7.2.4 Calculating Current Yield On Bond

What is Current Yield?

Current yield is a measure of the cash flow (interest or dividends) that an investor gets from an investment relative to its current market price. Unlike yield to maturity, which considers all future cash flows (including capital gains or losses), current yield focuses exclusively on the income received annually or semi-annually.

Formula for Current Yield

The current yield of an investment can be calculated using the following formula:

$$ \text{Current Yield} = \frac{\text{Annual Cash Flow}}{\text{Current Market Price}} \times 100 $$

• Annual Cash Flow is the total annual income received from the investment.
• Current Market Price is the current price at which the investment is trading in the market.

Example Calculation

Consider a four-year, semi-annual, 9% bond that is currently trading at a price of 96.77. The bond pays 9% annually but in semi-annual installments; thus, each period’s interest payment is 4.5% of the face value. However, for simplicity in calculating current yield, we use the total annual cash flow.

Using the formula provided:

For our example:

Plugging in these values:

Key Considerations

• Nominal Yield vs. Current Yield: While nominal yield reflects the total yield provided by a bond as a percentage of its face value, the current yield is specifically based on its market price. Hence, it can be a more practical measure for secondary market investors.
• Market Price Impact: As bond prices fluctuate, the current yield will vary. If a bond sells at a discount (below face value), the current yield will be higher than the coupon rate and vice-versa.
• Income Focused Measure: Current Yield does not account for any capital gains or losses incurred if the bond is sold before maturity. It concentrates purely on the interest income or dividends.

Frequently Asked Questions (FAQs)

What is the difference between Current Yield and Yield to Maturity (YTM)?

Current yield only considers annual interest payments and the current market price, while YTM accounts for the total returns over the bond’s entire lifetime until maturity, including interest payments and the difference between purchase price and par value.

Why is current yield important for investors?

Current yield is a valuable metric for investors who prioritize steady income from their investments. It is particularly useful for those seeking to identify more attractive buying opportunities in the bond market.

How does bond price affect current yield?

Since current yield is inversely related to the price of the bond, if the bond’s market price decreases, the current yield increases, making it potentially more attractive for income-focused investors.

Example Chart Displaying Current Yield vs. Bond Price

    graph TD
	A[Current Yield] --> B[Higher]
	A --> C[Lower]
	B --> D[Bond Price Decrease]
	C --> E[Bond Price Increase]

Glossary

• Annual Cash Flow: The total amount of cash generated by an investment in one year, usually in the form of interest or dividends.
• Current Market Price: The present price at which an investment can be bought or sold in the market.
• Nominal Yield: The interest rate stated on the face of the bond, representing the same as the coupon rate.
• Yield to Maturity (YTM): A comprehensive measure of bond yield accounting for interest payments and the profit or loss incurred if held until maturity.

Key Takeaways

1. Understanding Current Yield: It holistically captures the yield solely based on the current market price and income without considering the initial investment or any potential capital gains/losses.
2. Helpful for Income Investors: It provides an insight into potential ongoing income, aiding in better decision-making for those focused solely on investment revenue rather than capital returns.
3. Market Price Impact: Fluctuations in bond market prices significantly impact the current yield, emphasizing the importance of market dynamics in yield calculations.

Understanding how to calculate the current yield of a bond is crucial for making informed investment decisions. It allows investors to assess the income potential of their bonds and to compare different bonds effectively based on their yield.