Understanding Yield to Maturity (YTM) and Factors Affecting Yield

Yield to Maturity (YTM) is a fundamental concept in fixed-income investing. It represents the total return an investor can expect to earn if a bond is held until maturity, assuming all interest payments are reinvested at the same rate as the bond’s current yield. YTM is essentially the internal rate of return for a bond, considering the bond’s current market price, par value, coupon payments, and time to maturity.

YTM is not easily calculated because it requires solving for the discount rate (r) in the bond pricing formula, which equates the present value of the bond’s future cash flows (coupon payments and principal repayment) to its current market price. The formula is as follows:

where

p = current market price of the bond

c = coupon payment

F = face value of the bond

n = number of periods until maturity

t = each period

Since solving for r is complex, iterative methods or financial calculators are typically used to compute YTM.

Factors Affecting Yield

Market interest rates, such as the Overnight Policy Rate set by Bank Negara Malaysia, are the primary determinant of bond yields and have a direct impact on price movements. Bond prices and yields are inversely related. When market interest rates increase, bond prices fall, resulting in a higher YTM, and vice versa.

This inverse relationship exists because the fixed coupon payments of a bond become less attractive when interest rates rise. For example, if new bonds are issued with higher coupon rates to reflect the increased market rates, existing bonds with lower coupon rates must be sold at a discount to offer competitive yields. This price adjustment ensures that the YTM for older bonds aligns with the returns available in the market for newly issued bonds

Inflation expectations play a significant role in shaping market interest rates. When inflation is expected to rise, central banks may increase benchmark rates to curb inflationary pressures. Higher expected inflation erodes the purchasing power of future bond payments, making existing bonds less appealing to investors. To compensate, bond prices fall, leading to an increase in yields. Conversely, when inflation expectations are low, interest rates tend to decline, which supports higher bond prices and lowers yields

When interest rates decrease, newly issued bonds offer lower coupon rates. In this scenario, existing bonds with higher coupon rates become more desirable, leading to an increase in their prices. This price increase lowers the YTM of those bonds, aligning them with the lower prevailing market rates.

This relationship is fundamental to bond pricing and reflects the opportunity cost faced by investors. Investors compare the return on an existing bond to the returns available in the market. As interest rates fluctuate, influenced by factors like inflation expectations, bond prices adjust to ensure yields remain consistent with market expectations and risk levels.

Credit risk is another important determinant of bond yields. Bonds with higher credit risk, indicated by lower credit ratings, typically offer higher YTM to compensate investors for the additional risk of potential default.

Issuers with lower creditworthiness are likely to offer higher yields to attract investors to take on the added risk. Creditworthiness is often evaluated by rating agencies, which assign credit ratings based on the financial stability and repayment capacity of the issuer. In Malaysia, credit rating agencies such as RAM Rating Services Berhad and Malaysian Rating Corporation Berhad play a significant role in assessing and assigning these ratings.

Changes in an issuer’s credit rating, whether an upgrade or downgrade, can affect a bond’s yield. A downgrade signals increased credit risk, leading to higher yields as investors demand greater compensation. Conversely, an upgrade reflects improved creditworthiness, often resulting in lower yields as the bond becomes less risky.

The term structure of interest rates refers to the relationship between bond yields and their maturities, which is depicted by the yield curve. The yield curve reflects market expectations for future interest rates and economic conditions. Typically, longer-term bonds offer higher yields due to the increased risk associated with holding them over time, which results in a positively sloped yield curve. 

In addition to the time-related risks, longer-term bonds may also include a liquidity premium, which compensates investors for the risk of holding a less liquid asset for an extended period. An inverted yield curve, however, occurs when longer-term bonds offer lower yields than shorter-term bonds. This phenomenon is often considered one of the most reliable indicators of an impending recession, as it reflects investors’ expectations for a decline in long-term interest rates and diminished confidence in the economy’s future growth.

Bond features, such as the coupon rate, can also influence bond yields. Bonds with higher coupon rates typically experience lower price volatility, resulting in lower yields compared to bonds with lower coupon rates. This is because higher coupon payments provide a steady stream of income, reducing the price sensitivity to interest rate changes.

Some bonds come with a callable feature, which allows the issuer to redeem the bond before its maturity. Callable bonds usually offer higher yields to compensate investors for the call risk. The issuer may choose to exercise the call option when market interest rates are low, which allows the issuer to redeem the outstanding bonds at a predetermined call price. This is favourable for the issuer because the bonds become expensive to service when interest rates are low, and they can refinance the debt by issuing new bonds at lower yields.

On the other hand, puttable bonds, which give bondholders the right to sell the bonds back to the issuer before maturity, tend to have lower yields. The put option provides additional protection to investors by allowing bondholders to sell the bonds if interest rates rise or if the issuer’s creditworthiness deteriorates, making these bonds less risky for investors and thus lowering their yields.

Economic and market conditions play a significant role in determining bond yields. For instance, periods of strong economic growth often lead to higher inflation expectations, which can prompt central banks to raise interest rates. This, in turn, typically results in higher bond yields. Conversely, during economic downturns, inflation expectations tend to decrease, which may lead to lower interest rates and bond yields.

Investor demand for bonds is also influenced by market sentiment, including factors such as geopolitical events and changes in monetary policy. For example, political instability or conflicts can increase uncertainty, causing investors to seek safer assets like bonds, thereby pushing yields lower. Similarly, shifts in monetary policy, such as interest rate cuts or quantitative easing, can impact bond prices and yields by altering the overall economic environment.

Conclusion

Yield to Maturity is a key indicator of a bond’s total return, taking into account all future cash flows and the time value of money. A good understanding of the various determinants of YTM, such as interest rates, credit risk, bond maturities, bond features, and broader economic conditions, will help investors make more informed decisions in the fixed-income market. By analysing these factors, investors can more effectively evaluate the risks and potential returns associated with their bond investments.