What is Yield?
Yield is the measure of cash flow of an investment over a period of time. It is expressed as a percentage. It considers all dividends or interest received from the investment during the term of the investment.
Yield is different from the total return. Yield is a complete measure of return of an investment as it includes all cash flows from an investment. It can be calculated based on cost and current price.
Yield on cost: When the yield is calculated on the purchase price, it is called the yield on cost.
Current yield: When the yield is calculated on the current market price, it is called the current yield.
In the Case of Bonds– Bond yield is the return one earns on the interest. Interest is also known as the coupon rate. Hence bond yields depend on the coupon rate. In the case of bonds, it is called normal yield. This is the annual return from investing in fixed income securities. Normal yield = Annual interest earned/Face value of the bond
What is Yield To Maturity?
YTM is nothing but the internal rate of return (IRR) of a bond. However, the investment must be held until maturity, and all the proceeds must be reinvested at a constant rate. YTM is similar to the current yield where it determines the return one can expect by holding the security for a year. However, YTM is slightly advanced and accounts for the time value of money.
Yield to maturity (YTM) is the total expected return for an investor if the bond is held to maturity. YTM factors all the present values of future cash flows from an investment which equals the current market price. However, this is based on the assumption that all the proceeds are reinvested back at a constant rate, and the investment is held until maturity. The price of the bond, the coupon payments and maturity value are known to an investor. However, the discount rate has to be computed. This discount rate is the yield to maturity. Often a trial and error basis is used to calculate this. Below is the formula for yield to maturity.
Yield To Maturity Formula
Below is the YTM formula
Where, bond price = the current price of the bond.
Coupon = Multiple interests received during the investment horizon. These are reinvested back at a constant rate.
Face value = The price of the bond set by the issuer.
YTM = the discount rate at which all the present value of bond future cash flows equals its current price.
One can calculate yield to maturity only through trial and error methods.
However, one can easily calculate YTM by knowing the relationship between bond price and its yield. When the bond is priced at par, the coupon rate is equal to the bond’s interest rate. If the bond is selling at a premium (above par value), then the coupon rate is higher than the interest rate. And if the bond is selling at discount, the coupon rate is lower than the interest rate. This information will help an investor to calculate yield to maturity easily.
Illustration on How To Calculate Yield To Maturity
To calculate YTM, let’s take an example of a corporate bond with a face value of INR 1,000. The current market price of the bond is INR 950. The bond pays a coupon of 4% annually. The bond matures in 3 years.
The details of the corporate bond are shown in the table below:
|Face Value||INR 1000|
|Coupon rate||4% or INR 40|
|Time to Maturity||3 years|
|Current market value||INR 950|
Since the bond is selling at a discount, the interest rate or YTM will be higher than the coupon rate. Using the YTM formula, the required yield to maturity can be determined.
INR 950 = 40/(1+YTM)^1 + 40/(1+YTM)^2 + 40/(1+YTM)^3+ 1000/(1+YTM)^3
We can try out the interest rate of 5% and 6%. The bond prices for these interest rates are INR 972.76 and INR 946.53, respectively. Since the current price of the bond is INR 950. The required yield to maturity is close to 6%. At 5.865% the price of the bond is INR 950.02
Hence, the estimated yield to maturity for this bond is 5.865%.
Why Yield To Maturity Keeps Changing?
Yield to Maturity is a return metric for Debt Funds. However, it fluctuates with changing market conditions. Thus, in practice, the YTM of an open-ended Debt Fund is different from the scheme’s actual returns.
Furthermore, since debt funds invest in multiple funds, a change in the YTM of a single bond will have an impact on the YTM of the debt fund. However, the magnitude of this change will be proportionate to the weightage of the bond in the debt mutual fund portfolio.
Taking the above example, let us understand how the changing market conditions impact the bond’s YTM. Let’s assume that the bond’s rating has been downgraded due to its poor performance after one year. As a result, the market value of the bond is now INR 700. Based on the changes, the details of the corporate bond after one year shown below:
|Face Value||INR 1000|
|Coupon rate||4% or INR 40|
|Time to Maturity||2 years|
|Current market value||INR 700|
Using the YTM formula, the required yield to maturity can be determined.
700 = 40/(1+YTM)^1 + 40/(1+YTM)^2 + 1000/(1+YTM)^2
The Yield to Maturity (YTM) of the bond is 24.781%
After one year, the YTM of the bond is 24.781% instead of 5.865%. Hence changing market conditions like inflation, interest rate changes, downgrades etc affect the YTM. An increase in YTM of the bond due to change in market conditions indicates the bond or debt fund is of low quality. Whereas, a decrease in the YTM due to change in market conditions shows the bond or debt fund is of high quality.
How To Interpret YTM for Your Debt Funds?
Yield to Maturity helps in only determining the potential returns of a debt mutual fund. However, it also gives a fair idea of the risks associated with the investments. For example, a debt fund having a high YTM means that the scheme has substantial investments in bonds with low credit ratings. Bonds with low credit ratings offer higher coupon rates in comparison to bonds with higher credit ratings.
However, it is important to note that these bonds have a downside as well. Low credit rating bonds have a greater level of credit and liquidity risk. Credit risk is when the bond issuer defaults on interest payments. At the same time, liquidity risk is when the fund manager is unable to exit their position on the bond quickly.
Therefore, while investing in debt funds, one should consider their risk profile. High-risk investors can consider investing in debt funds with higher YTM to generate greater returns. While low-risk investors can opt for funds with lower YTM that invest primarily in bonds with high credit rating.
How to Calculate Future Returns for your Debt Funds?
YTM of debt funds changes over time. However, one can estimate their future returns from Debt investments. Estimating the future returns helps in many ways, such as how much one should invest to reach their target amount, pay for a future expense, etc.
The calculations are only an estimate of potential returns and do not guarantee any returns. To compute the potential future returns, one should know the following details of a fund:
- Yield to Maturity (YTM)
- Expense Ratio
- Modified Duration
Also, one should take into account the interest rate cycle of the Reserve Bank of India (RBI).
The below formula can be used to estimate one year return from a debt fund investment:
Expected 1 Year Return = YTM + (Interest Rate Change x Modified Duration ) – Expense Ratio
Let’s understand the calculation with an example. A debt fund has its modified duration as five years, YTM 9%, and an expense ratio of 1.25%. The anticipated interest rate change is 0.5% (decrease), and the expected one year return is 10.25%.
Expected 1 Year Return = 9 + (5*(0.5)) – 1.25 = 10.25%.
Now, instead of a decrease in interest rate, if there is an increase (0.5), then the Expected return would be:
9 + (5*(-0.5)) – 1.25 = 5.25%.
Therefore, from the above example, the bond’s expected one-year return was the same when the interest rates have decreased by 0.5%. While when the interest rates increased by 0.5%, the expected return is lower.
Following are few important terms in yield to maturity formula
Face value/ Par value
Face value or par value is the value of the bond upon maturity. In other words, this is the price paid to the bondholder at the maturity date.
Present value/ Market value
Present value or market value of the bond is the current market price. The bond prices are subject to fluctuations on the basis of the interest rate changes. Both price and yield have an inverse relationship.
The coupon rate is the interest rate paid to the bondholder by the bond issuer. The coupon rate is paid on the bond’s face value and not on the market value.
The interest rate of a bond is not the same as its coupon rate. Let’s understand this with an example. Mr Ananth buys a bond at INR 1,000 (face value), and the coupon rate is 10%. Mr Ananth gets INR 100 (10% of INR 1,000) every year for his investment as annual coupon payments. The effective interest rate for him is 10%.
On the other hand, Ms Sushma buys a bond at INR 2,000 (at a higher price to its face value). The face value of the bond is INR 1,000, and the coupon rate is 10%. Here, Ms Sushma also gets a yearly payment of INR 100 (10% of INR 1,000) as annual coupon payments. However, since she bought the bond at INR 2,000, the rate of interest for her investment is 5% (INR 100 of INR 2,000).
Similarly, had an investor bought the bond below its face value, the interest rate would be higher than the coupon rate.
Discount and Premium
Bonds trade either at discount or premium. When,
Market value = Face value, the bond is trading at par
Face value < Market value, the bond is trading at a premium
Face value > Market value, the bond is trading at a discount
Time to maturity
Maturity is the duration or date when a bond’s principal amount is repaid with interest. For example, a 10-year government bond matures in 10 years. The bondholder receives the principal amount along with interest at that time. Most commonly, maturity is referred to as time to maturity. This depicts the amount of time between now and the bond maturity date.