“Price is what you pay, value is what you get”. In an investment world nothing holds truer than these words from Warren Buffett.
Humans are driven by an innate quality of asking “what’s in it for me?”! And the answer we want to hear is some sort of value add, else why would we even bother in the first place. And when it comes to investing, it is that added value which makes it worth a while. We invest to compound, to add on to what we already have. And it is this incremental value which we want to gain is what drives our investment decisions.
YIELD TO MATURITY (YTM) YTM is the discount rate used to equate the present value of all future cash flows of a bond, which includes the principal amount plus the remainder of the coupon payments, to its current market price. YTM can be thought of as a ‘valuation methodology’ for a bond, where it enables an investor to ascertain whether an investment is lucrative or not.
Fundamentally, YTM is the internal rate of return (IRR) an investor earns, provided a bond is held till maturity and is expressed in percentage terms.
There are certain underlying assumptions which needs to be taken into consideration while calculating YTM:
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An investor has brought a bond at a market price;
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For a fixed period of time;
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Being held till maturity;
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With timely coupon payments, which are reinvested; and
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Fixed principal amount invested.
Taking the above into consideration, YTM can be calculated as below:
Example 1 (YTM calculation): YTM on a bond with a face value of ₹100, market price of ₹110, annual coupon rate of 7.5% paid semi-annually, term to maturity of 9 years, will be 6.085%
To put it in layman’s terms, when an investment is made in a bond, it is effectively a loan to the bond issuer and in return an investor will get their initial investment repaid after a fixed period of time plus regular coupon payments (interest payments) for the term of the loan. The total value of these combined payments, over the term or duration of the bond, is what a bond yield is all about.
Relation between YTM and Market Price The relation between the market price and YTM of a bond is like a see-saw, when the market price of a bond rises, YTM goes down, and vice-versa.
Now, why is there an inverse relation between the market price and YTM? To understand that we need to understand the impact of interest rate (I.e. coupon rate) movement on the market price. Let’s look at this for two scenarios: 1) when the interest rates increase, and 2) when the interest rate decreases.
Scenario 1: when the interest rates rise in the market, the market price of a bond is forced to drop in the secondary market as now there will be less takers for investing in those low coupon paying bonds. Investors will now have an option to invest in the newly issued bonds which will be offering a higher coupon rate due to a rise in the interest rates.
Decline in the demand for the existing bonds will push for an adjustment to its market price to attract investors. The bond issuer will now need to compensate investors for the difference between the low coupon rate on the existing bond and the higher coupon rate on the newly issued bonds. And they will achieve this by reducing the market price of the existing bonds.
As new issuance of bonds will attract higher interest rates, the market price of the existing bonds will decrease to an extent where the YTM on a newly issued bond equals the YTM on an existing bond. Only then the existing bonds will be of the same value to an investor like a newly issued bond. A higher YTM, driven by a rise in the interest rates, will drive the market price down.
Scenario 2: on the other hand, when the interest rates fall in the market, demand for the existing bonds will increase.
Investors will be willing to pay a premium on the market price of the existing bonds to earn higher coupon rate being offered by those bonds as opposed to the newly issued bonds which will comparatively pay a lower coupon due to fall in the interest rates.
This will drive the market price of the existing bonds upwards, and it will be adjusted to a price where the YTM on the existing bond equals YTM on the newly issued bonds which will be equal to the decreased coupon rate (Note: on first issue of a bond, YTM equals its coupon rate).
Example 2 (YTM and market price relation): Let’s consider the existing bond used in example 1 above, which has a face value of ₹100, market price of ₹110, annual coupon rate of 7.5% paid semi-annually, term to maturity of 9 years, and YTM of 6.085%.
Bond issuer of the existing bond wants to raise additional funds from the market and decides to issue a new bond. This new bond will attract the prevailing interest rate in the market as its coupon rate, and will be issued at a face value of ₹100, with a term of loan of 10 years.
On its first issue, the market price of the bond will always equal its face value, and YTM will equal its coupon rate given the bond hasn’t started trading and is not impacted by the market forces.
We will look at two scenarios:
Scenario 1: interest rates rose to 8.0% Increased interest rate will drive the coupon rate (8.0%) on the newly issued bonds to be higher than the coupon rate on the existing bonds (7.5%). This will lead to an increase in the YTM of the existing bond, which now equates to YTM on the newly issued bond, being 8.0%; while the market price of the existing bonds will decrease to ₹96.84 (below face value), making them trade at a discount.
Scenario 2: interest rates fell to 7.0% Reduced interest rates will drive the newly issued bonds to have a lower coupon rate (7.0%) than the existing bonds (7.5%). This will drive down the YTM on the existing bonds to 7.0%, while the market price of the existing bonds will increase to ₹103.30 as they will be more attractive for investing, making them trade at a premium.
YTM, market price, and the coupon rate of a bond are all either inversely or directly related. Underlying driver for a movement in these three key metrics is the market interest rate, also referred to as ‘interest rate’ in this blog.
Do note that the interest rates, as part of the monetary policy, are not the only driving factor causing a movement in bond metrics. There are other factors to be considered including the demand and supply of a bond, and the credit rating of a bond issuer.
