Difference Between Current Yield and Yield to Maturity

Current Yield vs Yield to Maturity
 

A bond is a form of a debt security that is traded in the market and has many characteristics, maturities, risk and return levels. A typical bondholder (lender) will be entitled to an interest rate from the borrower. This interest is known as a ‘yield’ and is received by the lender depending on the maturity period and the interest rates prevalent in the market. This article explores the two forms of yield; ‘current yield’ and ‘yield to maturity’ (YTM) clearly highlighting the differences between the two.

What is Current Yield?

A current yield is the interest rate paid to the bondholder at the current period. The current yield does not reflect the value of holding the bond till its maturity. For example, if I bought a bond with a face value of $1000, with yield 5%, and held it for a year, at the end of the year I would receive the face value of $1000, plus my interest of 5% for holding the bond for a year (assuming no change in interest rates occurred during this period). Current yield is calculated by dividing the annual cash flows by the market price; therefore, fluctuation in the market prices will greatly affect the current yield of a bond.

What is Yield to Maturity (YTM)?

Yield to maturity (YTM) is also an interest rate associated to bonds but reflect the entire return that the bondholder will receive until the bond’s maturity date. The calculation of the YTM is more complicated than the current yield as it involves a number of variables such as par value of the bond, its coupon rate, market price and maturity date. The YTM gives an estimate of the total returns to the bondholder, as it is difficult to predict the rate accurately at which coupon payments received by the bond holders will be reinvested due to fluctuations in the market rates. The relationship between the bond price and YTM is an inverse relationship, and when the YTM increases the price of the bond falls and vice versa.

Current Yield vs Yield to Maturity

Current yield and YTM give the bondholder an idea of the rate of return that can be expected, if the bond is bought. These two forms of interest are different from each other in that current yield is the interest paid during the current period, and the YTM reflects the total returns to the bond holder of holding the bond till maturity. Unlike current yield, the YTM takes into consideration the reinvestment risk (the rate of reinvesting the coupon receipts). Further, a bond that has a higher YTM than its current yield it is said to sell at a discount (when the price of the bond decreases the YTM increases) and a bond that has a lower YTM than its current yield will sell at a premium. When the YTM and current yield are equal the bond is said to sell at ‘par’ (face value).