The coupon interest payments made by the issuer; Any capital gain (or capital loss) when the bond is sold; and
Income from reinvestment of the interest payments that is interest-on-interest.
The three yield measures commonly used by investors to measure the potential return from investing in a bond are briefly described below:
i) Coupon Yield
24.2 The coupon yield is simply the coupon payment as a percentage of the face value. Coupon yield refers to nominal interest payable on a fixed income security like Government security. This is the fixed return the Government (i.e., the issuer) commits to pay to the investor. Coupon yield thus does not reflect the impact of interest rate movement and inflation on the nominal interest that the Government pays.
Coupon yield = Coupon Payment / Face Value
Face Value: Rs.100
Market Value: Rs.103.00
Coupon yield = 8.24/100 = 8.24%
ii) Current Yield
24.3 The current yield is simply the coupon payment as a percentage of the bond's purchase price; in other words, it is the return a holder of the bond gets against its purchase price which may be more or less than the face value or the par value. The current yield does not take into account the reinvestment of the interest income received periodically.
Current yield = (Annual coupon rate / Purchase price)X100
The current yield for a 10 year 8.24% coupon bond selling for Rs.103.00 per Rs.100 par value is calculated below:
Annual coupon interest = 8.24% x Rs.100 = Rs.8.24
Current yield = (8.24/Rs.103)X100 = 8.00%
The current yield considers only the coupon interest and ignores other sources of return that will affect an investor's return.
iii) Yield to Maturity
Yield to Maturity (YTM) is the expected rate of return on a bond if it is held until its maturity. The price of a bond is simply the sum of the present values of all its remaining cash flows. Present value is calculated by discounting each cash flow at a rate; this rate is the YTM.
Thus YTM is the discount rate which equates the present value of the future cash flows from a bond to its current market price. In other words, it is the internal rate of return on the bond. The calculation of YTM involves a trial-and-error procedure. A calculator or software can be used to obtain a bond's yield-to-maturity easily.