What is Yield to Maturity (YTM)?

Though issuing equity is a popular way for organizations to raise money, some organizations consider issuing debt securities, too. They are like bonds through which the government and some corporations borrow money from the public. At the time of issue, they promise to repay the fund acquired, at a particular time in the future, with interest. Debt securities are also called fixed-income securities.

The interest is a return for investors in exchange for the funds invested. When interest rate is an important factor to consider, the investor must understand and calculate yield to maturity while investing in debt securities.

This article spotlights what is a yield to maturity, how is it calculated, an example, and the uses of YTM.

Understand Yield to Maturity (YTM)?

The term Yield to maturity is made up of two key terms– ‘Yield’ and ‘maturity’. Yield means the return investor gets from the debt security for a specific time. The yield can be calculated by dividing the interest amount by the price of that debt security. Maturity means a predetermined date on which the issuer of the debt security is obliged to repay the principal amount.

The Yield to maturity (YTM) refers to the expected annual rate of return on a debt security if it is held till the maturity date. It is the rate of return the bondholder can expect if:

• (I) the bond is held till the maturity date
• (II) principal repayment and all the interest payments were made timely, and
• (III) interest payments are reinvested at the same rate as YTM. Yield to maturity is also termed as ‘book yield’ or ‘redemption yield’.

It can be also defined as the internal rate of return (IRR) on a debt security. This means the rate which leads to equal the present value of the security’s future cash flow to its market value. Therefore, YTM is a time-weighted rate.

There is a thin line of difference between the current yield and Yield to Maturity. The main point of difference is the consideration of the time value of money. The current yield presents the expected return for the bondholder if it is held for one year, whereas, YTM involves discounting the future interest payments, rather than only considering present value.

Another difference is that the interest rate remains constant over time, whereas, YTM tends to vary with changes in the market price of the bond. If the bond is traded at discount, YTM will be higher, as the investor will get the par value at the maturity. On the contrary, if the bond is traded at a higher price than face value, the YTM will be lower as the investor will get face value at the time of repayment.

Most of the time, the yield to maturity concept is useful for bonds, and debt funds. In addition to returns, YTM gives investors an idea about the potential risk involved in the case of debt funds. If the debt funds provide a higher yield, it signals more risk. The reason is usually debt funds constituting bonds with lower credit ratings provide higher yield due to high risk.

One of the major problems with Yield to maturity is that it avoids the reinvestment risk. The concept of YTM by nature assumes that all the interest payments are reinvested. Though, in unfavourable situations, reinvestment may not prove to be a good option. Another drawback is that YTM gives an estimated and not accurate figure. Though due to more benefits, it is considered a wholesome measure for estimating the returns.

Calculating YTM

The Yield to Maturity can be calculated using the following formula.

YTM = [Annual interest + {(FV - Price)/Maturity}] / [(FV + Price)/2]

Here,

Annual Interest - Interest/coupon payment every year

FV - Face Value of the bond

Price - Present value/ current market price of the bond

Maturity - Number of years till the maturity of Bond

If there are multiple bonds, the YTM can be arrived at by calculating the weightage average of the YTM of all bonds in the portfolio.

Here is an example of Yield to maturity for a single bond.

Example

A bond is currently traded at Rs. 800 in the market. Though, it was issued at Rs. 1000. On this bond, the yearly interest payout is Rs. 80. The coupon rate for the bond is 8%. The bond will reach maturity in 7 years.

The YTM can be calculated as under.

YTM = [Annual interest + {(FV - Price)/Maturity}] / [(FV + Price)/2]

= [80 + {(1000 - 800)/7}] / [ (1000 + 800) / 2]

= 12.06%

Thus, the YTM on the bond is nearly 12.06%.

Uses of YTM

The Yield to Maturity is an important metric for investors since it helps them to make more informed investment decisions. YTM can be compared with the required yield from the bond to decide whether the investor should buy it.

For instance, an investor wants to invest in a bond that can earn him at least a 10% yield. Now, he comes across a bond and calculates its Yield to maturity. The calculation shows that he will get approximately 8% yield out of the bond. He can reject the bond for investment as the yield from the bond doesn’t match his required rate of yield.

It also aids the investors in comparing various bonds and their expected returns. Investors can even compare the bonds with different maturities and interest rates as YTM is presented as annualized rate irrespective of the number of years to maturity.

YTM enables the investor to understand how changes in interest rates may affect their existing investment portfolio. Every change in market price brings potential profit or loss for the bond traders. As market price is a part of the calculation of YTM, it is among the significant factors considered by bond traders.

Yield to maturity holds more importance as it incorporates the concept of the time value of money while calculating the return from bonds.

To sum up, yield to maturity gives investors an idea about an expected annual return from the bond if they stay invested till maturity. The concept of YTM gained additional importance due to the consideration of future cash inflows. Additionally, the bond is marketable security and its price fluctuates over time. The market price also forms part of the calculation of this measure. These all make it a thorough measure of return from debt securities.

Though, a never-changing fact is that the future is uncertain and the market cannot be figured out. The theoretically estimated yield can differ in reality.