The yield to maturity (YTM) reflects the return on investment earned at the current price if the bond is held to its maturity date and redeemed at par or we may define it in a manner that the YTM is the discount rate that equates the present value of future inflows from the bond equal to its present price.
Whenever we are interested in buying a bond from the bond market the bond’s issuer, promises to pay back the principal (or par value) when the loan is due (on the bond’s maturity date). In this time lag issuer is committed to pay the interest in order to compensate the use of money. The interest payment is made on coupon rate which is fixed.There is an inverse relationship between the coupon rates and the bond prices when:• Interest rates rise, leads to increase in income, whereas the price of the bond declines.
• Interest rate decline, leads to declining income, whereas the price of the bond rises. (Marcus, 2001)Also keeping one thing in to consideration is that the coupon is inversely related to duration because higher coupons lead to quicker recovery of the bond’s value, resulting in a shorter duration, relative to lower coupons. If coupon rate is > market rate then it is favorable for issuer and if coupon rate is < market rate then it is favorable for purchaser. The reason behind the variations in the coupon rates of various bonds is the market interest rate; company’s performance, time length, and credit worthiness of the issuer so all these factors have an implication on the bond yields.
The equation of YTM is mentioned below:VB =(Eugene Brigham, 2001, p. 277)WhereVb = the current market price of the bondn = the number of semiannual periods to maturityk = the semi annual periods to maturitym = face valueint = the semi annual coupon in dollars.The above mentioned equation is based on the working phenomenon of trial and error so we take a look at another equation which gives us the exact guess of the discount rate:YTM = I + (FACE VALUE – MARKET VALUE)/n(FACE VALUE + MARKET VALUE)/2We calculate the YTM of the bonds on the basis of this formula.Suppose:Coupon Rate = 10%YTM = 9%Face value = $1,000Market Value = $1,069Period = 10 YearsInterest = 100Here, we put the data the equation, in order to compute or equate YTM.
YTM = 100 + (1000 – 1069)/10(1000 + 1069) / 2YTM = 9%The above mentioned calculation reveals us the fact that whenever the price of the bond goes upward its interest rate goes downwards, when the bond is mature. The rate of return on bonds most often quoted for investors is the yield to maturity (YTM), a promised rate of return that occurs only under certain assumptions. It is the compound rate of return an investor will receive from a bond purchased at the current market price if:I. The bond is held to maturity, andII. The coupons received while the bond is held are reinvested at the calculated yield to maturity for that bond (Helfert, 2001).
If investors are not willing to take risk or take a tentative approach regarding the price fluctuations, then the investor opt the strategy to invest their funds in short term bonds unless they receive a higher yield to maturity on long-term bonds. Short term investor also generated the profit if the interest rate rises. Keeping one thing in the mind that barring default, an investor will actually earn this promised rate if, and only if, the above mentioned conditions are met.