds to determine which one is a good investment
For ABC
- = Annual coupon payment / Current market price
- = 100/ 1500
- =6.66%
For XYZ
- = Annual coupon payment / Current market price
- = 100/ 1200
- = 8.33%
Well, clearly, it is the Bond with a higher yield that attracts the investor, as it gives a higher return on Investment. Therefore, Investors will select bond XYZ for investment, as it offers a higher current yield of 8.33% as compared to 6.66% offered by ABC.
Relevance and Use
- One of the essential use of the Current Yield is to identify the yield of a bond that reflects the market sentiment. As the current yield is calculated based on current market prices, it is said to be the accurate measure of yield and reflects the true market sentiment.
- The Investor who wants to make an effective investment decision would rely on the current yield to make a well-informed decision. Suppose an investor is considering making an investment and founds Bond A & B. The bond with higher is more attractive to the investor.
- It is considered to be a dynamic and fundamentally accurate measure as it keeps on changing as per the inflation expectationsInflation ExpectationsInflation expectations refer to the opinion on the future inflation rate from different sections of the society, such as investors, bankers, central banks, workers, and business owners. As a result, they take this rate into account when making decisions about various economic activities they want to engage in in the future.read more of the investors, as opposed to coupon rate that stays constant over the time period of the bond.
- It is always higher for a discount bond, as investors demand a higher yield for the amount of risk they are taking by investing in it.
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