Yield to Maturity
Yield is a calculation of the cash flow of the project over time which is expressed as a percentage. It takes into account all dividends or interest earned during the investment period. When a bond is held till maturity, the total return expected on it is called yield to maturity. It is also known as book yield or redemption yield. It is an annualized rate of return. It works on the belief that the security is purchased at the current price and is held till maturity and all interest and coupon payments are made in a timely manner. The YTM has some variants namely:
- Yield to call: When the bond can be repurchased by the issuer before maturity it is known as yield to call.
- Yield to put: The bondholder has the option to sell the bond back to the issuer at a fixed rate on a specified date.
- Yield to worst: It is the lowest yield of YTM, YTP, YTC, and others.
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Yield to maturity (YTM) refers to an investor’s total expected return if the bond is held to maturity. All present values of future cash flow from an investment that equals the current market price are factored in by YTM. This is, however, dependent on the premise that all proceeds are invested back at a steady rate and that the investment is kept until maturity. An investor knows the price of the bond, the coupon payments, and the maturity value. However, the discount rate has to be determined and this discount rate is the yield to maturity.
How is it calculated?
Yield to maturity is calculated with the help of the following formula:
Let us take a few examples to understand how the yield to maturity formula works.
Example 1.
A bond has a market value of 900$ and the face value of the same is 1500$. The yearly coupons are priced at $200 and have a coupon rate of 15% which will mature in 6 years.
MP – 900$
FP – 1500$
C- 200$
n- 6 years
YTM = {C+ [ (FP- MP)/n]} / [(FP + MP)/2]
= {200+ [(1500-900)/6]} / [(1500+900)/2]
= [ 200 + (600/6)] / (2400/2)
= (200+100) / 1200
= (300) / (1200)
= 25%
The YTM is 25%
Example 2
A company issues 10% annual bonds of Rs 3000 whose Market Price is Rs 2800 which matures after 4 years having a coupon rate of 10%. Calculate YTM.
C= 300
FV= 3000
MP= 2800
N= 4
YTM= {C+ [ (FP- MP)/n]} / [(FP + MP)/2]
= {300+ [(3000-2800)/4]} / [(3000+2800)/2]
= [ 300 + (200/4)] / (5800/2)
= (300+50) / (2900)
= (350) / (2900)
= 12.07 %
The YTM is 12.07 %
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Coupon rate vs YTM
- The bond is known to be sold at a discount if the bond’s coupon rate is less than YTM.
- The bond is known to be sold at a premium if the bond’s coupon rate is more than YTM.
- The bond is known to be sold at par if the bond’s coupon rate is equal to its YTM.
Limitations:
- The bond is to be held till maturity which is practically impossible as there are various options of bonds that can help to earn better in a short span.
- The rate of investment is the same for all investments so a smart investor will always look for better options.
- Yield to Maturity YTM does not imply taxes to be paid by an investor on their bond investments.
- YTM estimates do not take into account the expenses associated with the purchase and sale of the bond.
Final Thought:
Yield to maturity is the internal rate of return (IRR) of a bond investment if you hold the bond until maturity and all payments made as scheduled and reinvested at the same rate.YTM is a very important concept to be understood before investing in bonds. YTM enables an investor to decide whether an investment is good or bad. A comparison of different bonds helps to decide which investment will be fruitful on maturity. The most important thing is that it gives the investor the expected returns.
Author: Urvi Surti
About the Author: Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).
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