Yield to Maturity - Explained
What is a Yield to Maturity?
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Table of ContentsWhat is a Yield To Maturity?How Does a Yield To Maturity Work?Calculating Yield to MaturityCalculating YTM Through Trial-and-ErrorExample of Yield to Maturity Uses of Yield To MaturityVariation of Yield to MaturityYield to Maturity LimitationsConclusion
What is a Yield To Maturity?
Yield to maturity (YTM) refers to the total return someone earns when he or she purchases a bond and holds it to the maturity date. The YTM is also referred to as, book yield or internal rate of return. This type of bond yield is long-term and it is given in terms of the annual percentage rate. It is the overall interest rate which an investor earns when he purchases a bond at the market price holds it to maturity. This is with the assumption that the payment is done in time.
How Does a Yield To Maturity Work?
Though yield to maturity and current yield may show similarities, you can still tell the difference. What makes the two look alike is because they both have to do with bonds. YTM accounts for the returns after the bond reaches maturity, while the current yield represents the returns of the bond at the current time. However, it means that unlike current yield, YTM does factor in time value of money. It also expects returns associated with bonds. On the other hand, the current yield evaluates the association between the current bonds price and its annual interest.
Calculating Yield to Maturity
To be able to calculate YTM, you must understand the connection between the bonds and its yield. You will also need to understand the different types of bond pricing. The bonds price rate can be at a discount, at an average or a premium. When the bond is priced at an average rate, then its interest rate will equal that of its coupon. When the bond rate is placed at the premium rate, its coupon rate becomes higher than its interest. Lastly, when the price is at a discounted rate (below average), it means that the coupon rate is below the interest rate. Therefore, when an investor wants to calculate YTM, he or she will solve the equation by working backward from the present price of the bond. This way, the investor will be able to tell the bonds approximate returns in the current market. Those who calculate YTM assumes that both the coupon payments and the bonds current yield are reinvested at similar rates. They also consider the bonds present market price, the average value, the coupon interest rate, and the maturity period when calculating YTM. Though complex, this method of calculating YTM is accurate and it can help investors to make a comparison between securities and their different maturity terms. Note that, though YTM may represent the annual rate of return on a bond, it is, however, calculated on a six-month basis. This is because the coupon payments are also calculated semi-annually.
Calculating YTM Through Trial-and-Error
Since the process of determining YTM may be complex, one can estimate it by using a bond yield table. Due to the basis point price value, the yields reduces as the bonds price goes up, and vice versa. Because of this, TYM can only be calculated using the trial-and-error method. To be able to calculate YTM using this method, you must first determine the cash flows. The equation for calculating yield to maturity is as follows:
Approximate TYM = (C+ (F-P)/n)/ (F+P)/2
Where: YTM = Yield to Maturity
C = Periodic coupon rate or returns payment
F = Face value (also refers to the value which the bond issuer will give back to the investor at maturity).
P = Bond price (the current bonds market price)
n = Years to Maturity (maturity period)
Example of Yield to Maturity
Let us take, for example, an investor currently holds a bond of a $100 par value, and the bond current price is discounted at $95.92. On the other hand, its maturity period is in 30 months, and it is paying a semi-annual coupon of 5%. In this case, the current bonds yield will be (5% coupon x $100 par value)/ 95.92 market price = 5.21%. After every six months, an investor who is also the bondholder receives a coupon payment of (5% x $ 100)/2= $5. In total, the investor would get 5 payments of $5, plus $100 being the face value of the bond due at maturity.
Uses of Yield To Maturity
YTM can be used in the following ways:
- Helps the investor to do an evaluation of whether or not purchasing a bond is a good business venture (investment). He or she is able to compare the YTM with the required returns to determine if the bond is worth buying.
- It can be used by an investor to draw comparisons between different bonds and the maturity terms. This way the investor will be able to know what to expect from each of the securities.
- With careful attention to assumptions, investors can use TYM to project future market changes and how the changes may affect their investments. For instance, when there is a drop in bond price, the yields rise while an increase in price reduces the yields.
- It can also be used to calculate risk statistics. Various forms of duration and convexity can be used to measure the sensitivity of the bond price to market variations.
Variation of Yield to Maturity
There are various common variations that are worth to note before you begin researching on a particular subject. They are as follows:
- Yield to call - This variation an assumption that the bond is repurchased by the person issuing before its maturity date. This results in a shorter cash flow period.
- Yield to worst - This type of variation, bonds can either be repurchased, put, or exchanged and also have the lowermost yields from YTM and its variant.
- Yield to put - With this particular variation, the holder of this bond can decide to sell the bond back at fixed price value and at a given date.
Yield to Maturity Limitations
YTM does have a few limitations which an investor should consider before making an investment decision.
- The results from YTM calculations are mostly estimated hence making it less reliable.
- Yield to maturity calculations does not account for investors tax payment on the bonds.
Though yield to maturity is calculated through estimation and it is viewed as unreliable, it is still a proven way in which investors can compare different securities in the market. It is ideal for those investors looking to invest in securities. Through YTM, they will be able to know whether or not investing in the securities is worth their time and money.