Question

An investor must choose between two bonds:

Bond A pays $80 annual interest and has a market value of $800. It has 10 years to maturity.
Bond B pays $85 annual interest and has a market value of $900. It has two years to maturity.
a. Compute the current yield on both bonds.
b. Which bond should he select based on your answer to part a?
c. A drawback of current yield is that it does not consider the total life of the bond. For example, the approximate yield to maturity on Bond A is 11.36 percent. What is the approximate yield to maturity on Bond B?
d. Has your answer changed between parts b and c of this question in terms of which bond to select?

Answer 1

a. Compute the current yield on both bonds.

Current yield = Annual coupon payment / current market price of bond

Bond A current yield = $80 / $800 = 0.1

Bond B current yield = $85 / $900 = 0.09

b. Which bond should he select based on your answer to part a?

Bond A, because it has a higher current yield.

What is the approximate yield to maturity on Bond B?

Approximate Yield to Maturity (YTM) = [C+ (F-P) / n] / [(F+P) / 2]

Where:

C = Coupon payment

F = Face value

P = Price

n = years to maturity

Because the face value is not specified in the question, we will assume is the same as the price.

Bond B YTM = [85 + (900-900) / 2] / [(900+900) / 2]

= 0.09

d. Has your answer changed between parts b and c of this question in terms of which bond to select?

Under the assumption that the price and face value of Bond b are the same, we can see that the YTM and the current yield are the same, so the choice of the bond (bond A) has not changed.

However, if the face value was higher or lower than the price, the YTM would be different to the current yield, for that reason, it is always best to check Yield to Maturity instead of current yield when choosing which bond to invest in.