Yield To Maturity Explained
Last Updated on December 28, 2023 by BFSLTeam BFSLTeam
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held till the time it matures. In other words, YTM is the rate of return that an investor would receive if they bought a bond at its current market price and held it until the bond’s maturity date, receiving all interest payments and the principal repayment.
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What is Yield to Maturity in Bonds (YTM)?
Yield to maturity (YTM) is the total return anticipated on a bond if it is held until maturity. It represents the average annual return earned by an investor who purchases a bond at its current market price and holds it until maturity, collecting all interest and principal payments due.
Bond YTM takes into account the bond’s coupon rate, the purchase price of the bond, the time remaining until maturity, and the face value of the bond. It is expressed as an annual percentage rate and is a key measure used by investors to compare the expected return of different bonds.
YTM assumes that all coupon payments are reinvested at the same rate until the bond matures and that the bond issuer will fulfil its obligation to pay both interest and principal at maturity. However, YTM is a theoretical calculation and does not account for factors such as changes in interest rates or credit risk that may affect the actual return of a bond investment.
How to Calculate Yield to Maturity (YTM)?
Although one may find a YTM calculator on the internet. But it is equally important to understand the YTM formula. The YTM calculation involves estimating the present value of all future cash flows from a bond, including interest payments and the return of principal at maturity. The YTM formula is as follows:
YTM = [(C + (F-P)/n) / ((F+P)/2)] x 100%
Where:
C = annual coupon payment
F = face value of the bond
P = purchase price of the bond
n = years until maturity
Example
Suppose an investor purchases a bond with a face value of Rs 1,000, a coupon rate of 5%, and 10 years remaining until maturity, at a price of Rs 900. The YTM can be calculated as follows:
YTM = [(50 + (1000-900)/10) / ((1000+900)/2)] x 100%
YTM = 6.85%
Therefore, the expected annual return on this bond is 6.85%.
Advantages of Yield to Maturity
- Comprehensive measure of expected return: YTM takes into account all future cash flows, including coupon payments and principal repayment, and provides a more accurate estimate of expected return than just looking at the coupon rate.
- Facilitates comparison between different bonds: YTM allows investors to compare the expected returns of different bonds, even if they have different coupon rates, face values, and maturities.
- Useful for bond pricing: YTM can be used to calculate the fair value of a bond, which is helpful for making investment decisions.
Disadvantages of Yield to Maturity (YTM)
- Assumes a constant interest rate: YTM assumes that interest rates remain constant over the life of the bond, which may not be the case in practice. If interest rates change, the YTM may no longer accurately reflect the expected return on the bond.
- Ignores reinvestment risk: YTM assumes that all coupon payments are reinvested at the same rate as the YTM, which may not be realistic in practice. Reinvestment risk arises from the uncertainty of future reinvestment rates.
- Ignores credit risk: YTM assumes that the issuer will fulfill all of its obligations under the bond contract, which may not be the case if the issuer defaults.
- Limited to fixed-rate bonds: YTM is most useful for analyzing fixed-rate bonds. It may not be appropriate for bonds with variable coupon rates or complex cash flows.
- May not be suitable for short-term bonds: YTM is designed for analyzing long-term bonds with many years until maturity. It may not be suitable for short-term bonds with a maturity of less than one year.
Final Thought
In conclusion, Yield to Maturity (YTM) is an important measure for investors to consider when analysing bond investments. It takes into account all future cash flows and provides a comprehensive estimate of expected return, facilitating comparison between different bonds. However, it is important to note that YTM has its limitations, such as assuming a constant interest rate, ignoring reinvestment risk, and credit risk. Ultimately, investors should use YTM as a tool, alongside other factors such as creditworthiness and market conditions, to make informed investment decisions.
Disclaimer: Investments in securities markets are subject to market risks, read all the related documents carefully before investing.
