Introduction
When someone says bond, how often does your mind immediately jump to a certain suave and glib individual dressed in impeccable suits? Fast car chases, surreal locations, awesome gadgets, beautiful ladies and a high probability of STDs. Oh, and the subtle yet menacing villain with the most devious and convoluted plans for global destruction, a boss who is always deprecative yet authoritative, a sad receptionist who is most times overlooked and a science whiz with the most ingenious weapon ideas. Typical Bond. My mind immediately goes to this Bond. The fly detective who always saves the world.
Most times though, in the real world, when adults utter the word, it isn’t the spy they are talking about. They talk of bonds in financial terms. A bond is a kind of loan. It is a loan offered by an investor to a borrower like a company or the government. The bond is issued by the borrower to raise money from the investors so they, the borrowers, can fund their operations. People invest in bonds as it offers an added income. The first way to make money from bonds is to hold the bond till its maturity date and reap the profits from the interest on the bonds. The second way is to sell the bond at a higher price than the amount paid for the purchase.
Yield to Maturity vs Discount Rate
When an investor wishes to purchase bonds, they ought to look into these terms – yield to maturity and the discount rate. They sound confusing but are important to know. Yield to maturity is the percentage of return from the purchase of a bond assuming that the investor has held the bond till its maturity. A discount rate, on the other hand, is the periodic amount of interest or the interest rate the investor will receive from the purchase of the bond. Let us see how these terms further differ from each other.
Differences Between Yield to Maturity and Discount Rate in a Tabular Form
Parameters of Comparison | Yield to Maturity | Discount Rate |
Definition | Yield to maturity is the annual estimated rate of return from an asset, assuming that the investor holds the asset till its maturity. | A discount rate is a rate charged by commercial banks for lending funds. |
Purpose | Yield to maturity is used to find the total return of a bond investment. | A discount rate is used to discount the future cash flows back to their present values. |
Advantage | One can compare the yield to maturity to the present value. | A discount rate is relatively cheaper; thus, one can easily borrow money from commercial banks. |
Disadvantage | With yield to maturity, the investment maturity has to be held up to receive the benefits. | With discount rates dependent on the market, a drop in the market values could lead to consequences. |
Also known as | Yield to maturity is also known as the book yield or the redemption yield. | A discount rate is also known as the bank rate. |
Calculation | Yield to maturity is calculated using a formula. It is complex and intricate. | A discount rate is fairly easy to calculate and does not require a formula. |
Term | Yield to maturity is usually from a long-term investment with a bond. | A discount rate is applicable for short-term loans. |
What is Yield to Maturity?
Yield to maturity is the rate of total return. It is an estimated rate dependent on whether or not an investor holds a bond till its maturity date. The investor must reinvest the interest payments at the same rate. Yield to maturity is a long-term bond yield but is calculated at an annual rate. It is essentially the internal rate of return (IRR) or the return on the investment associated with buying the bond and reinvesting the coupon payments at a fixed interest rate. Yield to maturity is also known as redemption yield or book yield.
In the market, a bond’s yield can be expressed as the effective rate of return. It is dependent on the actual market price of the bond. As interest rates of bonds rise and fall, the market prices of the bonds will also see a change as the sellers or buyers of the bonds will find the yield more or less attractive at the new rates. Therefore, it can be seen that yield to maturity and bond prices are inversely proportional i.e., they move in opposite directions.
The calculation of yield to maturity comprises the potential gains or losses an investor might face with the changes in the market prices. Calculating yield to maturity is a complex process that requires coupon rates, interests etc.
Yield to maturity is useful to determine if purchasing a bond is a good investment or not. Once the investor knows the yield to maturity of a bond that they are considering buying, they can compare it to the required figures and conclude its usefulness. Since yield to maturity is expressed at an annual rate (irrespective of the period of maturity), it can be used to compare bonds that have different maturities as the value of different bonds is expressed at an annual rate too.
Yield to maturity has a few common variations. They are as follows:
- Yield to call: this assumes that a bond will be called or repurchased by the issuer before the bond reaches its maturity. This leads to a shorter cash flow period.
- Yield to put: this is similar to yield to call only here, the holder of the put bond can choose to sell the bond back to the issuer at a fixed price based on the terms of purchase of the bond.
- Yield to worst: this is the yield calculation when the bond has multiple options. For example, when an investor is evaluating a bond with both the provisions – call and put – they would calculate the yield to worst depending on the option terms that have the lowest yield.
What is a Discount Rate?
A discount rate is the rate charged by a bank when it lends funds. It is often offered in the terms of a short-term loan of twenty-four hours or less. By managing discount rates, the central bank can affect economic activity. Lower the rates, the expansion of the companies becomes possible as costs of funds for borrowers are reduced. Higher rates help reign in the economy when inflation is higher than necessary. The discount rate is also known as the bank rate.
Banks usually avoid taking such loans as it shows a sign of weakness. The discount rate for a bank is decided by the Board of Directors of regional Federal Banks every fourteen days and this rate is approved by the Board of Governors of the Federal Reserve System.
Banks that borrow from the Federal Banks fall under three categories. They are as follows:
- The primary credit program: this is the first tier. It is when the Federal Bank provides capital to the banks with good credit. This discount rate is usually set above the market value and
- The secondary credit program: this is the second tier. It is when the Federal Bank offers the loan at a higher rate than the primary rate to banks that do not qualify for primary credit. These banks are smaller and may not be as financially healthy as the ones in the first tier.
- The seasonal credit program: this is the third tier. It is when the Federal Bank provides loans to banks with seasonal needs in places like farming (agriculture) and resort communities (tourism). These are smaller financial institutions with higher seasonal variations in their cash flows. Their businesses are relatively risky and thus, the interest rates are higher.
Borrowing money from the Federal Bank is rare and the smaller banks use this option sparingly. They use it only when they cannot find other willing lenders in the market. The discount rates offered by the Federal Bank are relatively higher than the inter-bank borrowing rates. These discounted loans are considered to be an emergency option for banks in distress. Borrowing from the Federal Bank, as already mentioned, is a sign of weakness to other market participants and investors. In countries other than the United States, the central banks use similar measures in different variants.
A discount rate is also a term used to determine the present value of future cash flows in the analysis of discounted cash flows (DCFs).
This discount rate is utilized by companies to calculate the Net Present Value (NPV). It is also used for the following reasons:
- To account for the riskiness of an investment
- To account for the time value of money
- To represent the opportunity cost of the business
- To act as a hurdle rate for decisions about investments
- To make different investments comparable
Main Differences Between Yield to Maturity and Discount Rate In Points
Following are the main differences between yield to maturity and discount rate:
- Yield to maturity is the percentage rate of return from a bond assuming that the investor holds the bond until its maturity. A discount rate is the rate charged by banks when they lend funds.
- Yield to maturity is used to find the total return an investor can gain from holding the bond to maturity, while a discount rate is used to discount the future cash flows to their present value.
- The advantage of yield to maturity is that it can be compared to the present value, while the advantage of a discount rate is that it is more affordable; thus, one can easily borrow money from commercial banks.
- The disadvantage of yield to maturity is that the profits will be gained by the investor only after the bond achieves maturity, whereas the disadvantage of a discount rate is that it is dependent on the market. A rise or fall in the market values determines the consequences.
- Yield to maturity is also known as a book yield or a redemption yield, while a discount rate is also known as a bank rate.
- Yield to maturity is very complicated to calculate, while it is fairly easy to calculate the discount rate.
- Yield to maturity has a complex formula for its calculation. A discount rate, on the other hand, has no specific formula for calculation.
- Yield to maturity is the yield anticipated from a long-term bond investment, whereas a discount rate is a rate charged for short-term loans.
Conclusion
Yield to maturity and discount rates are both used to determine the highs and lows of the market. Yield to maturity is the percentage rate of the total return from an investment in a bond assuming that the investor will hold the bond till it reaches its maturity date. Investors use yield to maturity to calculate the differences and yields from the money that they have invested. Calculating the yield to maturity is a complex process and involves complicated formulae. It helps analyze the financial situation of the company in the market and might help improve the investor’s portfolio. Yield to maturity can be obtained only on the long-term investment of a bond.
A discount rate, on the other hand, applies to the short-term loans provided by the central bank or the federal bank to the banks in need. It is the rate charged by the bank that lends funds to the other banks. The discount rates offered by banks can regulate market prices. Higher rates reign in the economy at the time of inflation and lower rates help the expansion of companies. Discount rates from the Federal Bank are issued at a higher rate than the market value and other banks use the option of obtaining loans from the Federal Bank sparingly since it is a sign of weakness. Calculating discount rates is fairly easy in comparison with calculating the yield to maturity. The term discount rate is also used to determine the present rate of future cash flows in the discount cash flow (DCF) analysis. Thus, the only similarity with these terms is that they help navigate the market. They are each applied to different scenarios and learning the significance of both helps keep one well-equipped to make sound investments in the dynamic market and also not immediately picture a certain someone when the word ‘bond’ is uttered. Although, the latter poses no harm.
References
- https://www.fool.com/investing/how-to-invest/bonds/
- https://economictimes.indiatimes.com/definition/bank-rate
- https://corporatefinanceinstitute.com/resources/knowledge/finance/discount-rate/
- https://smartasset.com/investing/discount-rate