Final answer:
The current yield on a bond is the annual interest payment divided by the bond's current market price, not the face value, issue price, or par value. It represents the return an investor would expect if the bond is bought at the current market price and reflects how market fluctuations affect bond yields.
Step-by-step explanation:
The current yield on a bond is calculated as the annual interest payment divided by the bond's current market price. To illustrate, if a bond with a face value of $1,000 and a coupon rate of 8% is trading at $964 in the market, the annual interest received by an investor is $80. The current yield is therefore computed by dividing $80 by the bond's current market price of $964, which results in approximately 8.3%. This yield is a reflection of the return an investor would expect to receive if the bond is purchased at the current market price and held until the next interest payment date.
It is important to note that the current yield is different from the bond's coupon rate, which is fixed and based on the bond's face value. Market dynamics such as changes in interest rates can cause the bond’s market price to fluctuate, which affects the current yield. For instance, when market interest rates rise, existing bonds with lower interest rates become less attractive and their market price may drop, leading to an increase in the current yield.