When you invest in bonds, there are several different types of yield that bond salespeople will talk about, including coupon yield and current yield. It’s important to understand what kind of yield is being promised on a bond or bond fund, and to know what it really means.
How coupon yield relates to your payout
The coupon yield, or the coupon rate, is part of the bond offering. A $1,000 bond with a coupon yield of 5 percent is going to pay $50 a year. A $1,000 bond with a coupon yield of 7 percent is going to pay $70 a year. Usually, the $50 or $70 or whatever will be paid out twice a year on an individual bond.
Bond funds don’t really have coupon yields, although they have an average coupon yield for all the bonds in the pool. That average tells you something, for sure, but you need to remember that a bond fund may start the year and end the year with a completely different set of bonds — and a completely different average coupon yield.
What current yield means to your investment
Current yield is derived by taking the bond’s coupon yield and dividing it by the bond’s price. Suppose you had a $1,000 face value bond with a coupon rate of 5 percent, which would equate to $50 a year in your pocket. If the bond sells today for 98 (meaning that it is selling at a discount for $980), the current yield is $50 divided by $980 = 5.10 percent. If that same bond rises in price to a premium of 103 (meaning it’s selling for $1,030), the current yield is $50 divided by $1,030 = 4.85 percent.
The current yield is a sort of snapshot that gives you a very rough (and possibly entirely inaccurate) estimate of the return you can expect on that bond over the coming months. If you take today’s current yield (translated into nickels and dimes) and multiply that amount by 30, you’d think that would give you a good estimate of how much income your bond will generate in the next month, but that’s not the case.
The current yield changes too quickly for that kind of prediction to hold true. The equivalent would be taking a measure of today’s rainfall, multiplying it by 30, and using that number to estimate rainfall for the month. (Well, the current yield would be a bit more accurate, but you get the point.)