Personal Finance

Yield to maturity

Keerthi Sanagasetti | Updated on February 20, 2021

Higher the number, higher the risk

A coffee time chat between two colleagues leads to an interesting explainer on bond market jargons.

Vina: Do you think I should try my luck with the bond markets?

Tina: While stock and bond market prices are unpredictable, don’t leave your investment decisions entirely to a game of luck.

Vina: Agreed! Today while bank deposit rates are at all-time lows, I came across a bond that promises a yield to maturity of around 8.8 per cent. Interest of ₹88 on a bond with a face value of ₹1000, sounds like a great deal. Doesn’t it?

Tina: No, that’s not how it works, Vina. You are mistaking the yield to maturity for the coupon rate. The two are not the same.

Vina: Jargons again! What is the interest I will earn?

Tina: The coupon rate when multiplied by the face value of a bond, gives you the the interest income that you will earn. Yield to maturity is a totally different concept.

Vina: Enlighten me with your wisdom, will you?

Tina: When you buy a bond in the secondary market, its yield will matter more to you than the coupon rate or the interest rate that it offers on face value. Because the yield on a bond is calculated with respect to current market price - which is now the purchase price for you.

The current yield is the return you get (interest income) by purchasing a bond at its current market price. Say, a bond trades at ₹900 (face value of ₹1,000) and pays a coupon of 7 per cent per annum. Your current yield then is 7.8 per cent.

Vina: What is the YTM then?

Tina: The yield to maturity (YTM) captures the effective return that you are likely to earn on a bond if you hold it until maturity. That is, the return you get over the life of the bond after accounting for —interest payments and the maturity price of the bond versus its purchase price.

The YTM for a bond purchased at face value and held till maturity will hence be the same as its coupon rate.

Vina: Hold until maturity? The bond I was referring to has 8 years left until maturity. Too long a tenure, right?

Tina: Yes! The bond whose YTM is 8.8 per cent and has a residual maturity of eight years must be paying you a coupon of 7 per cent annually. That isn’t too high when compared to what other corporates have to offer.

Vina: So, should I now look for bonds that offer even higher YTMs?

Tina: Don’t fall prey to high yields, Vina. A high deviation from the market rate often signifies a higher level of risk. Higher YTMs are a result of a sharp drop in the current bond market price, which is most likely factoring in perceived risk of default or rating downgrades.

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Published on February 20, 2021
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