A Yield is a rate that shows the return you get on a bond. The basic yield formula is: yield = coupon amount / price. There are a few kinds of yield related to bonds; when investors or analysts refer to yield, they usually mean the yield to maturity (YTM). YTM measures the annual return earned of an investor if he holds this bond until maturity, it is essentially the IRR. If the investor buys a bond today at market price and he holds the bond until maturity, assuming all the coupons and principal will be received as scheduled, he will receive a rate of return equal to the YTM (or the IRR). The following equation will help us understand the YTM as it relates to the market price of a bond. Note that the final cash flow should include both the principal and the coupon. If the coupon is not received annually, we can annualize the yield using the same technique of calculating EAR.
If the YTM is less (greater) than the bond’s coupon rate, the market price is greater (lesser) than the par value, and we say the bond is selling at a premium (at a discount). If YTM is more than the coupon rate, we say the bond is selling at a discount. If the YTM is equal to the coupon rate, the bond is trading at its par value (selling at par).
The calculation of YTM can be very complicated due to some complex coupon structures, therefore the calculation is usually performed with a financial calculator or Excel.
Other types of yield used in bond valuation are:
- Nominal yield or coupon yield = total coupons paid during one year / face value of the bond. Fixed at issuance.
- Current yield = total coupons paid during one year/ current market price of the bond