Yield-to-maturity is the expected total return or rate of interest an investor would earn, by holding a bond until maturity and reinvesting all cashflows from the bond (coupon payments and principal repayment at maturity) at this rate.
The price of a bond at any time reflects the present value of all its future cash flows. At the time of issue, the bond’s market price is equal to its face value (the issuing price, e.g. ` 1,000) since it is assumed that all coupon payments will be reinvested at the coupon rate, until maturity. The coupon rate at this point, is same as what is currently available in the market for other debt instruments with similar risk and maturity profile. However, as time passes by, the market interest rate fluctuates while the coupon rate on the bond remains fixed. When the market rate rises above the coupon rate being offered on the bond, the bond looks less attractive and starts trading at a discount (price drops below face value). When market interest rates drop below the coupon rate, the bond sells at a premium (price rises above face value).
The calculation for YTM at any point assumes that all coupon payments during the life of the bond, are reinvested at an interest rate such that the present value of these cashflows equals the bonds current market price. This interest rate at which all cashflows are assumed to be reinvested is called the Yield-To-Maturity of the bond, at that point in time.
Suppose a power company, Energy Grid Pvt. Ltd. issues 10% semiannual bonds of face value ` 1,000, and 3 years maturity on 1st Oct. ’18. These bonds will pay 5% coupon or ` 50 every six months until 30th Sept. ’21. The first coupon payment of ` 50 will be received on 31st Mar. ’19, the second coupon will be received on 30th Sept. ’19 and so on. The investor will reinvest these payments at the available interest rate on receiving them. He will receive back his principal of ` 1,000 on maturity (30th Sept. ’21) along with the last coupon payment of ` 50. YTM is the interest rate at which we assume the investor reinvests all these payments.
YTM helps in comparing returns from two bonds or debt investments. YTM is never constant during the life of a bond. If Energy Grid bond sells for less than ` 1,000 today, this implies the current market rate is higher than its coupon rate. Hence YTM at this point will be higher than 10% (coupon rate). If the bond was selling for more than ` 1,000 i.e. the available rates is less than the bond’s coupon rate, YTM would be less than 10%.