Current Yield vs. Yield to Maturity: Why They Differ

Let’s talk about bonds and something called yield, which can be a bit confusing, but we’ll break it down. Imagine you are lending money to a company or the government when you buy a bond. They promise to pay you back the amount you lent, known as the face value or par value, at a future date, called the maturity date. They also promise to pay you interest along the way, usually at regular intervals, like twice a year. This interest payment is calculated as a percentage of the face value, and that percentage is called the coupon rate.

Now, think of the current yield as a snapshot of your immediate return on investment based on the bond’s current market price. It’s a simple calculation. You take the annual interest payment you receive and divide it by the bond’s current market price. For example, if you have a bond with a face value of $1,000 and a coupon rate of 5%, it pays $50 in interest per year. If the bond is currently trading in the market for $900, the current yield would be $50 divided by $900, which is roughly 5.56%. Essentially, the current yield tells you how much income you are getting right now relative to what you paid for the bond in the market. It’s like looking at the annual rent you receive from a house divided by the price you paid for the house.

Yield to maturity, often shortened to YTM, is a more comprehensive measure of a bond’s return. It’s the total return you can expect to receive if you hold the bond until it matures. YTM takes into account not only the interest payments, just like current yield, but also any difference between the bond’s purchase price and its face value. This difference is crucial. Bonds don’t always trade at their face value. Market prices fluctuate due to changes in interest rates and the perceived creditworthiness of the issuer.

Let’s consider two scenarios. First, imagine you buy a bond for less than its face value, say $900 for a bond with a $1,000 face value. This is called trading at a discount. In this case, when the bond matures, you will receive the full $1,000 face value. This means you’ll not only get the annual interest payments, but you’ll also get an extra $100 when the bond matures, the difference between what you paid and what you receive back. This extra $100 is like a bonus return. Yield to maturity factors in this bonus. Because of this extra gain at maturity, the yield to maturity will be higher than the current yield in this discount scenario.

Now, think about the opposite. What if you buy a bond for more than its face value, say $1,100 for a bond with a $1,000 face value? This is called trading at a premium. When this bond matures, you will still only receive the face value of $1,000. This means that although you receive the regular interest payments, you will actually lose $100 when the bond matures, the difference between what you paid and what you receive back. This $100 loss reduces your overall return. Yield to maturity accounts for this loss. Therefore, in a premium scenario, the yield to maturity will be lower than the current yield.

The special case is when a bond is trading at par. Trading at par means the bond’s market price is exactly equal to its face value, for example, buying a $1,000 face value bond for $1,000. In this situation, there is no difference between the purchase price and the face value. When the bond matures, you receive back exactly what you initially invested, the face value. There is no extra gain or loss at maturity to influence the overall return beyond the interest payments. Because YTM factors in the difference between purchase price and face value, and there is no difference when trading at par, the yield to maturity effectively becomes the same as the current yield. The only return you are getting, as calculated by both measures, is from the interest payments relative to the price you paid, which is the face value in this case.

So, in summary, current yield is a simple income measure, while yield to maturity is a more complete return measure that includes both income and the impact of buying a bond at a discount or premium. Unless a bond is trading right at its face value, meaning it’s trading at par, these two yields will generally be different. Understanding this distinction is key to properly assessing the potential returns of bond investments.