Difference between Yield to Maturity and Current Yield
In the world of bonds and fixed-income securities, understanding the concepts of yield to maturity (YTM) and current yield is crucial for investors to make informed decisions. While both measures provide insights into the returns on a bond investment, they differ in their calculations and implications. This article aims to highlight the key differences between yield to maturity and current yield.
Yield to Maturity
Yield to maturity is the total return an investor can expect to receive if they hold a bond until its maturity date. It takes into account the bond’s current market price, its face value, the time remaining until maturity, and the interest payments received during the bond’s life. The YTM formula is as follows:
YTM = (C + (F – P) / n) / ((F + P) / 2)
Where:
– C is the annual coupon payment
– F is the face value of the bond
– P is the current market price of the bond
– n is the number of years until maturity
The yield to maturity is expressed as an annual percentage rate, reflecting the total return on the bond investment. It provides a more comprehensive measure of the bond’s return, as it considers the interest payments and the potential capital gain or loss upon redemption.
Current Yield
On the other hand, current yield is a simpler measure that calculates the annual return on a bond based on its current market price and the annual coupon payment. It does not take into account the time remaining until maturity or the potential capital gain or loss. The current yield formula is as follows:
Current Yield = (Annual Coupon Payment / Current Market Price) 100
The current yield is expressed as a percentage and provides a quick assessment of the bond’s annual return relative to its current market price. It is particularly useful for comparing the returns of different bonds with similar coupon rates but different market prices.
Difference between YTM and Current Yield
The main difference between yield to maturity and current yield lies in their calculations and the factors they consider. Here are some key distinctions:
1. Time Factor: YTM takes into account the time remaining until maturity, while current yield does not. This means that YTM provides a more accurate measure of the bond’s return over its entire life, whereas current yield focuses solely on the current return.
2. Capital Gain/Loss: YTM considers the potential capital gain or loss upon redemption, whereas current yield does not. This is because YTM incorporates the bond’s face value in its calculation, while current yield only considers the current market price.
3. Application: YTM is more suitable for long-term investors who plan to hold the bond until maturity, as it provides a comprehensive measure of the bond’s return. Current yield, on the other hand, is more useful for short-term investors or those who are interested in comparing the returns of different bonds with similar coupon rates.
4. Market Price Sensitivity: YTM is less sensitive to changes in market price, as it considers the bond’s face value. Current yield, however, is more sensitive to market price fluctuations, as it is based solely on the current market price.
In conclusion, while both yield to maturity and current yield provide insights into the returns on a bond investment, they differ in their calculations and implications. Understanding these differences is crucial for investors to make informed decisions and choose the appropriate measure for their investment strategy.
