The current yield is the annual income from a financial instrument or an investment, usually bonds, based on its current price instead of the face value. We may also call it a running yield. We can calculate it by dividing the annual coupon payment from a bond (or any other financial instrument) by its current price.
It is the return that one would expect if they invest in a bond and keeps it for one year (until the interest payment date). But, this return is not the return that an investor would get if they hold the bond until maturity. Running yield exists because the price of the bonds keeps fluctuating due to the economic situation, and it approaches maturity.
A point to note is that many consider running yield as a better measure of a return from a bond than the nominal one or the coupon rate. However, this measure is not complete as it does not factor in the time value of money.
Current Yield – Why it Matters?
A point to note is that the coupon rate for the bond remains the same throughout the term. But, the investors’ expectations keep changing with the variation in interest rates and inflation in the economy.
Thus, the running yield represents the return at which level investors want to hold that specific bond. We can say that investors will send the prices of the bond up or down until the running return on the bond equals other securities with a similar risk profile.
Therefore, the running return better reflects the return of the specific bond in comparison to other similar available options. To the investors, such a measure helps select the bonds that generate higher returns, especially in the short run. It also supports an investor in making a better decision when facing a choice between two bonds with the same risk and maturity.
Many consider running yield as a fundamentally correct measure. It is because the return continues to change based on the investors’ expectations about the inflation and overall interest rate scenario.
The formula for the current yield is – Annual Coupon Payment / Current Bond Price
Let us understand the calculation with the help of an example. Company ABC issues a 20-year bond having a face value of $100. The bond has a coupon rate of 9%, and it pays annually, while its current market value is $97.
Also Read: Bond Valuation
The annual coupon payment, in this case, will be $9 (9% * $100). Putting the values in the current yield formula, we get 9.28% ($9 / $97).
In this case, the running yield is more than the nominal rate (or coupon rate) of 9%. It is because the current price of the bond is less than the face value.
If we assume the bond is currently available at its face value, i.e., $100, then the current and nominal yield will be the same at 9%. And, if we assume that the bond is trading at a premium, say $110, then the current or running yield will be less at 8.18% (9 / $110).
The running yield on the discount bond is always more than the coupon rate and vice versa. It is because there is an inverse relationship between the bond yield and its market price.
We can calculate the running yield for a stock as well. To figure it out, we need to divide the dividend from the share by its current price.
Nominal Yield and Yield to Maturity (YTM)
Nominal yield, as said above, is the coupon rate. The yield to maturity is the total return that an investor would earn if they hold the bond until maturity. Suppose an investor buys a 10-year bond with a 6% coupon rate at $900. In this case, the total return for the investor would include a $60 coupon each for ten years, the par value of $1,000, and a capital gain of $100. To calculate the YTM, we add the present value (PV) of the coupon payments and capital gains.
All three types of yields– nominal, current, and YTM – share a fascinating connection. This relationship depends upon whether the bond is trading at par value, discount, or premium.
- At the par value, all three yields are equal.
- If the bond is trading at a premium, YTM will be the lowest, while nominal will be the highest.
- In case the bond is trading below the face value, the nominal will be the lowest, and YTM will be the highest.
As said above, the current or running yield is a better and more accurate measure of a bond’s return. It is because it reflects the prevailing market sentiments. However, to make a well-informed decision, an investor must use this measure and other indicators, including YTM.