Contrast current yield with yield to maturity
The idea
Current yield is the annual coupon divided by the price, and it deliberately ignores everything except this year's income: no pull to par, no reinvestment, no time value. Yield to maturity is the single discount rate that makes the present value of all the bond's cash flows equal its price, so it takes in the coupon, the capital gain or loss to redemption and the timing of both. For a bond bought at a discount, yield to maturity exceeds current yield, because the pull to par adds a gain the current yield cannot see; at a premium the order reverses. Yield to maturity also assumes coupons are reinvested at the yield itself, which is the assumption most often quietly violated.
Formulas
Current yield
current yield = annual coupon ÷ flat price
- annual coupon
- the coupon in money for a year, not the coupon rate
- flat price
- the quoted price, excluding accrued interest
It counts the coupon and nothing else. Because it ignores the pull to par it overstates the return on a premium bond and understates it on a discount bond, and it says nothing at all about a zero.
A practice question
Current yield is the annual coupon divided by the bond's:
- price — correct
- par valueWhy not: That returns the coupon rate, which is fixed in the indenture and never moves. Using the price is what makes the measure respond to the market.
- yield to maturityWhy not: A rate divided by a rate. Current yield relates a cash amount to a price.
Using the price rather than par is what makes the measure respond to the market rather than to the indenture.
A harder one
A bond with a 6% coupon and a par value of $1,000 trades at $800. Its current yield is:
- 6.0%Why not: 60 ÷ 1,000 — divided by par rather than price, which just returns the coupon rate. Current yield uses what the bond costs today.
- 7.5% — correct
- 4.8%Why not: 6% x 0.8 — the coupon rate scaled *down* by the discount. A discount raises the income return, so the price belongs in the denominator, not as a multiplier.
Sixty dollars of coupon on an 800 price is 7.5%, higher than the coupon rate because the bond trades at a discount.
The hardest tier
An investor holding a discount bond to maturity in a falling rate environment will most likely earn a realised return:
- below the original yield to maturity — correct
- above the original yield to maturityWhy not: Falling rates raise the bond's *price*, but a holder to maturity never sells. What they experience is coupons reinvested at less than assumed.
- exactly the original yield to maturityWhy not: That would require every coupon to be reinvested at the original yield, which falling rates rule out.
Coupons get reinvested at rates lower than the yield assumed, so the compounding falls short of the promise.
In the app: 18 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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