Investor has a loads of investment options available to him/her, for the purpose of investment. Depending on preferences and financial goals,investor can choose best suited investment asset class. Bond is one such investment class meant for risk averse and long term investors.
Bond is a debt market instrument, in which investor provide loan to an entity be it government or corporate. Entities borrow fund for a fixed time at variable interest rates or fixed interest rates.
Before getting to know yield till maturity, lets understand how bonds work?
Bonds are generally issued by company to raise capital to finance new projects, maintain ongoing operations or to refinance existing debts. The issuer, issues bond with a promise to pay interest at a fixed or variable rate to be paid at specific interval of time for fixed time period. Issuer also return the principal amount on a future date.
So, the bond holder actually has two type of return one being holding period return and other being yield till maturity. Holding period return is simply the return earned by holding the bond for a specific period and selling it in the secondary market. Bond has an active secondary market, where an investor can sell his 10 years bond after buying the bond 4 years after being issued. That’s simple profit being realized after selling at rate higher than it was bought.
The second return we mention is YTM i.e. yield till maturity. YTM is very similar to current yield, dividing annual cash inflows from a bond by market price of that bond to determine how much amount an investor must pay to buy a bond for holding it for a year. In simple term it is the present value of the bond’s future payment, by factoring in the time value of money.
Bond prices share relationship with YTM, if the bond is trading at par, bond interest rate is same coupon rate, in case the bond prices are trading above par, i.e, in premium, then the bond interest rate will be lower than coupon rate, and in case the bond is trading at discount, i.e, lower than the face value of bond, in that case bond interest rate will be above the coupon rate.
Calculating YTM is similar to calculating Internal rate of return(IRR). While calculating YTM, and to earn the YTM, investor assumes that he reinvest coupon at a constant interest rate for the entire period till the Bond’s maturity .
Yield with bond share an inverse relationship. As bond price increases, yield decreases and vice-versa. YTM are an annualized return , whereas coupon are paid semi annual basis , thus YTM is also often calculated on semi annual basis.
YTM is often used for making investment in bond, thus understanding whether investing in the bond at a specific time is good or not. It is also used to compare the bonds with different maturities and coupons as YTM expresses value of different bond on same terms.