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A good portfolio combines investments in various assets like shares, cash, and bonds. Each asset’s unique features, when invested in the right proportion, help reduce risks.
Investing in bonds aims to provide a stable, low-risk income. It’s crucial to understand potential profitability before investing.
What is Yield to Maturity?
Yield to Maturity, or yield until bond validity, helps calculate investment returns. Using full payments for interests and principal, YTM calculates fixed-income bond returns. YTM computation is a crucial ability for investors since it compares bond earnings and profits.
Assumptions while calculating YTM
- The investor keeps the bond until maturity.
- The issuer pays all interests and principal amounts on time.
- All received interests are reinvested in the bond.
Components involved in computing YTM
- Face Value – Indicates the worth of the bond at the time of maturity.
- Coupon/Interest Rate – Rate of return an investor gets at specific intervals for investing in bonds.
- Maturity – Bond Validity, after which the bond expires.
- Bond Price – Current market value of the bond.
Different scenarios in computing YTM
Bond at Par – The bond price or market value is equal to the face value of the security (ignore decimal differences).
Here, the bond’s purchase price equals the repaid principal at maturity.
Example:
FV of Bond = ₹ 100
Bond Price = ₹ 100
At Premium – The bond price or market value is more than the face value of the security.
Here, the recovered principal at maturity is less than the bond’s purchase amount.
Example:
FV of Bond = ₹ 100
Bond Price = ₹ 120
At Discount – The bond price or market value is less than the face value of the security.
Here, the principal exceeds the purchase price, yielding higher income for investors buying discounted bonds.
Example:
FV of Bond = ₹ 100
Bond Price = ₹ 80
How to calculate Yield to Maturity?
Below are ways to calculate YTM
Calculation of YTM through approximation.
Using this formula gives an approximate rate of return with slight decimal differences.
YTM Formula = {C + [(F-P)/n)]} / {(F + P)/2}
C = Coupon (In ₹)
F = Face value
P = Market value or bond price
n = Number of years to maturity
Example: 10% ABC LTD 2028, FV = 100, P = 98
The coupon is calculated against face value.
C= FV * Coupon Rate = 100*10% = ₹10
YTM = {10 + [(100-98)/5)]} / {(100 + 98)/2}
YTM = 10.004 % ~ 10%
Calculation of YTM using trial and error
P = C1/(1+i)^1 + C2/(1+i)^2 + C3/(1+i)^3 + ……+ Cn/(1+i)^n + FV/(1+i)^n
C = Interest in ₹
i = YTM rate
P = Bond price
FV = Face Value.
In this method, YTM is unknown, and P is known. So, you substitute known values in the equation and try different values of ‘i’, until the equation results in the bond price
Considering the same example as above:
C= ₹10, FV = 100, P = 98, n = 5
98 = 10/(1+10%)^1 + 10/(1+10%)^2 + 10/(1+10%)^3 + 10/(1+10%)^4 + 10/(1+10%)^5 + 100/(1+10%)^5
98 = 10/1.1 + 10/1.21 + 10/1.331 + 10/1.4641 + 10/1.61051 + 100/1.61051
98 = 9.09 + 8.26 + 7.51 + 6.83 + 6.21 + 62.09
Considering YTM to be 10%, we get a value of ₹ 99.99, slightly greater than 98.
So, we will have to recalculate with another number.
Keeping these 3 points in mind will help in finding the bond YTM faster.
Bonds at par: YTM ~ Coupon Rate
Bonds at a discount: YTM > Coupon Rate
Bonds at a premium: YTM < Coupon Rate
What are SGB bonds?
SGB is Sovereign Gold Bond. The RBI is the authorised issuer of this government bond.
Each gram of gold is considered one unit, and an individual investor can hold up to a maximum of 4 kg.
The SGB price of each unit is based on the market value of 999 gold as of that date.
These bonds mature in eight years, but investors can redeem early after a five-year lock-in.
This transaction with the government does not transfer any physical gold but deals only in cash.
A fixed rate of 2.5% per annum on the initial investment is paid to investors as a return on these investments, and this interest amount is credited semi-annually.
This resembles a standard bond, but unknown face and redemption values at maturity prevent YTM computation.
The redemption value of these bonds is calculated based on a 3-day average market rate of gold at the time of maturity.
Bottomline
Yield to Maturity (YTM) is a key tool for analysing investment returns, considering both current and future income. It aids investors in making informed decisions by providing expected returns.
However, YTM has limitations. It’s based on assumptions that may not always hold true and doesn’t account for taxes or trading costs. Therefore, it’s best used as a guide alongside other tools, rather than a definitive earnings predictor.
FAQs
A higher Yield to Maturity (YTM) indicates a potentially higher return compared to bonds with lower YTMs. However, it often comes with increased risks, such as a higher default risk or longer maturity periods. While a bond purchased at a discount means that the YTM is higher, it’s important to remember that no indicator guarantees 100% accuracy and should be used in conjunction with other analysis tools and strategies.
Yes, Yield to Maturity (YTM) can be considered a market rate. It’s the discount rate that equates the present value of a bond’s future cash flows, including principal and coupon payments, to its current market price. YTM fluctuates with market interest rates. However, it assumes consistent reinvestment at the YTM rate and doesn’t account for possible effects of contingent events. Therefore, it’s not an expected or risk-adjusted rate.
Yield to Maturity (YTM) increases when the bond’s market price decreases. This is because YTM is the discount rate that makes the present value of a bond’s future cash flows equal to its current market price. Also, YTM rises with inflation as investors anticipate that central banks will increase interest rates to control inflation. However, it’s important to note that YTM assumes all coupon payments are reinvested at the same rate.
Yes, Yield to Maturity (YTM) can be negative. This is uncommon but can occur in unstable markets or during high inflation. A negative YTM means the investor receives less than they invested, which can happen if the bond’s price is much higher than its par value. However, even a negative YTM might be better than holding cash during hyperinflation. Remember, YTM calculations are based on certain assumptions.
Yield to Maturity (YTM) is often seen as a more accurate measure of a bond’s return as it considers the present value of future coupon payments. However, it’s based on assumptions, such as reinvestment of all coupon payments at the same rate. Changes in interest rates can cause YTM to fluctuate. Therefore, while YTM provides a comprehensive view, it doesn’t guarantee 100% accuracy.
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