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What is the difference between YTM and current yield?

Understanding the Difference Between YTM and Current Yield

When it comes to the bond market, yield reveals critical information about a bond’s profitability. To delve deeper into such an investment, it’s essential to understand two key terminologies: Yield to Maturity (YTM) and Current Yield. While both terms pertain to the same bond yield concept, they demonstrate different aspects.

Understanding YTM (Yield to Maturity)

YTM, or Yield to Maturity, represents the total annualized return an investor anticipates when buying a bond and holding it until it matures. It’s a complex measure because it includes all potential bond income sources, from interest payments to gains from purchasing the bond at a discount or losses from buying it at a premium. In simplistic terms, YTM could be compared to the internal rate of return of a bond.

YTM is especially meaningful as it combines the bond’s present income from interest and any potential capital gain or loss if you were to hold the bond until maturity. It not only encompasses the coupon rate, which is the interest promised to bondholders annually, but also takes into account any difference between the price you paid and the face value you receive at maturity.

To calculate YTM, one needs to solve the following formula, for which a financial calculator or bond function in financial software is usually used:

Where:

  • = Annual coupon payment (the interest payment the bond will pay each year)
  • = Face value of the bond (also known as the par value; it is the amount the bond will be worth at maturity and the amount the bond issuer agrees to pay back the bondholder)
  • = Present value of the bond (the current price at which the bond is trading in the market)
  • = Number of years until maturity

Understanding Current Yield

On the other hand, the Current Yield reflects a bond’s annual income as a percentage of its current price. Unlike YTM, the current yield only accounts for the income received from interest payments and does not consider any capital gains or losses if the bond is held until maturity.

The current yield is a simpler calculation compared to YTM. It relies only on the annual interest payments and the market price. It doesn’t consider the bond’s maturity.

To calculate the current yield, use the formula:

Current Yield = (Annual Coupon/Interest Payment / Market Price of the Bond ) x 100%

Key Differences Between YTM and Current Yield

While both YTM and current yield provide important information about a bond’s profitability, their main points of difference lie in their level of comprehensive data.

Income Inclusion

The Current Yield focuses solely on the return from coupon payments as a percentage of the market price of the bond. It offers a snapshot of the bond’s relative profitability at the current time.

Contrastingly, YTM provides a holistic view of bond profitability. It sums up all possible earnings from a bond, including periodic interest payments and any capital gain, should you decide to hold the bond until its maturity.

Capital Gain or Loss

While YTM considers capital gains resulting from buying the bond at a discount or losses from purchasing it at a premium price, Current Yield does not factor these elements. For this reason, YTM is considered a more precise measure of a bond’s overall return.

Complexity and Calculation

The Current Yield calculation only requires the bond’s annual coupon payment and the current market price. Whereas, calculating YTM can be complex as it considers the bond’s price, face value, time till maturity, and coupon rate. Thus, generally, financial calculators or bond functions in financial software are used for calculating YTM.

In Conclusion

While both YTM and current yield have their own unique roles, understanding the distinction between them is critical for investors. The current yield offers a quick snapshot of a bond’s profitability in relation to its market price, while the YTM gives a comprehensive picture of the total returns when holding the bond until maturity. An investor should consult both measures to get a complete understanding of a bond’s potential yield before making an investment decision.

Investing in bonds can be as complicated or straightforward as you make it. Use the above information to inform your investment decisions, and remember to always conduct thorough due diligence before investing in any financial instrument. Keep in mind that while bonds are regarded as a less risky investment than stocks, every investment comes with its own degree of risk. As such, diversification is a good practice to spread and minimize potential risk.