(3) Current Yield

Definition

The current yield is a financial metric used to measure the annual yield of an investment, such as a bond. It’s the ratio of a bond’s annual interest income to its current market price.

Origin of the Name

The word "yield" has a meaning of "produce." In agriculture, it’s used to describe the quantity of crops or fruits produced by fields or trees. In finance, "yield" is employed to indicate the return or income from an investment.

Pros and Cons

Pros

1. Simplicity: The current yield is simple to calculate, providing a quick evaluation of investment returns.

2. Real-time Evaluation: Based on the current market price, the current yield provides a real-time evaluation of investment returns.

3. Comparison of Investments: The current yield can be used to compare the current returns of different bonds.

Cons

1. Reflects Only Current Income: The current yield only reflects the current income situation and does not consider the lifetime yield of the bond, such as the repayment of the principal at maturity.

2. Ignores Time Value of Money: The current yield does not consider the time value of money; it does not discount cash flows.

3. Ignores Market Fluctuations: The current yield does not consider fluctuations in the market interest rate and how changes in bond prices affect investment returns.

4. Ignores Reinvestment Risk: The current yield does not consider the reinvestment of bond interest income, nor does it consider the potential changes in reinvestment yields.

Application

Type	Description	Applicability of Current Yield
Zero-coupon bonds	These bonds do not pay interest during the term, only paying the face value at maturity.	Not applicable, zero-coupon bonds do not have a periodic interest expense, so the current yield cannot be calculated.
Fixed-rate bonds	These bonds pay a fixed interest periodically throughout the term and return the principal at maturity.	Yes, the current yield is a measure primarily used to calculate the cash flow return of fixed-rate bonds.
Floating-rate bonds	The interest payment of these bonds is tied to a benchmark interest rate (like LIBOR), and the rate changes as the benchmark rate changes.	Yes, the current interest payment can be used to calculate the current yield.
Convertible bonds	These bonds allow the holder to convert them into a specific number of common shares under certain conditions.	Yes, but the possibility of the bond being converted into stock needs to be taken into account, as this may affect the calculation of the current yield.

Calculation

Formula

The formula for calculating the current yield is:

$$
Current\ Yield = \frac{Annual\ Interest\ Income}{Current\ Market\ Price}
$$

Where:

• Annual Interest Income is the annual interest income of the bond.
• Current Market Price is the current market price of the bond.

Example

Let’s say you purchased a bond with a face value of 1,000 dollars at a purchase price of 950 dollars. The bond has a maturity period of two years, and the coupon is paid annually with a coupon amount of 50 dollars.

First, calculate the bond’s coupon income:

$$
\text{Coupon Income} = \text{Coupon Amount} \times \text{Number of Coupon Payments}
= 50 \text{ dollars} \times 2 \text{ years}
= 100 \text{ dollars}
$$

Next, calculate the bond’s capital gain or loss:

$$
\text{Capital Gain/Loss} = \text{Face Value} – \text{Purchase Price}
= 1,000 \text{ dollars} – 950 \text{ dollars}
= 50 \text{ dollars}
$$

Then, calculate the bond’s cash flow:

$$
\text{Cash Flow} = \text{Coupon Income} + \text{Capital Gain/Loss}
= 100 \text{ dollars} + 50 \text{ dollars}
= 150 \text{ dollars}
$$

---

Now, calculate the bond’s current yield:

$$
\text{Current Yield} = \frac{\text{Coupon Income}}{\text{Bond Purchase Price}}
= \frac{100 \text{ dollars}}{950 \text{ dollars}}
\approx 0.105 \text{ or } 10.5\%
$$

Current Yield vs Yield to Maturity (YTM)

Similarities

Similarities	Current Yield	Yield to Maturity
Purpose	Used to estimate the annual return an investor will receive while holding a particular bond.	Used to calculate the total return expected on a bond if held until maturity.
Income Measure	Both rates reflect income from the bond.	Both rates reflect income from the bond.
Basis for Comparison	Provides a basis for comparing the return of different bonds.	Provides a basis for comparing the return of different bonds.
Influenced by Interest Rates	Both rates are influenced by the current interest rate environment.	Both rates are influenced by the current interest rate environment.

Differences

Differences	Current Yield	Yield to Maturity
Calculation	Only takes into account the annual interest payments.	Takes into account both annual interest payments and any capital gain or loss that the investor will experience upon maturity of the bond.
Time Factor	Does not factor in the time value of money.	Takes the time value of money into consideration.
Reflects Price Changes	Does not fully reflect price changes due to its focus on current income.	Fully reflects price changes, including those due to changes in interest rates.
Predictive Nature	Provides a simple snapshot of return based on current conditions.	Provides a complete picture of the potential return over the life of the bond.