Understanding the Difference Between Current Yield and Yield to Maturity (YTM)

When making investment decisions in the bond market, two key metrics that investors use to evaluate the potential returns are current yield and yield to maturity (YTM). Both measures are important but provide different insights into bond performance. This article aims to demystify the differences between these two metrics and how they can impact investment strategies.

Current Yield

Definition: Current yield is a measure of the income interest or coupon payment generated by a bond relative to its current market price. It provides a quick and straightforward way to gauge the immediate return on a bond investment.

Calculation

Current yield is calculated using the formula:

Current Yield frac{text{Annual Coupon Payment}}{text{Current Market Price}}

Focus

The primary focus of current yield is on the bond's annual coupon payments in relation to its current market price. It does not take into account the capital gains or losses that could occur if the bond is held until maturity.

Yield to Maturity (YTM)

Definition: Yield to maturity (YTM) is the total return anticipated on a bond if it is held until it matures. It includes all future coupon payments and any capital gain or loss that may occur from the difference between the purchase price and the par value of the bond.

Calculation

YTM is calculated as the discount rate that equates the present value of all future cash flows (both coupon payments and the face value at maturity) to the current market price of the bond. The formula for YTM is:

P sum_{t1}^{N} frac{C}{(1 YTM)^t} frac{F}{(1 YTM)^N}

Where:

P - Current market price of the bond C - Annual coupon payment F - Face value of the bond N - Number of years to maturity YTM - Yield to maturity

Solving for YTM requires iterative methods or financial calculators, as it involves finding the rate (YTM) that makes the present value of all future cash flows equal to the bond's current market price.

Focus

YTM provides a more comprehensive measure of a bond's total return. It considers all future cash flows, including coupon payments and the return of the principal at maturity, and takes into account the time value of money. This makes YTM a more accurate measure of the expected return on a bond over its entire life.

Summary

Current Yield focuses only on the bond's annual income relative to its price, providing an immediate return assessment. Yield to Maturity (YTM) represents the total return over the life of the bond, accounting for all cash flows and the time value of money. While current yield is useful for quick comparisons and assessing short-term returns, YTM is generally considered a more complete measure of a bond's potential return.

Example

To illustrate the difference between current yield and YTM, let's consider an example:

Example: Calculate the current yield on a bond with a Rs.1,000 par value, a 4% coupon rate, and a market price of Rs.920.

Solution:

Using the formula for current yield:

Current Yield frac{1,000 times 0.04}{920} frac{40}{920} 0.0435 4.35%

Next, let's calculate the YTM for the same bond. Assuming we have the necessary data and use a financial calculator or software, we find that the YTM is approximately 4.97%.

As you can see, the YTM (4.97%) is higher than the current yield (4.35%), reflecting the additional return from the capital gains that would be realized if the bond is held until maturity.

In conclusion, while current yield is a useful quick measure of a bond's immediate returns, yield to maturity provides a more comprehensive view of the total return and risk associated with a bond investment. Understanding both metrics can help investors make more informed decisions in the bond market.