Bonds are usually issued by large companies or governments, as a way to borrow money from investors to fund expansion or capital expenditure. The issuer promises to repay the loan on a future date, known as the maturity date.
Let’s look at a bond with a $1,000 par value, a 5% coupon rate and 3 years to maturity. The investor will receive a $50 coupon in year 1 and another $50 coupon in year 2. When the bond matures in year 3, the investor will receive another $50 coupon, plus $1,000 capital, which was the original cost of the bond.
This $1,150 payment is agreed when the bond is issued, with the investor receiving annual coupons and par value when the bond matures.
However, bond prices are decided by the market and will fluctuate due to changes in credit ratings and current and future interest rates.
Yield to Maturity, or YTM, measures a bond’s rate of return when buying it at different times when the price may vary from the original par value.
Let’s again look at our bond with a par value of $1,000, 5% coupon rate and 3 years to maturity.
If you buy this bond at $950, your YTM would be 6.9%, higher than the 5% on offer if you bought it at par value of $1,000. If you buy it at $1,100, the YTM would be 1.6%.
As you can see, the lower the bond price, the higher the YTM.
Our bond with a $1,000 par value, 5% coupon and 3-year maturity is scheduled to pay out $1,150 in 3 years. As these payment amounts are fixed, you would want to buy the bond at a lower price to increase your earnings, which means a higher YTM. On the other hand, if you buy the bond at a higher price, you will earn less - a lower YTM.
