Types of Bond Yields

Understanding yield starts with a simple question: how do you measure the return on a bond? The answer depends on what you include in the calculation. Each yield type adds a layer of information, from the most basic (nominal yield) to the most comprehensive (yield to maturity).

Coupon (Nominal) Yield

• Nominal yield is the annual interest rate printed on the face of the bond at issuance
• Expressed as a percentage of par value ($1,000 for corporate and government bonds)
• Formula: Nominal Yield = Annual Coupon Payment / Par Value
• A bond with a $60 annual coupon and $1,000 par has a 6% nominal yield
• Nominal yield is fixed for the life of the bond (except for variable-rate securities)
• It does not change regardless of the bond's market price

Exam Tip: Gotchas

Nominal yield never changes after issuance. If a question asks "what happens to nominal yield when interest rates rise?", the answer is nothing. Only the market price changes.

Current Yield (CY)

Now that you know nominal yield only looks at par, the next step is measuring return based on what you actually pay.

• Current yield measures the annual return based on the bond's current market price (not par)
• Formula: Current Yield = Annual Coupon Payment / Current Market Price
• Examples:
  • $60 coupon, bond trading at $900: CY = $60 / $900 = 6.67%
  • $60 coupon, bond trading at $1,100: CY = $60 / $1,100 = 5.45%

• Current yield does not account for any capital gain or loss at maturity

Think of it this way: Current yield answers a simple question: "If I buy this bond today, what percentage of my purchase price comes back as annual interest?" It ignores everything else.

Exam Tip: Gotchas

Current yield only considers annual income relative to price. It ignores the gain from buying at a discount or the loss from buying at a premium. That is why YTM is a more complete measure.

Yield to Maturity (YTM)

Current yield misses the capital gain or loss you realize at maturity. Yield to maturity fixes that.

• Yield to maturity (YTM) is the total annualized return if the bond is held to maturity
• Accounts for: annual coupon payments, any capital gain (discount) or loss (premium), and the time value of money
• YTM is considered the most comprehensive yield measure for bonds
• Also called a bond's basis

Approximation Formula:

YTM = [C + (FV - PV) / n] / [(FV + PV) / 2]

Where:

• C = annual coupon payment
• FV = face value (par, typically $1,000)
• PV = current market price (purchase price)
• n = years to maturity

Key assumption: YTM assumes all coupon payments are reinvested at the same YTM rate (the reinvestment assumption)

Why does this matter? In reality, when you receive coupon payments, the prevailing interest rate may be higher or lower than your YTM. The calculation pretends you can always reinvest at the same rate, which is unrealistic but gives a standardized way to compare bonds.

The Yield Hierarchy

This is one of the most frequently tested concepts on the Series 7. In the table below, NY stands for nominal yield:

Exam Tip: Gotchas

The exam frequently tests the yield hierarchy. For discount bonds, think "everything increases as you add more to the calculation" (the capital gain at maturity boosts each successive yield). For premium bonds, the capital loss at maturity drags each successive yield lower.

Yield to Call (YTC)

Not all bonds make it to maturity. Callable bonds can be redeemed early, and yield to call measures the return in that scenario.

• Yield to call (YTC) is the annualized return assuming the bond is called at the first call date
• Uses the call price (often par or a slight premium) instead of par value
• Uses the call date instead of the maturity date

Approximation Formula:

YTC = [C + (Call Price - PV) / n] / [(Call Price + PV) / 2]

Where n = years to call date (not maturity)

Which Yield Gets Quoted?

• Callable bonds trading at a premium are quoted on a yield-to-call basis (issuer has incentive to call and refinance at lower rates)
• Callable bonds trading at a discount are quoted on a yield-to-maturity basis (issuer is unlikely to call)

Exam Tip: Gotchas

When a callable bond trades at a premium, always use YTC (not YTM). The issuer will likely call the bond to refinance at lower rates. Quoting YTM on a premium callable bond would overstate the investor's expected return.

Yield to Worst (YTW)

• Yield to worst (YTW) is the lowest possible yield an investor can receive without the issuer defaulting
• Calculated by comparing YTM and YTC at every possible call date, then selecting the lowest
• For a premium bond: YTW is typically the YTC at the earliest call date
• For a discount bond: YTW is typically the YTM (bond is unlikely to be called)
• YTW is the most conservative yield measure; it represents the worst-case scenario for the bondholder

Exam Tip: Gotchas

YTW is always the lowest yield in the set. For premium bonds, YTW equals the yield to the earliest call date. For discount bonds, YTW equals the YTM because the issuer has no incentive to call.

Discount Yield (Bank Discount Yield)

This yield type applies to short-term money market instruments, not traditional bonds.

• Used for Treasury bills, commercial paper, and bankers' acceptances
• Based on face value (not purchase price) and uses a 360-day year
• Formula: Discount Yield = [(FV - Purchase Price) / FV] x (360 / Days to Maturity)
• Discount yield understates the true return because it uses face value (larger number) in the denominator rather than the lower purchase price

Exam Tip: Gotchas

Discount yield always understates return. The denominator uses face value (which is higher than purchase price), so the fraction is smaller than the actual return on investment.

Yield Summary Table