Current yield versus yield to maturity: which number is the real return?

"Yield" is one word doing at least three jobs, and confusing them is the most common error in bond arithmetic. Here are the versions that matter, in order of increasing honesty.

1. Coupon rate — what the contract pays

Coupon rate = annual coupon ÷ face value.

A 5% coupon on $1,000 pays $50. This number never changes and tells you nothing about your return, because it ignores what you paid. It is a property of the bond, not of your position.

2. Current yield — income on the money you actually spent

Current yield = annual coupon ÷ price paid.

Buy that 5% bond for $947.51: current yield = 50 ÷ 947.51 = 5.28%.

Better, but still incomplete — and incomplete in a specific, predictable way. It counts the income and ignores the capital movement. You paid $947.51 for something that will repay $1,000 at maturity. That $52.49 gain is real, contractual, and completely invisible in the current-yield figure.

3. Yield to maturity — the whole picture

Yield to maturity (YTM) is the single discount rate that makes the present value of all the bond's remaining cash flows equal to its current price. It captures the coupons and the pull of the price back to par.

It is the same equation from the previous lesson, run backwards. There you knew the yield and solved for the price. Here you know the price and solve for the yield. There is no closed-form solution — it is found by iteration — which is why every bond desk on earth runs it in software.

The example, resolved

Our 3-year, 5% coupon bond priced at $947.51:

• Coupon rate: 5.00%
• Current yield: 5.28%
• Yield to maturity: 7.00% — by construction, since 7% is the rate we used to price it

Where does the missing 1.72% come from? The pull to par. The bond will repay $1,000 on a bond bought at $947.51: a $52.49 gain spread over 3 years, roughly $17.50 a year on an average investment of about $974. That's ≈1.8% a year of capital return, which added to the 5.28% income return lands right at 7%.

A useful back-of-envelope approximation (not exact, but close for short maturities):

Approximate YTM = [ coupon + (face − price) ÷ years ] ÷ [ (face + price) ÷ 2 ]

= [ 50 + 52.49 ÷ 3 ] ÷ [ (1,000 + 947.51) ÷ 2 ] = 67.50 ÷ 973.76 = 6.93% — within a whisker of the true 7.00%.

Premium bonds run the same logic in reverse

Buy a bond at $1,050 that repays $1,000, and the pull to par works against you: a $50 loss, guaranteed by contract, baked in the day you buy. Current yield will therefore always overstate the return on a premium bond, and understate it on a discount bond. This is why quoting current yield on a premium bond is, at best, sloppy.

What YTM quietly assumes

YTM is the right number, and it is not a promise. Its honest fine print:

• You hold to maturity. Sell early and you get the market's price on that day, which YTM says nothing about.
• The issuer pays in full and on time. YTM is a contractual calculation; it does not price the possibility of default. A distressed bond can show a spectacular YTM precisely because the market doubts it will be paid — a high yield is the market's price for risk, not a free gift.
• Coupons are reinvested at the same yield. In reality you reinvest at whatever rates exist when each coupon lands. This is called reinvestment risk, and it means realised return rarely matches YTM exactly.

Knowing these three caveats is what separates using YTM from being fooled by it. When you see a bond screen showing an unusually high yield, the professional reflex is not excitement — it is the question "what is the market pricing in that I haven't seen yet?"

In the data

The US Treasury publishes its yield curve as a par curve, below: each yield is the coupon a new Treasury of that maturity would need in order to be issued at exactly 100.

At a price of 100 current yield and yield to maturity coincide, so this is the one table where the two numbers agree. Any real bond trading away from par has a current yield that differs from its yield to maturity, and you compute it from its coupon and price, as in the steps below.

Try it now

1. A bond with a 6% coupon, $1,000 face, trades at $900 with 5 years left. Current yield: 60 ÷ 900 = 6.67%. Approximate YTM: [60 + 100/5] ÷ [(1,000+900)/2] = 80 ÷ 950 = 8.42%. Explain in one sentence why YTM is the higher number.
2. Same bond at $1,100: current yield 5.45%, approximate YTM = [60 − 100/5] ÷ 1,050 = 40 ÷ 1,050 = 3.81%. Now explain why YTM is the lower number.
3. The table below sets six sovereigns' Moody's ratings beside what the market charges each year to insure their debt, the credit default swap spread (a fraction: 0.0334 is 334 basis points). Find the lowest-rated country and the highest-rated one and compare their spreads. Where a low rating sits next to a high price for protection, you are looking at the second caveat above in the wild: extra yield as compensation for the chance of not being paid in full, described, not recommended.