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Understanding Bond Yields: Current Yield vs. Yield to Maturity
Bonds are generally considered low-risk, reliable investments. They’re issued by corporations and government entities as a way of raising capital. By purchasing a bond, you’re essentially providing a loan. The issuer is then obligated to repay you over time, with interest. There are several ways to compare bonds to decide which ones may be right for you, including by looking at current yield versus yield to maturity. Each can be useful, but they communicate different things.
What Is Current Yield?
A bond’s current yield is the return you’re getting right now based on the bond’s price today. Dividing the annual interest payment by the bond price will give you the current yield. It provides a snapshot of the bond’s cash flow and can fluctuate depending on the price of the bond at any given time.
Comparing current yields on bonds might help guide your investment strategy. Just keep in mind that the current yield is focused on the present moment. It doesn’t reflect a bond’s total returns at the time of maturity.
What Is Yield to Maturity?
Yield to maturity is another way of evaluating a bond, but it takes a longer view than the current yield. It looks at the annual rate of return if the investor holds on to the bond until maturity. It factors in all coupon payments (also known as interest payments), as well as the return of the principal—the original purchase amount—when the bond matures.
In this way, the yield to maturity is the more comprehensive measuring stick. It can help investors compare bonds over time and make a more informed decision.
Calculating a bond’s yield to maturity is a bit complicated, however. The formula goes like this:
Coupon payment + ((face value — present value) / number of years it takes to reach maturity) / (Face value + present value) / 2
A bond’s face value, or par value, is its value when the bond is first issued. It’s also the amount you’ll get back when the bond matures. (The par value for most bonds is $1,000.) The coupon rate, which is the interest the bond pays, typically doesn’t change once the bond is issued. If you buy a bond at face value, the yield to maturity is the same as the coupon rate.
The yield to maturity is higher if you buy a bond at a discount.
The yield to maturity is lower if you buy a bond at a premium.
Current Yield vs. Yield to Maturity
The yield to maturity predicts a bond’s value once it reaches the end of its term. That includes all interest payments and the return of the principal. The current yield communicates a bond’s present cash flow, or how much income it’s generating based on the current bond price. Both can be helpful when it comes to comparing bonds and refining your investment strategy.
Example of Current Yield vs. Yield to Maturity
Let’s say you have a bond that’s currently priced at $800. The face value is $1,000 and the coupon rate is 6%. That puts the annual interest payment at $60. The maturity period is 10 years. Using the formula mentioned earlier, you’d take the following steps to calculate the yield to maturity:
60 + ((1,000 — 800) / 10) = 80 / (1,000 + 800) / 2 = 900 / 80 / 900 = 0.0888
The yield to maturity here is 8.9%.
Now let’s look at the current yield, which is fairly easy to calculate. To find this, we simply divide the annual interest payment ($60) by the current bond price ($800). That works out to 7.5%. In this case, the yield to maturity is higher than the current yield.
The Bottom Line
There’s more than one way to calculate bond yields. The yield to maturity is a more complicated approach, but it could provide a more accurate long-term prediction. The current yield offers a snapshot of a bond’s present cash flow. Both are useful.
Your investment portfolio is just one piece of your overall financial health. For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We’re here to help you make informed financial decisions and secure your future.
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