Introduction
A coworker was discussing her investments with a broker. She was confused because she had purchased a 10% bond, but the broker kept repeating that it had a 9% yield to maturity. Here, this concept will be explained to help the coworker understand why the broker told her a different rate from the one she thought she was buying.
Valuation of Bonds
First it is necessary to understand some primary concepts, to better understand the term yield to maturity. The most important is what a bond is.
Bond is a paper issued to represent when a company or government borrows money from public or banks and agrees to pay it back later.
The amount of money borrowed is the par value of a bond. Usually, this amount is $1,000.
The third concept is coupons payments, which are like interest. The company makes regular payments to the bondholders, like every six months or every year.
A written agreement between the company and the bondholders is the legal stuff, call indenture. It is declared the amount of the coupons payments and when the money (par value) is going to be paid back to the bondholders.
The date when the company will pay the par value back to the bondholders is called maturity date, and the market interest rate will be the fluctuation of the interest rate of the bonds, which changes every day, based on the market.
One of the good things about bonds is that the interest rates (coupon payment) are fixed. So, if the market goes down or up, the amount will be remain the same. It is good if the market goes down, because the bond becomes valuable with the lower interest rate of the market. However, if the market stays higher, than the bond will lose, because remains the same and the market rate is better.
The present value of a bon ...