Short term rate of return on a bond
In short:
Current yield is the short-term rate of return on a fixed-income security, such as a bond. Typically, current yield will represent the rate of return an investor can expect to earn by purchasing a bond at its current price and holding it for one year. Current yield can and does change as the traded value of the bond or fixed-income security changes over time.
Key Points
- Current yield is the rate of return a bond investor can expect to earn by buying a bond at its current price and holding it for one year.
- Coupon rate and Current yield will only be the same when the current value of the bond is the same as the face value of the bond.
- If an investor wants to hold the bond for a long period of time, they will likely use YTM to calculate an expected rate of return.
What is Current Yield
Current yield is the expected rate of return on a bond or fixed-rate security that is bought and held for one year. Unless the bond’s current price is equal to the bond’s face value, current yield and the coupon rate will not be the same. Additionally, current yield is different from yield to maturity in that it does not take into account the time value of money. An investor using current yield is unlikely to hold onto a bond for a long period of time.
So what’s the value of current yield?
The reason current yield is used is that bonds typically do not trade at their face value after they are issued. Normally bonds will trade above, called trading at a premium, or below, called trading at a discount. When the bond trades at a different price than the face value of the bond, the effective yield of a bond will be different than its stated yield.
For example, if a bond has a face value of $1,000 and annual coupons of $64 then the stated yield of the bond is 6.4% ( $64/$1,000 ). Now if the bond trades at a discount to par (face value) its yield will increase. Say the bond now trades at $900, the current yield is 7.11% ( $64/$900 ). Conversely, if the bond trades at a premium to par, say $1,100 the current yield would decrease to 5.82% ( $64/$1,100 ).
As you can see, yield and bond price are closely linked.
Why Bonds Trade Differently than their Face Value
There are a number of factors that affect the initial yield chosen for a bond or fixed-income security when it is offered. One of those factors is the current interest rate environment, that is, what is the average interest rate for the type of organization offering the bond.
Over time and for a variety of reasons, this average interest rate value will change. Since bonds are fixed-income investments, they are obligated to pay the same annual amount no matter what. As a result, the only way to account for the change in average interest rates is to change the traded value of the bond which effectively changes the interest rate the bond is paying.
Let’s look at an example to make more sense of this.
So, if you’re a bond investor and you’re looking at a bond paying a coupon rate of 5% and the average coupon rate for new bonds issued by a similar organization is 7.5% would you want to buy the 5% bond at its original price (meaning you make 5%)? Probably not since you could buy a similar bond and make 7.5% instead.
Odds are, you’re not the only investor who wouldn’t want to buy the 5% bond and only make 5% on it. This means, that if the current holder of the 5% bond wants to sell their 5% bond, they will have to sell it at a discount to the original value they paid for it. What selling it a discount from the original value they bought it at does is increase the effective interest rate of the bond.
In the case above, the person selling the 5% bond will likely have to discount their selling price so the bond’s yield results in a 7.5% yield for the new buyer.
Key Points
- Current yield can change but the coupon rate does not change.
- Coupon rate is the sum of annual cash payments divided by face value.
- Coupons are “cash payments” | Coupon rate is the rate of return
How Current Yield is Calculated
The calculation for current yield is much more straightforward than for yield to maturity. Current yield is calculated by taking the annual cash flow of the bond divided by the current price of the bond. The formula is provided below:
Frequently Asked Questions
Nominal yield is the coupon rate of a bond, this is a fixed value. Current yield is the effective one-year yield on a bond, this value can and often does change. Current yield and nominal yield are not the same, in that they refer to different things.
Coupon rate and Current yield will only be equal when the current price of the bond is the same as the face value of the bond. When the current price of the bond is higher than the face value, the current yield will be lower than the coupon rate. Conversely, when the current price of the bond is lower than the face value of the bond, then the current yield will be higher than the coupon rate.
A bond’s coupon is a “cash payment” whereas the coupon rate is the yield of the sum total of annual coupon payments divided by the face value of the bond. Coupon rate does not change after the bond has been issued.