Formula to Calculate Current Yield of a Bond
The current yield formula of a bond essentially calculates the yield on a bond based on the Market price, instead of face value. The formula for calculating the current yield is as follows:
Examples
Example #1
Suppose there are two Bonds. Bond A & B. The details are as follows:
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.
Scenario #1: Discount Bond
Suppose Bond is trading at 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 bond
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 maturity, Current Yield, Yield to the first call, etc.
If you observe closely, the current yield of a discount bond 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.
Example #3
Suppose an investor wants to invest in the Bond market and shortlists two bonds according to his risk tolerance. Both bonds have the same level of risk & maturity. Based on the details provided below, which bond should the investor consider investing in?
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 of 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.
Calculator
You can use the following calculator.
| Annual coupon payment | |
| Current Market price | |
| Current Yield of Bond | |
| Current Yield of Bond = |
|
|
Relevance and Use
The relevance of the Current yield formula can be seen in evaluating 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 return (Current yield). As a result, bond prices fluctuate and prices increase/decrease as per the required rate of return of the investors.
- One of the essential use of the Current Yield formula 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 formula 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 expectations 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.
Conclusion
Broadly speaking, the current yield is an accurate measure of calculating the yield on a bond as it reflects the market sentiment and investor expectations from the bond in terms of return. 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. Moreover, it is a reliable measure given its sensitivity to inflation expectations of the bond market investors.
Recommended Articles
This has been a guide to the Current Yield of a Bond Formula. Here we learn how to calculate Current Yield using its formula along with examples and downloadable excel template. You can learn more about financial analysis from the following articles –
