Holding a bond for one year vs holding a bond long term
In short:
The difference between current yield and yield to maturity lies within what each yield is intended to calculate. Current yield is the measurement of the rate of return an investor would receive if they bought a bond at its current price and held it for one year. Yield to maturity is the rate of return an investor would receive if they bought a bond at its current price, received all its coupon payments on time and in full, reinvested those coupon payments at the same rate of return, and held the bond until its maturity.
Both current yield and yield to maturity are useful, however, which one an investor will use depends on their objective.
Key Points
- Yield to Maturity, is the expected return of a bond held until maturity. That is, the effective long-term rate of return of the bond.
- Current yield is the expected return of the bond if held for one year.
- The calculation for current yield and yield to maturity are different.
- A coupon is the payment made by a bond, similar to a dividend with stocks.
In-depth:
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. It 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.
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 $75 then the stated yield of the bond is 7.5% ( $75/$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 8.3% ( $75/$900 ). Conversely, if the bond trades at a premium to par, say $1,100 the current yield would decrease to 6.8% ( $75/$1,100 ).
As you can see, yield and bond price are closely linked.
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:
What is Yield to Maturity
Yield to Maturity (YTM) is the expected rate of return on a bond or fixed-rate security that is held to maturity. Since bonds do not always trade at face value, YTM gives investors a method to calculate the yield they can expect to earn on a bond.
Assumptions of YTM are that the investor holds the bond until its maturity date, all coupon payments are made in full and on time, and all coupons are quickly reinvested at the same rate of return. In practice, reinvesting coupon payments at the same rate of return will likely prove difficult so YTM may only give an investor a general yield idea and metric for comparison.
Additionally, YTM accounts for the time value of money. That is, money today is worth more than money tomorrow. This is especially important for long-term bonds since the maturity date may be 10, 20, or 30 years from the purchase.
How Yield to Maturity is Calculated
There are two methods for calculating yield to maturity (YTM). One method applies to zero-coupon bonds and the other to traditional coupon-paying bonds. Since traditional coupon bonds are more common we’ll discuss how YTM is calculated for traditional coupon bonds.
With YTM we need to account for the present value of future payments made on the bond. That is, since money today is worth more than money tomorrow the payments we receive in the future will not have the same value as if they were received today. Accounting for this we discount those values back to what they would be worth if received today.
The formula below illustrates the process and the math:
What we are doing in this formula is discounting all the coupon payments that will be made by this bond by both an interest rate and the year in which the coupon will be received. This allows us to find the present value, what they are worth if received today, of these coupons and face value.
When the sum of all the coupons and face value is equal to the bond price then the interest rate used to accomplish this is the YTM.
If you are interested in the details of how this works, our Yield to Maturity article goes in-depth with examples of both coupon bonds and zero-coupon bonds. We also have an article on how to Calculate Yield to Maturity in Excel.
Frequently Asked Questions
The difference between current yield and yield to maturity lies within what each yield is intended to calculate. Current yield is the measurement of the rate of return an investor would receive if they bought a bond at its current price and held it for one year. Yield to maturity is the rate of return an investor would make if they bought and held the bond until its maturity.
Yield to maturity is not always greater than current yield. Which one is greater will depend on if the bond is trading at a premium or a discount. At a premium, YTM is likely to be less then current yield, and the opposite if trading is trading at a discount.
If yield to maturity is lower than current yield, the bond is trading at a premium to its par value. If the yield to maturity is higher than the current yield then the bond is trading at a discount to its par value. If yield to maturity and current yield are equal, then the bond is at par value.