What is Yield to Maturity (YTM)? Definition, Formula and Calculation
Yield, maturity, coupon, and yield to maturity are a few terms debt securities investors need to be familiar with. These values can drive an investor’s decision on whether to purchase and hold a bond for better returns in the long run. Yield to maturity helps bond investors determine the total returns they can expect from bond investments.
If you’re planning to invest in bonds, the following sections could help you make informed investment decisions. Read on!
What is the Yield to Maturity (YTM) of a Bond?
Yield to maturity refers to the total returns expected on a bond upon its maturity. Yield to maturity consists of two important terms “Yield” and “Maturity.” Yield is the annual return on investment. It includes both the dividends and interests you can receive from an investment during its tenure. Investors and analysts express yield in percentage.
Maturity is the last date that marks the end of an investment period for debt securities. As the maturity gets over, investors receive their promised payments. Combining these two words helps us get an outline of what yield to maturity is.
Yield-to-maturity is an important term for any investor who wishes to invest in debt mutual funds. As the name suggests, YTM gives investors an idea of returns for holding their bonds till “maturity.” YTM is the total return investors can expect if they keep their money until maturity. It is expressed as an annual rate.
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Now let’s deep dive into yield to maturity.
How Does the Yield to Maturity Value Work?
Yield-to-maturity is an internal rate of return that a bond can generate by its maturity date. The present purchase value of a bond can help you calculate its future cash flow. Although yield to maturity is the annual representation of bond returns, it is calculated based on six months.
However, a volatile market affects bond prices, which fluctuate with interest rates. It is here where the coupon rate comes to play. A bond’s coupon rate stays constant until maturity. The cost and yield of that bond will change as per the market but not coupon rates.
As the interest rate in the market falls below the coupon rates, bond prices tend to increase. This makes a bond attractive to investors. However, when the interest rate increases above the coupon rate, bond prices fall.
When the market interest rate is at par with a bond’s coupon rate, you may observe an average bond price. Therefore, while calculating YTM, investors require assuming that a bond’s current yield and coupon payment are similar during reinvestment.
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Why is Yield to Maturity Important?
The importance of calculating yield to maturity is given below:
- First, it helps investors understand how market changes can affect their debt portfolios based on yield and price fluctuations.
- Investors can use YTM to determine which securities they can add to diversify their investments.
- YTM allows investors to draw a comparative study and make an informed decision before investing in a bond.
- Investors can anticipate whether a bond they choose will bring in good returns compared to their current status.
- Time value of money helps in better analysis of a bond’s future returns while calculating YTM.
How to Calculate Yield to Maturity?
Yield to Maturity Formula:
You can use the YTM formula to calculate a bond’s yield to maturity.
Yield to Maturity formula= [C+ {(F-P)/N}] / [{(F+P)/2}]
Here, C= Coupon rate, F= bond’s face value, N= years for the bond to mature, and P is the bond’s current market value.
Yield to Maturity Calculation:
Investors need to know the bond’s current value to calculate the yield-to-maturity ratio. Therefore, analysts use different trial and error methods by assuming various interest rates to calculate the bond price. This process continues until the bond’s current value matches its market price.
The formula to calculate a bond’s current value is given below.
Present value of Bond (P) = [C/ (1+R)] + [C/ (1+R) ^2] +…..+ [C/ (1+R) ^t] + [ F/ (1+r)^t]
Example of Yield to Maturity Calculation
To understand the calculation of YTM, let’s consider the following example.
A corporate bond currently trading at Rs.95.92 has a face value of Rs.100. The bond’s coupon rate is 5% and has 3 years to mature.
Let’s calculate the yield-to-maturity of the bond as per the formula [C+ {(F-P)/N}] / [{(F+P)/2}]
YTM= [5+ {(100-95.92)/3}] / [{(100+95.92)/2}]
YTM= 6.542%
Therefore we see that yield-to-maturity of this corporate bond is 6.54%
By now, it must be evident that the manual calculation of YTM is quite complicated and time-consuming. Instead, you can opt for yield-to-maturity calculators available online to end the hassle.
What are the Variations of Yield to Maturity (YTM)?
There are three variations to yield-to-maturity.
1. Yield to Call
In this variation, bond issuers must redeem their bond before it matures. Therefore, as the bond is redeemed before maturity, a YTC bond has a shorter cash flow period.
An issuer ‘calls’ a bond to reduce debt structure or refinance it during a low-interest period.
Yield to call formula = (C/2)* {(1-(1+ YTC/2)^ -2t) / (YTC/2)}+ (CP/(1+ YTC/2)^2t)
Here, C is the annual coupon rate, YTC is yield to call, t is remaining time before call date, and CP is the call price.
2. Yield to Put
Like yield to call, a bondholder can sell the bond back to the issuer at a special rate on a fixed date.
3. Yield to Worst
This variation generally brings in the lowest yield compared to other YTM variants, provided no defaulting exists. An issuer can put, call or exchange a yield to the worst bond before it matures.
How is YTM Useful for an investor?
Yield to maturity is useful for investors in the following ways:
- One can determine if a particular bond is a worthwhile investment.
- It helps an investor to compare one bond with another and decide which is the best buy to gain after maturity.
- Investors can also use YTM to compare maturity terms of bonds and determine the returns from each security.
- They can anticipate how market changes can affect their portfolio with YTM computation.
- Investors can use the yield to maturity value to compute market-related risks and the susceptibility of a bond’s price.
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What are the Limitations of Yield to Maturity?
The limitations of the yield to maturity metric are given below:
- Yield to maturity provides a result based on estimations or approximations. This makes YTM less likely to be reliable.
- YTM computations do not account for an investor’s taxes on bonds.
- It anticipates the future, which might or might not be true.
- The YTM formula does not take bond investment risks into consideration.
- The formula also does not capture the transaction costs, brokerage, and expense ratio into consideration.
Final Word
To conclude, YTM or yield to maturity is an essential metric that allows an investor to anticipate future cash flows of a bond if they hold it till maturity.
It further helps them consider which bond to invest on for better returns in the long run. This has been all about yield to maturity and its importance for investors.
FAQs
Ans: Yield is calculated as the net cash flow divided by the current market value or principal investment. The formula for calculating yield is-
Current yield formula= Annual cash flow / Market price
Ans: A Yield to Maturity higher than coupon rate indicates that the bond is sold at a discount to its face value. However, if YTM is lower than the coupon rate, the bond is sold at a premium price.
Ans: The current yield of a bond is its annual income divided by the securities’ current price. This current yield gives a realistic picture of a bond’s worth.
Ans: Whether a high or low yield to maturity value is better depends on your risk-taking capacity. For instance, if you can sustain a high-risk investment for higher returns, you may opt for a high YTM.
However, investors not comfortable with risky investments can choose a low YTM. Furthermore, opting for both high and low-risk yields to maturity can result in a proper diversification in your portfolio.
Ans: To calculate yield to maturity using trial and error, you need to assume various rates as the bond’s present value. This calculation has to go on until your answer is equivalent to the current market price of a bond.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
