How you can use this measure to take investment decisions?
Yield and yield-to-maturity (YTM) are commonly used to arrive at investment decisions. They provide a common benchmark to evaluate different investment instruments.
Yield is the percentage rate of return paid on a stock in the form of dividends, or the effective rate of interest paid on a bond or note. There are many kinds of yields depending on the investment.
Forms of yield
YTM is the most popular measure of yield in the debt market. YTM is the percentage rate of returns paid on a bond, note or other fixed income securities if the investor buys and holds it till its maturity date.
Current yield is the coupon rate divided by the market price and gives a fair approximation of the present yield. The yield on government securities is impacted by various factors. These include prevailing interest rates, inflation rate, level of money supply in the economy, future interest rate expectations, and borrowing program and monetary policy of the government.
Calculating YTM
The calculation for YTM is based on these variables:
• Coupon rate
• Length of time to maturity
• Market price of bond
YTM is basically the internal rate of return on a bond. It can be determined by equating the sum of the cash flows throughout the life of the bond to zero. One of the major assumptions underlying YTM is that the coupon interest paid over the life of the bond is assumed to be reinvested at the same rate.
The YTM is obtained through a trial and error method by determining the value of the entire range of cash flows for the possible range of YTMs so as to find the one rate at which the cash flows sum up to zero.
Yields and bonds
Yield and bond price are inversely related. So, a rise in price will decrease the yield and a fall in the bond price will increase the yield. In fact, both inflation as well as the interest rate tends to have an impact on the value of a bond. Usually, there is an immediate and predictable effect on prices of bonds with every change in the level of interest rates. When the prevailing interest rates in the market rise, the prices of outstanding bonds will fall, to equate the yield of older bonds in line with higher interest new issues.
This happens as there would be very few takers for the lower coupon bonds, resulting in a fall in their prices. The prices would fall to an extent where the same yield is obtained on the older bonds as is available for the newer bonds.
In case the prevailing interest rates in the market fall, there is an opposite effect. The prices of outstanding bonds will rise, until the yield of older bonds is low enough to match the lower interest rate on the new bond issues. These fluctuations in bond prices contingent with changes in the interest rates tend to ensure that the value of a bond will never be the same throughout its life. A bond's value is likely to be higher or lower than its original face value, depending on the market interest rate, the time to maturity and its coupon rate.
