📚 PASS Investment Adviser (Level 1) Difficulty: Intermediate ℹ️ Info   ~5 min read
📌 Chapter 9.5 — Traditional Yield Measures

Imagine you are a credit analyst reviewing a portfolio of corporate debentures for a high-net-worth client. A bond issued by a blue-chip infrastructure firm is trading at a significant premium, costing Rs. 1,150 for a Rs. 1,000 face value instrument. While the company’s 8% coupon seems attractive compared to current bank deposit rates, your analysis must look past the nominal rate to determine the actual income return.

By calculating the current yield, you reveal that the investor’s effective annual income is significantly lower than the stated coupon because the capital deployed is substantially higher than the par value.

This phenomenon occurs because the ‘current yield’ formula acts as a stabilizer, measuring the return based on the actual price paid rather than the par value printed on the certificate. When a bond trades at a premium, the denominator in your calculation increases, which mathematically forces the resulting percentage to drop below the coupon rate. For an analyst, this is a critical check; it prevents the trap of assuming that a high coupon bond always provides a high income yield.

If you ignore this adjustment, you will overestimate the cash-on-cash return the client will receive, potentially leading to an unsuitable investment recommendation.

Consider two bonds with identical 10% coupon rates. Bond A trades at par (Rs. 1,000), while Bond B trades at a premium (Rs. 1,200). For Bond A, the current yield remains 10%. For Bond B, the current yield drops to approximately 8.33%. This simple mathematical reality serves as a powerful signal in the secondary market.

An analyst must recognize that the investor in Bond B is essentially ‘buying’ a higher interest rate with their upfront capital, effectively paying extra today to secure future cash flows that are now relatively less rewarding in percentage terms.

This insight is essential when comparing assets within a fixed income portfolio or evaluating the impact of declining interest rates on bond prices. As rates fall, prices of existing bonds rise, and the current yield of those bonds begins to compress toward the market’s new, lower interest rate environment. An analyst who masterfully tracks these shifts can provide clearer guidance to clients about whether a premium-priced bond still fulfills their income requirements or if capital erosion at maturity will negate the benefit of the coupon payments.1

Nuance

⚠️ Nuance
Candidates frequently mistake the current yield for the total return, failing to realize that current yield is merely a snapshot of income. In the Indian market, particularly with long-tenure Government Securities (G-Secs) or high-grade corporate bonds, the distinction between current yield and yield to maturity (YTM) is the most common point of failure. A bond might have an attractive current yield, but if it is trading at a deep premium, the YTM may be much lower because the investor faces a guaranteed capital loss upon maturity. Always remember that current yield ignores the ‘pull-to-par’ effect that governs the bond’s valuation as it approaches its maturity date.

Check Your Understanding

Practice Question 1

A corporate bond with a face value of Rs. 1,000 carries a 12% coupon and is currently trading at Rs. 1,500. What is the current yield?

Practice Question 2

If an investor purchases a bond at a premium, which of the following statements regarding the relationship between the coupon rate and the current yield is always true?

This is a companion read for Section 9.5 — Traditional Yield Measures from PASS Investment Adviser (Level 1) by Akhilesh Gururani, available on Amazon Kindle.

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  1. Current yield does not account for the capital loss an investor suffers if they hold a premium bond until maturity, as the bond will redeem at face value, which is lower than the purchase price. ↩︎