By Sameer Bhardwaj.
How are bond yields different from coupon rate?
Getty Images. Bond yield, also known as the yield to maturity YTM is the interest rate a bond holder receives if a bond is held till maturity.
Bonds are debt instruments that are used to raise funds from the market and carries a specified interest rate, which is also known as the coupon rate and have a defined maturity period. The buyer of the bond is entitled to receive a stream of interest payments and the principal amount on maturity. Bond markets provides a vital source of credit, which is needed for capital formation and economic growth.
Stock Market
In the G-sec market, the government raises capital to finance its capital and revenue expenditures whereas, companies raise money using corporate bonds to fund their business expansion plans. In addition, the Reserve Bank of India and central banks across the world use bond markets to manage economic variables like inflation, liquidity and interest rates.
Ever wondered how such YTM is calculated? Theoretically, the YTM of a bond is that rate that equates the present value of the stream of interest income to its face value.
Portfolio Review
As most of the bonds are traded in the secondary market, therefore, the YTM of the bond differs from the coupon rate or the specified interest rate. This is because when the bond is purchased from the secondary market, the market price differs from the face value, which is due to the changing interest rates and the credit ratings of the issuer.
Retail investors can either trade in bond markets through brokers or can invest through mutual funds. No matter what route the investors take, it is interesting to understand how YTM is calculated and the factors that influences its movement. Let us look at a hypothetical example to understand the yield function.
The maturity date of the bond is 1 August On 1 July , the current market price of the bond in the secondary market was Rs What is the YTM of the bond on 1 July ? In our example, it is 1 July The final input is the basis, which is optional and can be left blank. The yield function simplifies calculations It also demonstrates the inverse relation between bond prices and bond yields.
After putting in these values, as shown in the illustration, it will generate a YTM of The last two inputs are not visible in the dialog box, but the same can be accessed by moving the scroll bar that is visible on the right hand side. The function also demonstrates the inverse relationship between bond prices and bond yields.
As the new bonds are issued at a revised rate, the prices of the old bonds react, which in turn affect their yields. A new bond with a higher coupon rate will reduce the demand for old bonds which creates a downward pressure on their prices and their yields go up. In the demonstrated example, if the price of the bond is increased to Rs 95, the yield declines to However, if the price goes down to Rs 89, the yield jumps to Moreover, a sudden fear of default by the issuer of a bond could spike its yield significantly due to a substantial fall in the market price.
Another important feature that can be explained using the yield function is the relationship between the coupon rate and the bond yield. If the yield is greater than the coupon rate, the bond sells at a discount. As is visible in the example, the current market price is less than the face value. On the other hand, if the yield is less than the coupon, the bond sells at a premium. X purchases a bond for Rs 1, The bond matures in four years.
Duration formula
Therefore, it pays Rs 50 a year in interest. X decides to sell his bond as he urgently requires his initially invested Rs Once he places an order to sell his bond, his order would enter the market and interested buyers would compare this particular bond with the other bonds in the market at that particular point in time. Since the interest rates must have gone up in the market after one year, a newly issued Rs bond with a maturity period of 4 years the time left for the bond from Mr. This accounts for Rs 60 a year. Interestingly, if an investor purchases bond from Mr.
In short, there is no enticement for the investor to buy a bond of Mr. X at the face value of Rs when he could make more profit after purchasing the new bond with an increased interest rate at same par value. Therefore, in such circumstances, Mr. X has to sell his bond at a discount to make it look more attractive. He should sell it at around Rs to make it look more attractive.
The investor would now receive Rs interest in addition to Rs 40 of principal when the bond matures. As investor has to pay less for the bond he would receive same profit over same maturity period similar to a newly issued bond paying a much higher interest rate.
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Therefore, bond prices have to go down to adjust for any rise in interest rates in the market.