When you buy an individual bond, you derive income from three different sources:
Simple interest consists of the bond's coupons, which are usually paid twice a year. Let us say you invest $10,000 in a four-year bond, paying 8% a year, semiannually. In return, you will receive two coupon (or interest) payments of $400 each, at six-month intervals every year. If you hold the bond until it matures, you will receive eight coupons that total $3,200. Those eight coupons are the simple interest.
If the coupon payments are spent, only the simple interest is earned. But if the coupons are reinvested, they produce additional interest; subsequently, if those earnings are reinvested, you earn interest on that interest, and so on. That entire income stream is called, logically enough, interest-on-interest, or compounded interest. Both interest income, and interest-on-interest, in different combinations, lie behind the different meanings of yield.
Yield appears in a number of phrases: coupon yield, current yield and yield to maturity. Each has a very precise meaning. Let's look at each in turn.
Coupon Yield
Coupon yield is set when a bond is issued. It is the interest rate paid by the bond (for example, 5½%, 7¾%), and it is listed as a percentage of par, or face value, which is the principal amount that will be paid at maturity.
The coupon yield designates a fixed dollar amount that never changes through the life of the bond. If a $1,000 par value bond is described as having a 10% coupon, that coupon will always be $100 for each bond, paid out in two $50 increments for the entire life of the bond—no matter what happens to the price of the bond, or to interest rates. That is the reason bonds are called fixed-income securities.
Current Yield
Almost as soon as a bond starts trading in the secondary market, it ceases to trade at par. A bond's current yield is its annual coupon divided by its market price.
To illustrate, let us assume you purchased three bonds: the first you bought at par, for $1,000; the second you bought at a premium to par, and paid $1,200; the third you bought at a discount to par, for $800. Each bond has a 10% coupon, and so each pays $100 in annual coupons. Dividing the coupon ($100) by the price results in a current yield of 10% for the par bond; 8.33% for the premium bond ($100/$1,200); and 12.5% for the discount bond ($100/$800). Thus, the current yield is equal to coupon yield for the par bond; the current yield (8.33%) is lower than the coupon yield (10%) for the premium bond; and the current yield (12.5%) is higher than the coupon yield (10%) for the discount bond. Current yield is quoted for fixed-income securities of any maturity, whether short or long.
Yield to Maturity
You can see from the above description that current yield is based only on the coupon and the current market price. Current yield, therefore, fails to measure two important sources of income that investors earn from bonds: interest-on-interest and capital gains or losses.
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