Bond Yield Measures – Current Yield and Yield to Maturity

Current Yield:

It is one of the simplest way to understand yield on a particular bond. It is calculated using following equation:

Current Yield = (Coupon/Market Price)×100

It is an approximation measure as time value of money is not used in the calculation.

Example:

Suppose the market price for a 10% G-Sec 2020 is Rs.120. The current yield on the security will be….?

Answer:

(10/120)×100 =8.33%

Yield To Maturity (YTM)

YTM is the most popular measure of yield in the Debt Markets.

It is also known as the Internal Rate of Return on a bond.

It is the return which an investor can get if he hold the bond till maturity. 

Even though it is the most popular measure it suffers from certain limitations. A critical assumption underlying the YTM is that the coupon interest paid over the life of the bond is assumed to be reinvested at the same rate (YTM).

Practically bonds pay interest semi-annually and investors are required to reinvest the coupons received. Reinvestment rate may or may not be equal to the YTM rate. Hence this is the llimitation with YTM.

YTM can be calculated using following formuale:

Illustration:

Consider a bond with an annual coupon rate of 10% redeemable after 3 years selling at Rs.90. What is the return earned by the investor who buys the bond and holds till maturity?

Answer:

As we use financial calculator, question can be solved as below:

PV = -90

PMT = 10

N = 3

FV = 100 (when nothing is specified, it is assumed that bond is redeemed at face value)

I/Y =?

Answer = 14.33%

YTM and Coupon relationship:

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Understanding Basics Of Bonds

Bond is a debt obligation assumed by a company. In other way bond is an instrument available with borrowers. Issuers raise money from the investors and in exchange of money issuer provides bonds. It is one of the debt market instrument. Now lets understand the terminology used in bonds.

Face Value: It is the par value of a bond. It is also the value on which interest is calculated. Normally this is the value on which bonds are issued and redeemed.

Coupon: It is the rate interest to be paid on bond. It is always calculated on the face value of the bond.

Maturity: This is the date on which the bond matures.

Redemption Premium: Certain times bonds may be redeemed at a value which is more than the face value. The amount of money paid over and above face value is known as redemption premium.

Call Option: It is the right available with the issuer of the bond to redeem the bonds before the maturity of the bond. Call option is exercised by the issuers in the declining interest rate scenario.

Put Option: It is the right available with investor to seek redemption before the maturity date of the bond. Put option is exercised by the investors in the increasing interest rate scenario.

Basis Point: Interest rate in the bonds is certain times explained in basis points. 1 percent is equal to 100 basis points. Let say there is 0.25% change in rate of interest. It can be explained as 25 basis point change in interest rate.

Bonds can be secured or non secured. The bonds which are backed by the assets of the borrower are known as secured bonds and vice versa.

Bonds can be convertible or non convertible. Convertible bonds are converted in the common stock/equity share of the borrowing company after a pre specified period while non convertible bond holder gets money at the time of maturity.