Bond yield to maturity

 Yield To Maturity  is one of the important measures of Bond investment. It shows the expected annualized return at the current market price of a bond.

 

When fixed coupon bond trade in market , its prices vary according to demand and supply. As price changes the rate of return or yield will vary. Price - Yield to maturity (YTM) relationship is given by the following formula

 

P = c1/(1+y) + c2/(1+y)^2 +....+cn/(1+y)^n + f/(1+y)^n

 

P is price at any point of time

C1,C2...Cn are coupon payments each year. For fixed coupon bonds C1=C2=...Cn

f = face value of the bond

y= Yield to maturity at any point of time before maturity

 

From this equation we can easily say Bond Price and yield has inverse relationship. Bond prices will inversely vary with prevailing interest rate also. Say, a bond is issued at 8% yield in 2015. Now if the interest rate goes up by a percent in market, as coupon is constant, P needs to go down to give 9% yield.

 

Sometimes the yield number will shoot up, if prices go lower just because of there is uncertainty about getting some of the coupons/ final face value of the bond back from countries and companies. Many of PIGS (Portugal, Italy, Greece, Spain) bonds spiked up in 2012, before ECB chief Mario Draghi announced a plan to buy those bonds and ensured to do whatever it takes to save Euro.

 

You can get the yield of any bond by having the current price ,coupon, face value and coupon flows in an excel and applying YIELD formula.

 

A zero coupon bond is one where coupon payments c1...cn are zero. Compounded interest payment made at maturity. A floating bond is the one where coupons or the final payment is determined based on some factor. For ex, it can be 1% above CPI  index annually or gold price index or the floating interest rate.

 

A zero yield or interest rate (y=0) was thought as the lower bound for the interest rates for decades. If you put y=0 into the equation , the investors get the exact invested money back as coupon payments and face value payment at the end. The currency (paper money +c oins) we keep can be considered as a bond with zero yield. A negative yield means , investors get less money than what they pay for buying bond. An investor will be better off having the currency instead buying a bond at negative yields. Zero interest rate served as a limiting point for the monetary policy for decades.

 

But in 2016, negative yield is quite common in advanced economies . Japan, Germany ,Sweden overnight savings rate are negative. Switzerland's 10 year bond yield is -.24% (Ref BI on Sweden)

 

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