Current yield is an essential measure in finance, particularly in the context of bonds. It represents the annual interest income generated by an investment, divided by its current market price. This metric offers investors a means to evaluate the ongoing income-generating potential of an investment in relation to its market value.
Formula and Calculation
The formula for current yield is:
For example, consider a bond with a 10% coupon rate and a face value (par value) of $1,000. If this bond is purchased at a market price of $800, the annual income generated by the bond is $100. Therefore, the current yield can be calculated as follows:
Types of Yield Measures
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Coupon Rate: The annual interest rate paid by the bond issuer, based on the bond’s face value. In our example, the coupon rate is 10%.
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Yield to Maturity (YTM): The total return anticipated if the bond is held until it matures, considering all coupon payments and capital gains or losses. YTM encompasses both the income from interest and the difference between purchase price and face value over time.
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Current Yield: Unlike YTM, current yield focuses purely on the annual interest income relative to the current market price, excluding capital gains or losses.
Special Considerations
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Market Price Fluctuations: As market prices of bonds fluctuate, the current yield changes accordingly. A lower market price results in a higher current yield and vice versa.
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Investment Horizon: Current yield is most useful for investors interested in the immediate income potential of a bond rather than long-term returns.
Historical Context and Applicability
Current yield has been a crucial measure in bond investment analysis for decades. It enables investors to compare the income-generating capability of bonds across varying market prices and economic conditions.
Examples
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Example 1: A bond with a face value of $1,000 and a coupon rate of 5% is bought at $950. Here, the annual interest income is $50, and the current yield is:
$$ \text{Current Yield} = \frac{50}{950} \approx 5.26\% $$ -
Example 2: For a bond purchased at $1,100 with the same face value and coupon rate, the current yield is:
$$ \text{Current Yield} = \frac{50}{1100} \approx 4.55\% $$
Related Terms
- Face Value: The value of a bond as stated by the issuer, to be repaid at maturity.
- Market Price: The current trading price of a bond in the bond market.
- Coupon Payment: The periodic interest payment made to bondholders.
FAQs
Q: How does current yield differ from yield to maturity (YTM)?
A: Current yield measures only the annual interest income relative to the current market price, whereas YTM encompasses the total expected return, including interest income and any capital gains or losses if the bond is held to maturity.
Q: Can current yield be used for all types of bonds?
A: Yes, current yield can be calculated for any bond, providing insight into the bond’s current income potential relative to its market price.
Q: Is a high current yield always better?
A: Not necessarily. A high current yield could indicate higher income but may also reflect higher risk or a bond price decline.
References
- Fabozzi, Frank J., Bond Markets, Analysis, and Strategies, 9th Edition, Pearson.
- Ross, Stephen A., et al., Corporate Finance, 12th Edition, McGraw-Hill Education.
Summary
Current yield is a fundamental financial metric that provides insight into the income-generating potential of an investment relative to its market price. Especially relevant for bond investors, it offers a valuable perspective distinct from other yield measures like the coupon rate and yield to maturity, focusing on the actual income rate of return at current market conditions. Understanding current yield allows investors to make informed decisions based on present income potential, adding depth to their investment analysis.
