To illustrate, let's assume that a 5% $100,000 bond will mature in 5 years and will pay interest each June 1 and December 1. Hence the bond will pay interest of $2,500 every six months until it matures. If the current market interest rate for this type of bond is 6%, the bond's current market value will be less than $100,000. The market value of a 5% bond in a 6% bond market will be approximately $95,735. This is the present value of the $2,500 of interest that will be received every six months for 5 years plus the present value of the $100,000 that will be received at the end of 5 years. (All of the cash amounts are discounted by the market interest rate. However, the 6% annual market rate will be restated to be 3% per semiannual period and the 5 years will be restated to be 10 semiannnual periods.)
The investor's yield to maturity will be the market rate of 6% (even though the bond's stated rate is 5%) consisting of the following two components:
- the current yield of more than 5.2% because the investor is receiving cash of $2,500 every six months ($5,000 per year) on an investment of only $95,735.
- a gain of $4,265 because the investor bought the bond for $95,735 but will receive cash of $100,000 at maturity.