YTM or yield to maturity is an effective way to find out the exact return that a bond offers when held till maturity. The YTM of bonds changes with the change in the purchase price of the bond. Even if a bond has a fixed coupon rate payable on the face value, the effective yield depends on at what price one purchases it.
Bonds are a type of Debt instrument issued by Companies, Financial Institutions & Governments in order to raise capital by borrowing money from investors. The issuer of a bond has the moral obligation to pay the principal back to the holder on the date of maturity.
A bond has 3 main aspects, which are-
To calculate the return of a Bond, these three factors have to be taken into consideration. Unlike other fixed-income instruments or debt instruments, the return on bonds is calculated on YTM (Yield to Maturity).
The yield of a bond can be also calculated on the “coupon rate” which is the fixed rate of interest at which a bond pays interest to its holders till its maturity. But as the Coupon rate is always calculated on the face value of the bond it is difficult to get the exact rate of return if the bond is not being traded at its par value. Due to this reason, YTM comes into the picture which helps you to calculate the exact yield of the bond till maturity with regards to its current price.
To calculate the yield of a Bond, you need to divide the interest of the bond by the Bond Price.
(Yield= Interest received by the Bond/Price of the Bond)
Let's consider 3 scenarios where the coupon rate of a bond is the same but the purchase price of the bond is different to find you how YTM is affected by the buying price of the bond.
Scenario-1 (At par)
Let's assume, you purchased a bond at its face value of Rs 1000 that gave you Rs 90 as interest at the end of 1 year then the yield% would be 90/1000*100= 9%.
Hence, the yield of the Bond is 9%. But as we all know bonds are not always bought at par or at the face value. In that case, the yield of the same bond will be different.
Scenario-2 (At a Discount)
Let's say, you bought a Bond at a discount of Rs50 from its face value of Rs 1000 then your buying price will turn out to be Rs 950. If the Bond has a coupon rate of 9% and 1 year to maturity then the YTM will be as follows-
Yield%=Interest received/Bond purchase price
Interest received =90
Purchase price= 950
YTM will be 90/950= 9.47%.
Scenario-3 ( At a Premium)
If you purchased the Bond at a premium of Rs80 of the face value of Rs 1000, having a coupon rate of 9% and maturity of 1 year then the yield will be,
Interest received= Rs 90
Purchase price= Rs 1080
YTM= 90/1080 = 8.33%.
By the following examples, it must be clear that the purchase price of a bond has a direct impact on the YTM of the bond. A bond bought at a discount to a face value will have a higher YTM than its coupon rate and a bond value bought at a premium to the face value will have a lower YTM than the coupon rate.