Bond Yield Measures – Current Yield and Yield to Maturity

Current Yield:

It is one of the simplest way to understand yield on a particular bond. It is calculated using following equation:

Current Yield = (Coupon/Market Price)×100

It is an approximation measure as time value of money is not used in the calculation.

Example:

Suppose the market price for a 10% G-Sec 2020 is Rs.120. The current yield on the security will be….?

Answer:

(10/120)×100 =8.33%

Yield To Maturity (YTM)

YTM is the most popular measure of yield in the Debt Markets.

It is also known as the Internal Rate of Return on a bond.

It is the return which an investor can get if he hold the bond till maturity. 

Even though it is the most popular measure it suffers from certain limitations. A critical assumption underlying the YTM is that the coupon interest paid over the life of the bond is assumed to be reinvested at the same rate (YTM).

Practically bonds pay interest semi-annually and investors are required to reinvest the coupons received. Reinvestment rate may or may not be equal to the YTM rate. Hence this is the llimitation with YTM.

YTM can be calculated using following formuale:

Illustration:

Consider a bond with an annual coupon rate of 10% redeemable after 3 years selling at Rs.90. What is the return earned by the investor who buys the bond and holds till maturity?

Answer:

As we use financial calculator, question can be solved as below:

PV = -90

PMT = 10

N = 3

FV = 100 (when nothing is specified, it is assumed that bond is redeemed at face value)

I/Y =?

Answer = 14.33%

YTM and Coupon relationship:

Advertisement