What is Yield to Maturity (YTM)?
Yield to maturity is a long-term bond yield that comes in the form of an annual rate. It is an investment’s internal rate of return, and it occurs only when the investor makes all the payments according to the schedule and reinvests at the same rate until the bond reaches maturity. Yield to maturity is also called redemption yield or book yield. It accounts for the current value of the bond’s future payments along with the factors in the time value of money. Review the following sections to find out how to calculate the yield to maturity, and what its limitations are.
How to Calculate Yield to Maturity?
It is necessary to learn how to estimate the yield to maturity since it is frequently used as a return metric for fixed-income investments and evaluating potential bonds. The YTM is based on some of the following assumptions:
- The coupon payments are reinvested at the same rate as the YTM.
- All the needed principal and interest payments were made on time
- The return is made on the assumption that the investor has held onto the instrument till maturity.
The discount rate in the yield to maturity makes the present value equal to the current market price of all the future cash flows of the bond. It facilitates a comparison between different bonds and what their expected return can be. This helps investors make informed decisions on how they can manage their portfolios better.
Yield to Maturity: Formula
Calculate the yield to maturity by using the following formula:
Where:
C = Coupon payment
P = Current price of the bond
F = Face value of the bond
n = Number of periods until maturity
To clarify the distinction between F and P, consider the following two points:
- Present Value (P): A bond’s present value is the current market price and how much the investors want to pay in the open market for the bond at the current date. It can be lower or higher than the bond’s face value based on the demand and supply and the market conditions.
- Face Value (F): A bond’s face value is also called the par value. It is the amount that has to be repaid to the investor on the date of maturity.
Yield to Maturity: Limitations
The YTM is used for comparing debt mutual funds and bonds, but it also has the following limitations:
Number of Assumptions
The yield-to-maturity calculation considers a lot of assumptions, including the future interest, the coupon payment, the bond’s price, etc. It is also assumed that all the coupons are reinvested at the same coupon in the bond. However, it may not be viable since the price can fluctuate. Also, the return can be different compared to the yield to maturity since the market can change at any time.
Risk
The YTM formula does not consider the risks that come with bond investment, including reinvestment or default risk.
Wrapping Up!
The yield to maturity of a bond is the internal rate of return needed for the future cash flows’ present value. It also considers the coupon payments and face value to make the current value equal to the bond price. The yield-to-maturity formula works under the assumption that every coupon payment is invested again at a yield equal to the YTM. It also assumes that the bond is held till maturity.
FAQs About What is Yield to Maturity (YTM)?
1. What does a higher yield to maturity mean?
A higher yield to maturity indicates a high return but also suggests the bond’s availability for less than its par value. Also, higher YTM also indicates a higher risk or discount from the bond’s face value. This leads to bargain opportunities where the investor must determine whether the fundamentals justify the discount or not.
2. Is there any difference between the bond’s yield to maturity and its coupon rate?
The primary difference between the coupon rate and the yield to maturity is that the YTM fluctuates, and the coupon rate is fixed. The yield changes depending on the interest rates available in the market and the price paid for the bond. Whereas, the coupon rate is contractually fixed.
3. Why is the yield to maturity important?
The YTM is important since it allows investors to compare the bonds and the returns they can expect to receive. It also helps in understanding how the market changes constantly and how it affects investments.
