Bond Yield and Yield to Maturity
October 4, 2012 in Bond
Bond yield is nothing but the return on bond investment. So suppose we buy the bond at the time of issue at a issue price or face value of 100 USD and the annual interest offered on the bond is 10% then our annual return or annual coupon value would be USD 10. The current yield on that bond would be the coupon value divided by the face value i.e. 10/100 = 10%. Hence on a new bond the current yield is equal to the interest rate returns on that bond.
The Bond Yield formula is as follows:
Yield on Bonds = (Coupon Value) ÷ (Face Value).
Now what happens if the market price of that bond changes. Let’s say that the inflation has gone up and hence the benchmark interest rates also. As we have seen above the market price of your bond would go down. Let’s say that the market price has gone down to 90 from the original 100. The point to be noted that even if the market price has gone down but the coupon value would remain same.
So now the current yield on that same bond = 10/90 = 11.11%. If I buy the bond at USD 90, my returns are better than the original yield of 10%. But is it enough to make my decision about the bond purchase?
No, it is not. What I would like to see is what would be total returns against the investment on that bond, assuming that I buy today and keep that bond till the maturity period.
Bond – “Yield to Maturity”:
Yield to Maturity (YTM) is nothing but the total returns on a bond if we keep the bonds till their maturity period.
Suppose the bond has 4 years remaining till it’s maturity date then the simplest formula for yield to maturity would be as follows:
Yield to maturity = Coupon value for 1st year + Coupon value for 2nd year + Coupon value for 3rd year + Coupon value for 4th year + The face value of the bond when we redeem it.
We will not go into the mathematical formula because the above example is the very simple yield to maturity. There may be different kinds of bonds i.e. Zero Coupon Bonds and all and the calculation would differ. Also in the above example we have take full 4 years but it could be 3 and half years or 7 years 2 months, just for example. What we wanted to cover is the concept of yield to maturity and hope that it is clear now.