After a bond is issued, its price is set by supply and demand.
What becomes more important to investors after issuance is the yield or return than an investment in a bond at the current market. Price will provide.
This is where the concept of yield to maturity or YTM becomes relevant yields maturity is the total return expected on a bond if held until it matures.
It includes the current price that is paid, coupon payments received, and the principle received at maturity to calculate the yields.
Maturity for bonds with multiple cash flows such as coupon payments, it is done iteratively by discounting all of the future cash flows back to the present value.
But what discount rate do we use? Well, the answer is the yields to maturity, and it is one of the most commonly referenced yield metrics in fixed income markets.
We basically solve for R so that the formula equals the market price of the bond.
While yields maturity provides a helpful high level comparison between different bonds, it comes with some assumptions that might not always hold in reality.
Assumption one, the bond is purchased at the current market price.
Well, this assumption is generally fine.
Assumption two, the bond is held until maturity.
Well, while not always true, this assumption isn't a problem.
Since yield to maturity is designed as a long-term holding measure anyway, so the assumption works with yield maturity.
Assumption three coupons received from the bond are reinvested until maturity at the same yield to maturity.
This is more problematic.
The assumption implies a constant reinvestment rate for all coupons equal to the perhaps very high yield to maturity when the bond is purchased.
In reality, interest rates fluctuate over time, meaning it is unrealistic to assume the same reinvestment rate to be achieved throughout the bond's life.
Despite these limitations, investors understand the constraints of yield maturity, and it remains one of the central benchmarks in bond valuation, given its importance for market participants.
Let's take a closer look at yield to maturity.
Yield to maturity consists of three key components, the coupon payments, reinvestment returns, and changes in the bond price.
Coupon payments are the periodic interest payments made by the bond issuer to the bond holder, which are a primary source of return.
The term reinvestment returns refers to the potential returns earned if the bond holder reinvests the coupon payments received at the same rate as the bond's yields maturity until maturity.
While this assumption is theoretically important, it is often unrealistic due to fluctuating interest rates.
However, this reinvestment assumption applies only to the coupon payments, not the bond's notional or principle amount.
Therefore, in cases where the coupon payments are relatively low, the impact of this assumption becomes less significant.
The bond price, on the other hand, plays a crucial role because if an investor buys a bond below par at a discount and the bond is redeemed at par, which is the standard practice in bond markets, the investor receives a return in the form of a capital gain.
Conversely, if an investor purchases the bond at a price above par premium and it is redeemed at par, this results in capital losses, which reduces the overall return of the bond position, or in other words, reduces its yield.
