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What Is the Current Yield?
Current yield is an investment’s annual income (interest or dividends) divided by the current price of the security. This measure examines the current price of a bond, rather than looking at its face value. If the market price changes, the current yield changes as well.
Current yield shows the expected return if an investor buys and holds a bond for a year. Although it is mainly used for bonds, current yield can also be calculated for stocks based on their dividends. However, current yield is not the actual return an investor receives if he holds a bond until maturity.
Key Takeaways
- Current yield measures the income generated by an investment, such as bonds or stocks, relative to its current market price rather than its face or par value.
- For bonds, the current yield is calculated by dividing the annual coupon payment by the bond’s current market price, with variations in market price leading to differences in yield.
- The current yield only accounts for income received and does not reflect the total return an investor might earn if the bond is held until maturity, which is better represented by the yield to maturity (YTM).
- Current yield highlights the income component of a bond’s return, serving as a quick gauge for investors comparing potential revenue streams from different financial instruments.
- Stock current yield can also be determined by dividing the annual dividend payment by the stock’s current share price, indicating the dividend income relative to the stock’s market value.
How Current Yield Works in Bond Investments
Current yield is most often applied to bond investments, which are securities that are issued to an investor at a par value (face amount) of $1,000. A bond carries a coupon amount of interest that is stated on the face of the bond certificate, and bonds are traded between investors. As bond prices change, investors may buy them at a discount (below par) or a premium (above par), impacting the current yield.
Calculating Current Yield: A Step-by-Step Guide
If an investor buys a 6% coupon bond at a $900 discount, they earn $60 in annual interest (6% of $1,000). The current yield is ($60) / ($900), or 6.67%. The $60 in annual interest is fixed, regardless of the price paid for the bond. On the other hand, if an investor purchases a bond at a premium of $1,100, the current yield is ($60) / ($1,100), or 5.45%. The investor paid more for the premium bond that pays the same dollar amount of interest, therefore the current yield is lower.
Current yield can also be calculated for stocks by taking the dividends received for a stock and dividing the amount by the stock’s current market price.
Important
As a financial theory general rule, investors should expect higher returns, for riskier investments. Therefore, if two bonds have similar risk profiles, investors should opt for the higher return producing offering.
Yield to Maturity: Understanding the Comprehensive Return
Yield to maturity (YTM) is the total return earned on a bond, assuming that the bond owner holds the bond until the maturity date. For example, let’s assume that the 6% coupon rate bond purchased for a discount of $900, will mature in the 10 years. To calculate YTM, an investor makes an assumption about a discount rate, so that the future principal and interest payments are discounted to present value.
In this example, the investor receives $60 in annual interest payments for 10 years. At maturity, the owner receives the par value of $1,000, and the investor recognizes a $100 capital gain. To find the bond’s YTM, add the present value of the interest payments to the capital gain. If the bond is purchased at a premium, the YTM calculation includes a capital loss when the bond matures at par value.
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