Bond Yields are Based on Present Value Formulas
Bond prices are calculated using a present value formula that discounts the differential between coupon, maturity and market values. While the calculations are straightforward how they are used is subject to NASD (National Association of Security Dealers) rules and investor preferences. It is important for the bond buyer to understand the subtle distinctions, especially with respect to priced to call bonds. These calculations apply to corporate, treasury and municipal bonds and most sovereign bonds. Preferred bonds usually have no stated maturity and in this case only current yield calculations are appropriate. These calculations are useful for both variable and fixed-rate bonds.
Current Yield Bond Calculations
The current yield is a simple ratio of a bond coupon divided by the bond price. For a bond with a 5 per cent coupon trading at 102 (par plus a two point premium) the current yield is 4.90%. The same bond in a higher interest rate environment where the bond price is 95 provides a current yield of 5.26%. If the bond was purchased at 100 (par) the yield to maturity is still 5 per cent under any calculation. The current yield simply reflects current market conditions and comparison to stocks and preferred debt that do not have a stated maturity.Obviously, zero coupon bonds do not have a current yield but rely only on a yield to maturity.
If a bond is purchased at a premium then the current yield will be lower than the coupon but as the bond moves to maturity the premium will move towards par and the current yield will increase. Conversely, the current yield declines as a bond purchased at a discount from par rises to par at maturity. Again, it is the yield to maturity that provides the total realized return of a bond.
Yield to Maturity and Yield to Call
A bond purchased at a premium, particularly in the over the counter bond markets must be priced at the lowest yield to either call or maturity. This is a NASD rule requirement and is designed to protect the bond buyer. In fact, it is always good advice to buy a bond at a fixed price rather than a yield so the buyer of the bond knows the yield advantage if a priced to call bond is not called and runs to maturity.
If a purchaser of a 5 per cent coupon, ten year bond with a five year 101 call feature buys a bond with a price of 105 the bond will have a yield to call of approximately 4.108 per cent and a yield to maturity of 4.76 per cent. Note the yield pickup if the bond is not called of .65 per cent ( or 65 basis points ). It only makes sense to price a bond to its lowest yield anyway since a premium bond with a high dollar price is often called at a call date.
Note also, that a discount bond will always be priced to maturity and ignores any call features. Were the bond to be called ( this sometimes happens due to the issuer wishing to change a bond covenant) early the advantage of the early capital gain was not foreseeable and in no way harms the bond purchaser.