What is Yield to Maturity?
Yield to Maturity (YTM) shows the internal rate of return of a bond in comparison to its current market price. Other names used for YTM are book yield or redemption yield. YTM represents the anticipated return on a bond based on the assumption that the bondholder holds it until the date of its maturity. Yield to Maturity also assumes that the investor buys a bond at the current market price and all interest payments occur on a timely basis.
How to Calculate Yield to Maturity?
The formula to calculate the Yield to Maturity of a bond is as below.
In the above formula, ‘C’ represents the interest or coupon payment of the bond. ‘FV’ and ‘PV’ denote the face and the present value of the bond. The face value of a bond represents its value when first issued. Usually, the issuer of the bond sets its value at the time of its issuance. Finally, ‘t’ denotes the time it would take for the bond to reach its maturity.
Yield to Maturity vs Current Yield
The Yield to Maturity of a bond is closely related to its Current Yield. The current yield of a bond represents its total cash inflows divided by its market price. Usually, the cash inflows from a bond only consist of the interests received from it, calculated using the face value of the bond multiplied by its applicable interest rate.
A company, Rise Co., issued bonds with a 5% yearly coupon rate. The par value of its bonds is $100. Furthermore, the current market value of the bond is $95. Its maturity period is 10 years. Therefore, using the above formula, the yield to maturity of Rise Co.’s bonds will be as follows.
Yield to Maturity = [($5 + (($100 – $95) / 10)) / (($100 + 95) / 2)]
Yield to Maturity = 5.64%
For the same bond, the current yield will be as follows.
Current Yield = $5 / $95
Current Yield = 5.26%
Importance of Yield to Maturity
Yield to Maturity is a critical metric for investors when deciding whether they want to invest in a bond or dispose of their owned bonds. Investors can calculate the YTM of a bond and compare it with other bonds to decide which of them has the best returns. Similarly, they can use YTM to compare the yields from a bond with their required yield for decision-making. YTM also makes great comparison tools for bonds with different maturities.
Limitations of Yield to Maturity
Despite its uses, Yield to Maturity can also have some limitations. Firstly, YTM does not consider the taxes paid or transaction costs that investors pay for the bond. Similarly, YTM makes some assumptions about the future, which may not be correct. For example, it assumes that investors will reinvest all the returns received from a bond and that they will hold the bond until maturity and get repaid for it.
Yield to Maturity is a crucial metric for investors. It shows the internal rate of return of a bond in comparison to its current market price. Similarly, YTM is closely related to the Current Yield of a stock. YTM is critical for investors in their decision-making process. However, it has certain limitations, as well.