What is Current Yield?
Current yield is the annual earnings from an investment––whether interest or dividends––divided by the asset’s current market price. This calculation provides a snapshot of an investment’s profitability based on its current price rather than its face or par value. It’s particularly relevant for bond investors who desire to know the potential return if the bond is held for the short term. It’s crucial to acknowledge, however, that the current yield doesn’t equate to the actual return if the bond is retained till maturity.
Key Highlights
- For fixed income securities like bonds, current yield represents an investment’s annual earnings—comprising both interest and dividends—divided by the security’s present market value.
- Fluctuations in a bond’s market price mean buyers might acquire bonds at a premium or discount, subsequently impacting the bond’s current yield.
- When it comes to equities, the current yield involves dividing the dividend amount by the stock’s existing market price.
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Why Understanding Current Yield Matters
Typically applied to bonds, current yield indicates the annual income earned based on the bond’s purchase price, making it a key metric for assessing short-term earnings potential. Bonds, usually issued at a par value of $1,000, have stated interest (coupon) rates. As these bonds are traded, their purchase price varies, affecting the current yield. Buying bonds at a discount or premium alters the expected return rate.
Step-by-Step: How to Calculate Current Yield
If you buy a bond with a 6% coupon rate at a discounted price of $900, the annual income remains $60 (calculated as $1,000 x 6%). The current yield here stands at $60 divided by $900, which equals 6.67%. The fixed annual income demonstrates that despite the bond’s market price, the earnings remain unchanged. Conversely, purchasing at a premium, say $1,100, lowers your current yield to 5.45% ($60 divided by $1,100). Hence, the premium bond offers the same interest income but at a lower return rate.
Assessing Stocks’ Current Yield
Stocks’ current yield is calculated by dividing the received dividends by the stock’s current market price. For prudent investment, as per general financial dogma, riskier asset classes could justify higher expected returns. Investors should therefore favor higher-return options within comparable risk parameters.
Enhanced Assessment: Factoring in Yield to Maturity
Yield to maturity (YTM) computes the total bond return, presuming the investor holds it till maturity. For instance, considering our 6% coupon bond bought at $900 that matures in 10 years, the investor gains annual interest of $60 for a decade. On maturity, you receive the bond’s par value of $1,000, availing a $100 capital gain which accumulates through the years. Summing the present value of the interest payments and the capital gain, YTM helps in understanding comprehensive return rates over the bond’s lifecycle. For premium bonds, YTM entails capital loss calculation as the bond matures to par value.
Related Terms: Yield to Maturity, Coupon Rate, Dividends, Capital Gain.
