The current yield of a bond measures the interest income that an investor gets from the bond. It’s represented using the following formula:
Current Yield = Annual Coupon Interest/Bond Price
- Annual coupon interest is the total coupon payment received by the bond annually
- Bond price is the market price of the bond
Let’s take a $1,000 par bond, with 8% coupon and 7 years to maturity. The price of the bond is $1,112.96.
The current yield of the bond can be calculated as follows:
Current yield = $80/1112.96 = 7.19% (or 8/111.296)
One of the biggest drawbacks of current yield is that is does not take into account the capital gain or loss from the bond and hence doesn’t represent the true yield from the bond. It does not account for the reinvestment risk or the fact that the bond matures at par value. In the above example, Current yield > YTM because YTM accounts for price dropping to par at maturity (capital loss).
If we know YTM and the capital gains from the bond, then the current yield will be = YTM – capital gains yield.
To know the actual yield from the bond, Yield-to-maturity (YTM) is a better measure. YTM, coupon yield and Current Yield are compared below:
- For a par bond, YTM = Current Yield = Coupon Yield
- For a premium bond, YTM < Current Yield < Coupon Yield
- For a discount bond, YTM > Current Yield > Coupon Yield