Even though the current yield is a better measure of bond return than the coupon rate (which is also called nominal yield), it is not a complete measure because it ignores the time value of money. Current yield is to bonds what dividend yield is to common stock. It is because it only accounts for the current income portion of the bond’s return.
Yield to maturity, the internal rate of return of a bond, is the preferred measure of bond yield in most cases.
Current yield can be calculated using the following formula:
|Current Yield =||Annual Coupon Payment|
|Current Bond Price|
Nominal yield, current yield and yield to maturity
There is an interesting relationship between the three measures of bond return namely nominal yield (coupon rate), current yield and yield to maturity depending on whether the bond is trading at discount, par or premium:
- If the bond is trading at face value, the current yield equals nominal yield (coupon rate) which in turn equals yield to maturity;
- If the bond is trading at discount (i.e. below face value), yield to maturity is higher than the current yield which is in turn higher than the coupon rate; and
- If the bond is trading at premium (i.e. above face value), coupon rate is higher than current yield which is in turn higher than the yield to maturity.
Company Z's 20-year $1,000 par bonds have a current market price of $970 and annual coupon rate of 9% paid semi-annually.
Find its current yield and tell whether its yield to maturity is high than the nominal yield.
Current yield equal the ratio of annual coupon payments to the clean price (i.e. flat price) of the bond.
Annual Coupon Payments
= Face Value × Annual Coupon Rate
= $1,000 × 9%
|Current Yield =||$90||= 9.28%|
Please note that the current yield is higher than the nominal yield i.e. the coupon rate. Since the price of the bond is lower than the face value of the bond, yield to maturity must be higher than the coupon rate and current yield.