Assume the following example: a yearly 6.5% coupon paying bond that matures in 5 years is currently selling for $1,050.
The Yield to Maturity (YTM) is 5.3344%, here's how to calculate:
- n = 5
- PV = ($1,050)
- PMT = $65 ($1,000 par x 6.5% annual coupon)
- FV = $1,000
- i or YTM = 5.3344 or 5.3344%
The Current Yield is 6.19%, here's how to calculate:
- ($65 coupon / $1,050 current price).
Now consider that there is another 5-year bond with the same credit rating and a 5.75% annual coupon selling for $928.92. The YTM and current yields are calculated below.
The yield to maturity (YTM) is 7.5072%, here's how to calculate:
- n =5
- PV = ($928.92)
- PMT = $57.50 ($1,000 par x 5.75% annual coupon)
- FV = $1,000
- i or YTM = 7.5072 or 7.5072%
The current yield is .0619 or 6.19%, here's how to calculate:
- ($57.50 coupon / $928.92 current price).
The yield to maturity is the yield earned on a bond based on the cash flows promised from the date of purchase until the date of maturity; whereas, the current yield is the annual coupon income divided by the current price of the bond.
Notice the current yields are the same at 6.19%; yet the price on the first bond is selling at a premium for $1,050 and the second bond is selling at a discount for $928.92. In addition, notice that the YTM and cash flows are different: $65.00 and 5.3344% versus $57.50 and 7.5072%.
Which calculation should be used? To answer this, we need to consider some of the following issues:
- Risk and return, tax consequences, and time horizon.
- Purchasing power risk. For example, discount bonds will appreciate to par value when the bond matures as opposed to a premium bond that declines from the original purchase price paid to par value.
- The effect of selling the bond before maturity and after an interest rate change. Calculate the duration and convexity of the bond to determine any adverse outcomes when interest rates increase and possible positive consequences when the interest rate decreases after purchase.
- Reinvestment rate risk to the investor. For example, if the investor does not want to take on reinvestment rate risk, consider a zero coupon bond that has no cash flows until the bond matures. In the above example, the 6.5% coupon bond has more reinvestment risk than the 5.75% coupon bond.
- Need for current cash flow. Look to purchase a bond with a coupon equal to the yearly cash flow needed. However, purchasing a bond at either par, discount, or premium will necessitate different tax treatment, and the after-tax returns should be evaluated.
A financial planner is only able to properly determine what is required in their client’s unique situation after considering all of the issues listed above.