Yield, Coupon, and Yield to Maturity are parameters that an investor uses to compare different investment options. However, the correlation and their difference are subtle and often easily confused. Have you ever thought about what yield is or its importance for investors like us? Understanding yield, coupon, and yield to maturity would clarify the concept and help us make informed investment decisions.
1. What is Yield?
Yield is the earning from our investments over a particular period, including all the interim cash flows. The dividends earned from stocks or the interests earned on debt instruments are considered for yield calculation. Yield is expressed as the percentage of the face value of the instrument or the current market value. It is a part of the total return, which considers all the cash flows from the investment.
2. How is Yield calculated?
Yield is calculated by dividing the net cash flow received by the amount invested or current value. It is calculated differently for stocks and bonds.
Yield For Stocks:
The yield is calculated in 2 ways, based on either the purchase amount or the current market price, whichever is easily available, as well as the dividend (i.e., the net cash flow):
- Yield on Cost (YOC)= Net Cash Flow / Purchase amount 100
For example, if an investor purchased a share five years ago for Rs 200, which gives a dividend of Rs 15 per share, then his Yield on Cost = 15/200100= 7.5%
- Current Yield = Net Cash Flow / Current Market Price 100
For example, the current stock price of the share mentioned above is Rs 210 with a dividend of Rs 15 per share, then his Current Yield=15/210100 = 7.14%
The more common practice is to use the current yield as yield for stocks since it is based on the current market price and gives a more realistic picture.
Yield For Bonds:
For bonds and, in extension, debt mutual funds, yield is known as normal yield. Bonds usually trade at a premium (higher than original) or a discounted (lower than original) value.
Yield or Normal Yield of a Bond= Interest received in a year/ face value (original purchase price) of the bond or current price.
Similar to the yield calculation for stocks, yield for bonds can also be calculated if the bond’s purchase price or the current market price is provided. Since bonds are traded in the secondary market, their purchase price and current market prices differ. Bonds have a predefined rate of annual interest declared at the time of issuance, called Coupon. It is related to the market rate of interest determined by the Government at the time of issuance of the bond.
Below are the two yields commonly looked at when evaluating bonds-
- Yield On Cost (YOC)= Net Cash Flow (i.e. coupon/interest) / Purchase amount * 100
For example, if an investor purchased a bond 5 years ago for Rs 1000, which gives an annual interest(coupon) of Rs 50, then his YOC = 50/1000100= 5%
The YOC and the coupon for bonds are the same and are calculated on the bond’s initial price, irrespective of the current market price.
- Current Yield = Net Cash Flow (i.e. coupon/interest) / Current Market Price * 100
Current Yield is the more commonly used concept as it is mapped to the bond’s current market price and not the purchase amount like YOC.
Let us take an example of a bond with purchase price of Rs 1000 and 5% coupon.
Purchase Price of Bond | Coupon | Current Market Price of Bond | Current Yield |
|---|---|---|---|
| Rs 1000 | 5%, i.e. Rs 50 p.a. | Rs 800 (lower than the purchase price) | Current Yield= Coupon / Current Market Price= 50/800 * 100 = 6.25% |
| Rs 1000 | 5%, i.e. Rs 50 p.a. | Rs 1100 (higher than the purchase price) | Current Yield= Coupon / Current Market Price= 50/1100 * 100 = 4.55% |
As shown in the table, the current yield changes with a change in the bond’s current market price. If the bond’s current market price falls, the current yield rises, and if it rises, the current yield rises. They are inversely proportional.
3. What is Yield to Maturity (YTM) ?
Yield to maturity (YTM) is defined as the total return that you can expect from your investments in bonds, provided you hold the bond till its maturity and all the proceeds of the bond are reinvested in the same as well. Since stocks do not have a maturity date, this concept applies to bonds only.
Yield to Maturity = Total Interest Earned from the Bond over the years/ Face Value of the Bond
Bonds pay interest to the bondholders. So, if you need to evaluate and make an informed investment choice about which bond to purchase, you need to calculate the present value of all these future coupons. Yield to Maturity measures the current value of all future coupons of the bond by reinvesting all the coupon payments in the same bond. It is mostly expressed in annual terms.
4. Yield to maturity Formula
There is a formula to calculate the approximate value of yield to maturity, which is-
Where:
- Annual coupon rate = Coupon for Bonds
- Market price refers to the current price of the bond
- Years to maturity can be calculated by taking the number of years remaining from the maturity date
5. How to Calculate Yield to Maturity?
Let us understand with an example by using the simple YTM formula. Assuming XYZ Ltd. issues bonds with a 5% annual coupon rate, face value Rs. 1000 and maturity 5 years.
| Coupon Rate (A) | 5% annually |
|---|---|
| Face Value of the Bond (i.e. the Purchase Price) = Par Value (B) | Rs 1000 |
| So, Annual Interest (C) | =5% of Rs 1000 = Rs 50 |
| Years to maturity (D) | 5 years |
In an ideal scenario with no change in bond price, the yield to maturity would also be 5%, i.e., the same as the coupon rate provided the bond is held till maturity.
Now, if the market rate of interest goes up to say 6%, this bond becomes less valuable, as investors would not find this investment (at coupon 5%) opportunity attractive. In such a case, the bond’s current market price would fall to, say, Rs 800. This would change the yield to maturity of the bond.
| Details | Calculation |
|---|---|
| Current Market Price -E | Rs 800 |
| YTM | = {C + (B – E)/D}/ {(B+E)/2} = {50+ (1000-800)/5}/ {(1000+800)/2}= 90 / 900 = 0.1 or 10% |
A bond investor would choose a bond based on the coupon, as he would like to hold it till maturity, in which case the YTM will be the same as the coupon rate. However, a bond trader would choose a bond based on the yield to maturity. A YTM calculator can help with these calculations.
6. What is the Yield to Maturity in Debt Mutual Funds?
Debt mutual funds have both Government and corporate bonds in them as underlying assets. These bonds pay interest periodically. For a debt mutual fund, YTM calculates the fund’s expected yield by taking the fund’s earning as a whole instead of a single bond. However, YTM is a good indicator for closed-ended funds and fixed-maturity plans as the portfolios are usually held till maturity. There is little scope of inflow and outflow of funds in the interim period.
However, for open-ended debt schemes, YTM may differ from the scheme’s actual returns, as there is constant inflow and outflow of money into the scheme that needs to be invested at the then-prevailing yield. Also, there could be a change in the fund’s portfolio based on the fund manager’s analysis and scheme’s objectives, i.e., the fund manager keeps buying and selling securities, because of which the YTM can change.
Here is an example of the Aditya Birla Sun Life Corporate Bond Fund, an open-ended scheme that has a YTM of 5.41%.
| Aditya Birla Sun Life corporate bond fund portfolio aggregates | ||||
|---|---|---|---|---|
| Fund | 1-Year High | 1-year Low | Category | |
| Number of Securities | 292 | 296 | 192 | 90 |
| Average Maturity (years) | 2.75 | 4.45 | 2.75 | 2.76 |
| Yield to maturity (%) | 5.41 | 6.89 | 4.87 | 5.27 |
| Average Credit Rating | AAA | — | — | – |
In the above table that represents a yield to maturity example, we see that the YTM of 5.41% for the fund (when calculated using its face value) increased to a maximum of 6.89% and fell to a minimum of 4.87% in that year. Yield to maturity changes due to the average price movement of all the bonds in the scheme. However, the category average of yield to maturity in similar funds is 5.27%, which means this fund has outperformed the category average.
Note: 1-year high and low depict the change in the number of bonds in the fund and the average maturity changes accordingly. This is because fund managers add and remove bonds from the fund as per the market scenario. So, the maximum number of bonds in the fund was 296 in a year, and the lowest was 192. Thus, the average maturity of the scheme also changed when the bonds were added and removed.
7. Limitations of Yield to maturity
Though we use yield to maturity to compare bonds and debt mutual funds, this measure has certain limitations.
- It doesn’t account for any capital gains tax payment. Investors need to pay a short-term capital gains tax as per their income tax slab if redeemed before 3 years and long-term capital gains tax if redeemed after 3 years. While calculating YTM, these taxes are not considered.
- Another limitation of yield to maturity is the number of assumptions. We assume the future interests while calculating YTM through a YTM calculator for debt mutual funds or bonds. We assume the future coupon payments and the price of the bond. The actual return can be quite different from the yield to maturity because the market can turn around anytime. We also assume that all coupons are reinvested in the bond at the same coupon, which might not be possible or viable since the price may fluctuate.
- The risks for bond investment like default risk (if payment of a coupon is not made on time) or reinvestment risk (if all coupons are not reinvested in the bond at the same coupon) are not captured in a YTM formula.
- The actual yield for the bond cannot be accurately estimated as there is price volatility in the bond price. So, the returns cannot be predicted ahead of time.
- A high YTM can mean higher returns, but it could mean that the bond’s quality is low, and hence the coupon offered is high. So, only a high YTM does not make it attractive, as the reason for high YTM needs to be ascertained.
- Certain features like call and put options of a bond are not incorporated in the YTM formula calculation. A callable bond gives the bond issuer an option to “call back” the bond even before its maturity from the investor by paying up the entire purchase amount. A putable bond gives the investor a right to demand the purchase amount to be paid to him by the bond issuer even before maturity. Both these options are not considered in the calculation of YTM.
- The costs of buying or selling a bond, such as transaction costs, expense ratio, brokerage, etc., are also not taken into consideration.
Primarily, yield to maturity helps to draw a comparison between bonds or debt mutual funds on the basis of their expected returns. It also helps investors to understand how changes in the market conditions, with the rise and fall of interest rates, affect their debt portfolio as well.
8. Frequently Asked Questions
What is the meaning of YTM?
YTM is yield to maturity which means the total return you expect from your investment in bonds/debt mutual funds if the same is held till maturity. It is expressed as a percentage of the current market price. It is used for comparing different bonds and debt funds with different maturities.
What is Ask Yield to Maturity?
The Ask Yield to Maturity is calculated when you paid the asked price for the bond and held it till maturity. The asked price is the price asked by the seller of the bond. You bid a price which is lower than the asked price. The asked yield to maturity fluctuates with the interest rate of the bond.
What is YTC?
YTC is Yield to Call. It can be defined as the yield of the bond if the bond is held until called for. A bond can be called before the maturity date as well.
What is YTW?
YTW is yield to worst. It refers to the lowest yield possible on a bond. YTW is important to understand the level of risk associated with the bond or the debt fund.
What is the effective yield?
A higher yield to maturity suggests a higher return, but it also indicates a higher risk as it indicates that the fund may be holding risky bonds in order to get a high yield. Thus, it depends on you whether you want to go for higher risk-return investments or not.
