Let’s look at a bond with a LKR 1,000 face value, a 5% coupon rate and 3 years to maturity. The investor will receive a LKR 50 coupon in year 1 and another LKR 50 coupon in year 2. When the bond matures in year 3, the investor will receive another LKR 50 coupon, plus LKR 1,000 capital, which was the original cost of the bond.
This LKR 1,150 payment is agreed when the bond is issued, with the investor receiving annual coupons and face 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 face value.
Let’s again look at our bond with a face value of LKR 1,000, 5% coupon rate and 3 years to maturity.
If you buy this bond at LKR 950, your YTM would be 6.9%, higher than the 5% on offer if you bought it at face value of LKR 1,000. If you buy it at LKR 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 LKR 1,000 face value, 5% coupon and 3-year maturity is scheduled to pay out LKR 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.