Calculating Bond Yields Made Easy

Contrary to popular notions, calculating bond yields is easy to do. You are provided with formulas, after all, so the only things you need are a basic calculator, pen and paper on one hand as well as the information required on the specific formula on the other hand.

Also, keep in mind the definition of bond yield. Its most general meaning is the amount of money returned to the bondholder, which is usually provided for in an annual basis and expressed as a certain percentage of the bond's initial investment.

There are two bond yields to be calculated in this article: the current yield and the yield to maturity. Calculating bond yields for all types of bonds should be easy to do once you know these two computations.

Calculating Current Yield

Math genius is not required in calculating the current yield (CY). Basically, you must divide the annual interest amount paid (IA) by the current market price (P) and then multiply by 100 to turn the fraction into its percentage form. In short:

CY = IA/P x 100

Let's take an example. You purchased a bond with a face value of $1,000 and an interest rate of 7% with a maturity period of 10 years at a discount of $950. The steps in calculating bond yields specifically the current yield will then be:

• Calculate the annual interest per year (IA).
$1,000 x 0.07 = $70

• Calculate the current yield (CY)
$70/$950 x 100 = 7.37%

Take note that the bond is purchased at a discount, meaning that you will have a positive yield at the end of the maturity period regardless of the events from year one to ten. Also, you will notice that the current yield is higher than the coupon rate because of the bond's discounted purchase price.

So, what is the importance of calculating bond yields using the current yield formula? It's simple: You can now make comparisons of investment yields between bonds that have similar maturity periods and credit risks.

Calculating Bond Yields to Maturity

But current yield only shows the rate of return for the present period, thus, ignoring money's time value. The question is whether you are willing to have the above example of the $1,000 dollar today or wait for a year to have the same $1,000 bond.

Admittedly, calculating the yield to maturity can be daunting by the looks of the formula. The two pieces of good news are that, first, the formula is straightforward and, second, it can be easily found in online sites.

The formula is as follows:

c(1 + YTM)-1 + c(1 + YTM)-2 + . . . + c(1 + YTM)-YUM + B(1 + YTM)-YUM = P

c = annual coupon payment in dollars
YUM = number of years until maturity
B = face value
P = purchase price

Using the above example again although the number of years left until maturity is 4 years, the yield to maturity can be computed at 8.53%.

Unlike current yield, the yield to maturity percentage is useful in the comparison of bonds with different maturity periods and interest rates. This is, of course, the most common scenario for investors.

In time, calculating bond yields will be less intimidating and will, instead, be part of your research into which bonds are the best investments.