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There is nothing cryptic about YTM

Yesterday, in my blog 'Still craving for Tax Free Bonds?', I had cautioned that when you buy any bonds from the secondary market, you have to consider its Yield-to-Maturity (YTM) and not the Coupon Rate. YTM is nothing but the effective returns, which may or may not be the same as Coupon Rate.

I guess there is a need to explain and remove any doubts that some of the prospective investors may have about 'YTM'.

Let us assume that a company XYZ has come out with a public offer of its bonds, on the following terms:
Face Value - Rs.1000 per bond
Rate of interest - 9% p.a. (also called the Coupon Rate)
Tenure - 10 years

So the original allottee in the public issue called Mr. Primary, who invests Rs.1000, will get Rs.90 as interest every year for 10 years and on maturity he will get back his Rs.1000. 
Yield-to-Maturity Curve

If you calculate the YTM for Mr. Primary — which is nothing but the IRR of the cashflows over these 10 years — you will arrive at a figure of 9% p.a. This, by the way, is same as the Coupon Rate. Hence, for primary issues, where you are buying bonds at the Face Value, your effective returns or the YTM is the same as the Coupon Rate.  

Now suppose, one year later, Mr. Primary needs money for an emergency and therefore decides to sell his bond in XYZ.

Mr. Secondary, interested in buying this bond, checks at the exchange and finds that the same is being sold for Rs.1050. He places his buy order with his broker.

Since company XYZ is committed to pay the Bond Coupon Rate and redeem it at the Face Value, Mr. Secondary, who invests Rs.1050, will also receive Rs.90 as interest every year for the remaining 9 years and the bond value i.e. Rs.1000 on maturity. 

If you calculate the YTM for Mr. Secondary — which is nothing but the IRR of the cash-flows over the balance 9 years —  you will get a value of 8.19% p.a. In other words, Mr. Secondary will effectively earn only 8.19% p.a. returns. 

Why are the returns lower, even though XYZ continues to pay 9% interest? That's because the purchase price is higher than the Face Value and there is loss of Rs.50 in the capital at the time of redemption. This reduces the effective yield. 

(By the way, if the bond is bought at a price lower than Rs.1000, the YTM would be more than 9% Coupon Rate).

Hence, when you are buying bonds from the secondary market, at prices which are different from the Face Value, you have to consider YTM and not the Coupon Rate. 

In case you are wondering why the bonds normally don't sell at the Face Value in the secondary market, you should read 'Why Gilts (and bonds) are prone to interest-rate risk?'.

And those who would like to know how to calculate IRR, can read 'Learn How to Calculate TRUE investment returns or TRUE loan cost'.

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