For every investor, the prospect of investing in bonds is exciting - given how risk-averse and rewarding they are, by nature. That being said, how does one know which bond to invest in? In today's market, there is information galore but how accessible is that information really - how easily can the investor look past the financial technicalities jargon and how deeply it can impact their choices. One reads enough about terms like yield to maturity, coupon rates and returns in every newspaper's economic supplement, but today we attempt to lift the veil off these.
BondsKart aspires to bring you the power to make informed choices.
YIELD TO MATURITY: THE BASICS
If you are considering investing in bonds, it's very likely that you are already familiar with this term. The yield to maturity is instrumental in helping an investor decide if the bond is worth investing in. Let us see how.
What does yield to maturity mean?
Yield to Maturity (YTM) is nothing but the internal rate of return that the bondholder would earn if he/she holds the bond till maturity. It is essential to note that the bond's yield to maturity goes up and down, depending on its market value and how many payments have been made.
Before going over to why YTM is instrumental in determining if a bond is worth one's money, one may wonder how it is any different from the bond's coupon rate. To clarify for readers, the coupon rate is the annual amount of interest that the bondholder will receive - without negotiation. To put it simply, the coupon rate is the amount of fixed interest that bond will earn each year from the issuer, while YTM is the rate of return on your investment.
How can Yield to Maturity help in Bond selection?
While there is always a slim margin of error, Yield to Maturity is instrumental in determining whether a bond is investment-worthy. Let us look at this example, to further illustrate how important the role of YTM is, for potential investors.
Imagine, a friend comes to you asking for a tidy sum of money, as a loan. They tell you they need about र1 lakh, and since you have some money put aside, you feel inclined to help them. They tell you that they can service the debt in parts, and at the end of one year, they can return the entire sum. The repayment plan that they offer you has two payouts - after six months, they pay you back र5000 as interest payment and at the end of the year, they pay the principal along with an additional र5000, as interest. The math simply states that if you lend your friend र1 lakh, you can expect to receive र1,10,000 in return, meaning you pose to make a profit of 10% interest over a year with two payouts.
To contextualize this example in the framework of bonds - an investor would know that they stand to receive nearly 10% p.a. (paid half-yearly) in coupon payments, if they invest र1 lakh in the said bond, with two annual payouts. If this arrangement of cash flow and interest rate suits the investor, they can go ahead and invest their money. The 10% in question, is the coupon rate of this bond and 11.2% p.a. is the YTM of the bond, and this helps an investor gauge if the bond is suited to their financial needs.
However, an investor must note that real bonds and their subsequent coupons and payments are never as simple. Cashflows vary, depending on the nature of the bond, and in many cases, the cash flows are complex as well. The central decision of any investment is whether or not it suits the investor's financial goals and plans, and the yield to maturity makes that decision, relatively easier.
YIELD TO MATURITY: DOING THE MATH
Now that we've understood the concept, in theory, let's venture into its execution. The concept in its essence is easy enough, and while the calculations may get complex in the process, the basics will always remain the same.
Example: Let us take a look at Mahindra Finance Bond's YTM and how it adds up.
Bond Name: Mahindra Finance Bond
Bond Type: Regular Income NBFC Retail Bond
Call Date: June 6, 2026
Face Value: र10,00,000
Payment: Annually
Price of the bond (as on 5 Jan 2020) = Rs. 10,52,767.12
So, if you invest in this bond, and hold it till maturity, the cashflow would be as follows:
Date | Cashflow |
5 Jan 2021 | - Rs. 10,52,767.12 |
6 June 2021 | Rs. 90,000 |
6 June 2022 | Rs. 90,000 |
6 June 2023 | Rs. 90,000 |
6 June 2024 | Rs. 90,246.58 |
6 June 2025 | Rs. 90,000 |
6 June 2026 | Rs. 90,000 + Rs. 10,00,000 |
Bond Price = i=1nCi/(1+r)(di - d0)/365+ Principal/(1+r)(dn - d0)/365
where, Ci = Coupon payment at time 'i'
di-d0 = no. of days since investment at time 'i'
d0= date of investment
So, in this case, the equation would be
1052767.12 = 90000/(1+r)(152/365)+ 90000/(1+r)(517/365)+90000/(1+r)(882/365)+90246.58/(1+r)(1248/365)
+90000/(1+r)(1613/365)+90000/(1+r)(1978/365)+1000000/(1+r)(1978/365)
To find YTM, we need to find the value of the 'r' that equates both the sides of the equation
If one wishes to do it manually, it's an iterative process where you have to zero down on the value of 'r' by trying different values of 'r' in iterations
Else, one could use the XIRR formula in Microsoft Excel or Google Spreadsheets to find the YTM value quickly
Another edge that knowing the YTM provides you with, is the ability to compare and contrast the bonds you're interested in. If an investor has x amount to invest and while one bond gets them a YTM of nearly 12% while another bond offers 14% for the same risk, the investor may find them more attracted to the higher yield bond that reaps them more rewards.
The world of investments and trading can appear maze-like for many investors - novice and seasoned, alike. In an environment where little is predictable, a measure that can help investors foresee what their returns may look like is welcomed with open arms - making it their best bet.