Understanding Bond Yields - Yield to maturity, nominal and current yld

The concept behind bond yields is important on the Series 7 exam, as well as for investors and people who are looking to become brokers.

There are 3 primary yields on a bond. They are:

Nominal Yield (Coupon Rate)
Current Yield
Yield To Maturity (YTM)
Yield To Call - If a bond is callable

Nominal Yield 

This is the stated rate on the bond itself. When an issuer puts out a bond, whether it is a corporate bond, municipal or Government bond  - it will have a stated coupon rate that is payable to par.

Example: A corporate bond bought at a par value of $10,000. The paying interest rate (nominal yield) is 5%. Regardless of the future price of this bond in the secondary market (after is traded through it's life), the bond will pay 5% to $10,000 each year. This is usually in semi annual payments. If a year later, this same bond is bought at a price of $103, meaning $10,300 (the $300 is the premium), the interest actually paid does not change. Thus, the nominal yield is fixed and never changes - regardless of price, maturity or amount of bonds held. 

Current Yield

This is the least important indicator of the 3 main main yields. Current yld is calculated (which you will likely be asked on the Series 7 Test) by dividing the annual income or coupon rate by the current price of the bond. Since a bond's price fluctuates in price throughout it's life - the current yield is always changing and so a bond should never be presented on merit by it's current rate of return. The CL is more important on a stock, since a stock does not have a guaranteed rate of return and guarantee on the principal like a bond has.

Yield To Maturity

The most important and accurate rate of return or yield on a bond is the yield to maturity - especially if it is a non callable bond. The YTM factors in the nominal rate and current yield combined. Since the coupon rate is only paid to par, if a bond is bought at a premium, the yield to maturity will be lower than the nominal yield. All bonds pay to par only and mature to par. So, if a bond at a premium is held to maturity, the premium is essentially lost. This is all factored into the price. On the reverse, discount bonds will have a higher yield to maturity than the stated nominal rate. Again, since all bonds pay to and mature to par, the discount amount is money gained during the life of the bond - so your overall yield is even better than the stated coupon.

Yield To Call

If a bond is callable, the yield to call basically acts as an early maturity. So the same concept of yield to maturity is applied to the YTC. The difference is the call date may never happen. It is the issuers choice whether to call a security. The issuer is obligated to return the par value at maturity, thus the yield to maturity is a guarantee if it goes to the end.

Know your bond yields on the series 7. Hopefully this helps you with the basic understanding.

American Investment Training