*What is Yield and YTM?*
These are important concepts but tend to be shrouded in confusion. Here's to grasping what it is all about.
*Step I: Understand borrowing and lending.*
A company or financial institution may need money to expand their business, build a new plant, purchase machinery, buy new land or acquire another company.
_One of the ways to raise money is to issue bonds._
Let’s examine this. On February 28, 2020, HMEL issued bonds of Rs 10 lakh each with a 10-year maturity, and a coupon of 9.18%.
*Face Value, or Par Value*: The FV is the value assigned to the bond. This is the amount of money loaned to the issuer and it will be returned to the lender on maturity. This is static. In this example is Rs 10 lakh.
*Maturity*: This is the length of time of the financial contract. In this case, it is 10 years. So the investor who bought a bond would be loaning HMEL Rs 10 lakh for a period of 10 years.
*Coupon Rate*: Now the investor needs to get compensated for lending his money. The CR is the annual rate of interest that could be paid semi-annually or annually. This is static, in the sense that it is fixed when the bond is issued. In this example it is 9.18% of Rs 10 lakh every year, over 10 years.
*Step II: Understand Yield.*
During these 10 years, the bond will be traded in the market. As with any instrument traded, the price will rise or fall. As that happens, the market price of the bond will differ from the Face Value (FV). But since the Coupon Rate (CR) is static, and is a percentage of FV, the return will differ. This return is called yield.
Let’s work it out.
FV = Rs 100
CR = 5% p.a
Amount investor earns every year = Rs 5 (5% of Rs 100 is Rs 5)
In the market, the price rises 📈 to Rs 110. A buyer is paying more than the FV of Rs 100. However, return is still Rs 5 per annum. Rs 5 on Rs 110 = 4.55%. So the bond yield has fallen because the bond price has risen.
In the market, the price falls 📉 to Rs 90. A buyer is paying less than the FV of Rs 100. However, return is still Rs 5 per annum. Rs 5 on Rs 90 = 5.55%. So the bond yield has risen because the bond price has fallen.
*Step III: Understand how interest rates and bond prices move in opposite directions*.
Interest Rate⬆️ -▶️- Price⬇️
Interest Rate⬇️ -▶️- Price⬆️
As you can see, the yield rises because the bond price has fallen. Or the yield falls because the bond price has risen. There is an inversely proportional relationship between the two. As interest rates go down, bond prices go up (+ve return) and as interest rates go up, prices go down (-ve return).
*Step IV: Understand YTM.*
YTM is yield to maturity.
YTM is the estimated annual rate of return for a bond assuming that the investor holds the asset until its maturity date and reinvests the payments at the same rate as its current yield.
So it depends on the price you paid when you purchased the bond - if it was on par or at a premium or a discount. The interest you will earn during the balance period. And the assumption that this interest will be reinvested at the same yield. In other words, YTM accounts for the present value of a bond’s future coupon payments. Put together, these are the components of YTM.
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