An interesting article by Jason Zweig in the Wall Street Journal brought up an important concept that most investors pay little attention to, the current yields on the bonds in their portfolios, and which yield should be considered when deciding what bonds to purchase.
There are several different yield calculations for different kinds of bonds. For example, calculating the yield on a callable bond is difficult because the date at which the bond might be called (the coupon payments go away at that point) is unknown. There is the yield to maturity, which is the yield from holding the bond to maturity (assuming that you can reinvest all the coupon payments at the same rate as the bond’s current yield.) And there is also the current yield, which is the one a bond buyer should use when comparing different bonds to purchase.
The current yield is defined as the ratio of the coupon interest to the current market price and is what you can expect to receive by buying that bond today at the currently quoted price.
Current Yield = Annual Cash Flow / Current Bond Price
However, if the bond were to be sold at a capital gain or loss, or if the bond is called (bought back before maturity by the issuer) then the current yield would not be realized by the holder.
In today’s low rate environment I would favor evaluating bonds based on their current yield, using the yield to maturity measure may not be an accurate representation of the return the holder will receive given that it will be difficult to reinvest the cash flow from the annual coupon at the same rate.