The English dictionary defines the word "yield" as produce in a natural, agricultural, or industrial product. But, when it comes to Fin-glish a.k.a. Financial English, it has a very different meaning. In financial instruments like bonds, there are six different types of yields. And knowing more about each of them becomes imperative if you want to get more bang for your buck. Today we bring you Yield to Maturity (or YTM).
What is it: Simply put, "Yield" in Fin-glish means "Returns". YTM is the most popular way to know the returns on your investment in bonds. As the name goes, it measures the return the bond gives you if you hold it to maturity and all the coupons are reinvested at the YTM rate. You may not actually do so, but YTM gives you a way to measure what your actual returns would be if you invest every coupon payment from the bond at a constant interest rate until the bond's maturity date.
In reality, it's not possible to reinvest at the same coupon rate all the time. Hence, we have to make an assumption that all coupon payments are reinvested at the same rate as the bond's current yield. Now keep in mind that the bond's current yield can be found out by dividing the annual coupon by the current bond price. So let's say that the face value of the bond is Rs 1,000 and the annual coupon is 10 percent, or Rs 100. The current price of the bond is Rs 900. So the current yield of the bond is 100/900 which is 11.11 percent. Note, that price and yield are inversely related. If the bond price falls, the yield increase and vice versa. But, when you invest in a bond via the secondary market, the price of the bond could be more or less than the original price, and hence current yield would give a misleading picture of your expected rate, so you have to calculate the YTM, since it measures not only the principal but also the expected gains or losses.
How to calculate the YTM:To calculate the YTM you need to factor in the following:
1) The bond's current market price,
2) Par value of the bond,
3) Coupon interest rate which the bond offers
4) Remaining time to maturity
Okay, calculating YTM using the traditional formula is easier said than done. Hence, it makes sense to use the Excel financial function tool to know the YTM. Or you could also use a number of free YTM calculators available online.
Why we need to know YTM:You can buy bonds in both the primary market when a company brings out its bond issue,or from the secondary market on the stock exchange. So, when you buy a bond in the secondary market you could land up paying more than the face value (premium) or less than the face value of the bond (discount). Hence, the actual rate of return you could earn would always be either higher or lower that the annual coupon rate. Hence, you need to know the YTM, since it gives you the yield the bond will give you from the day you buy it till date it expires when you get the principal.
Let's say the par value of the bond is Rs 1,000, annual rate is 10 percent and bond matures in five years.
YTM if the market value of the bond is Rs 900 is 12.83 percent
YTM if the market value of the bond is Rs 1000 is 10.00 percent
YTM is the market value of the bond is Rs 1,100 is 7.53 percent .
Remember, higher yield bond will give you a higher return.
Updated Date: Dec 21, 2014 03:44:37 IST