Current yield (CY) is the expected rate of return based on an annual coupon payment and current market price of a bond. Thus, it does not account for all cash flows if an investor holds a bond until the maturity date. In other words, current yield represents the expected return if an investor purchased a bond and held it for a year.
This measurement is widely used in the secondary market. If a coupon payment is fixed until the maturity date, the market price of a bond will change following fluctuations in the prevailing level of interest rates. If interest rates are declining below the coupon rate, the current price of a bond will appreciate above its par value. In contrast, if the prevailing level of interest rates shifts above the coupon rate, the current price of a bond will plunge below its par value.
The current yield formula is very simple.
An investor is considering the purchase of a bond of $1,000 par value and an annual coupon rate of 11.5% at a current market price of $991.
The annual coupon payment is $115.
Let’s assume that in the example above a 5-year bond is considered. We have calculated both CY and YTM at various market prices from $800 to $1,200 and applied this data to the graph.
As we can see, YTM is higher than CY if the current price of a bond is below its par value. If the bond is traded above its par value, its YTM will be lower than CY.
There is some relationship between the market price of a bond and its current yield.
- If a bond is traded at a discount to its par value, its CY is above the coupon rate.
- If the current market price equals its par value, the CY equals the coupon rate.
- If a bond is traded at a premium to its par value, its CY is below the coupon rate.
Any investor should take into account that current yield is based on the following assumptions:
- It is calculated at a specific date and can change over time.
- It considers cash flow to be received in the next year and does not consider cash flows expected to be received in the future (further coupon payments and par value to be paid at maturity).
- It does not consider that semiannual coupon payments can be reinvested.