Question

Explain why the current yield does not correctly reflect the true yield (yield to maturity) of a bond. Also discuss the effect of maturity on the error.

Answer 1

In contrast to yield to maturity, which will reflect the total payment of the bond as well as the rate of return earned when the investor invests in the bond until it reaches maturity, current yield only considers the coupon payments made on the bond during the current period. As a result, the current yield does not accurately reflect the bond's true yield.

 

The yield to maturity will take into account the prices of these bonds along with the face value of the bond and it will attempt to adjust the principal payment along with the coupon payment in respect to this face value. Market value is not derived from the rate of return which will be made after investment into the bond, so it will recalculate the yield to maturity.

 

The impact of maturity on error is also significant because, as bonds are held until they mature rather than being liquidated to compute the yield to maturity, maturity will reflect changes in the rate of return. Any change in the holding period will result in significant changes in yield to maturity computations.