Yield to maturity (YTM) is a crucial concept for any investor considering fixed-income securities like bonds. It goes beyond the simple stated interest rate, providing a more accurate picture of the overall return you can expect to earn if you hold the bond until its maturity date.
What is yield-to-maturity
It is the total return predicted to be gained on a bond in a fixed-rate security. It is calculated by taking into consideration that the investor will hold the security till the date of maturity. In this period, all the proceeds or interest accrued on the bond is reinvested in the same bond without being withdrawn or invested in any other security. Moreover, the yield-to-maturity is expressed as an annual rate, and for this reason, it is regarded as a long-term bond yield.
YTM is also known as redemption or book yield. So, if you need to make a conscious decision about which bond to invest in, calculate the present value of the future coupons generated and the repayment of the bond's original price.
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Why is yield to maturity important
Yield-to-maturity (YTM) is important for investors when comparing different bonds. Depending on YTM, investors choose which bonds to add to their portfolio, tailored to their goal of either receiving steady gains until maturity or making a profit through price appreciation of the bonds over time. This helps investors understand how market conditions affect their portfolios in a single figure. An investor can thus clearly see the future returns from the bond.
The yield-to-maturity formula is given as:
YTM = [Annual Coupon Rate + (Face Value of Bond - Market value of Bond) / Remaining Years of Maturity x 100] / [(Face Value of the Bond + Market Value of Bond) / 2]
For example, let us consider the following values.
The annual coupon rate of a bond = 5%,
Face value or the price of purchase of the bond at the time of purchase = Rs. 1000,
The current market value of the bond = Rs. 600,
The annual coupon rate of this bond = Rs. 50
Year for maturity = 5 years
YTM = [50 + (1000-600)/5 x 100]/ [(1000+600)/2] = 16.25%
Now, suppose the current market value of the bond increases to Rs. 800. The YTM then would be:
YTM = [50 + (1000-800)/5 x 100]/ [(1000+800)/2] = 10%
There are a few limitations while calculating Yield-to-maturity. These include:
- The future coupon rate and the price of the bond are assumed, and the YTM is calculated. The calculations may vary greatly because the bond prices are unstable due to market fluctuations.
- It is assumed that the interest gain from the bond is again reinvested in it entirely at the same coupon rate. However, market rate fluctuations can highly influence investor decisions.
- The formula does not consider the payments withdrawn and not reinvested into the same bond.
- A high YTM is not the benchmark of good yields. It represents low bond prices and can be a big deterrent to investors from continuing the investment until maturity.
- The calculations do not consider the costs involved in purchasing the bond, such as brokerage, transaction costs, and other expenses.
- In case an investor redeems the bond within 3 years of the maturity period, a short-term tax on returns is levied. Even if the amount is withdrawn after maturity, a long-term tax on returns is levied. This tax is not taken into consideration while calculating profits.
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Why is Yield-to-maturity useful
Yield-to-maturity provides an investor with a measurement of the total returns that can be expected on a bond if it is held until it matures. It considers all coupon payments and any gains or losses that happen if the bond is bought at a price other than its par value. While bonds may have different maturities, coupons and face values, the YTM factors all these parameters and provides a single metric against which investors can compare various bonds.
In general, YTM is directly proportional to risk, with a higher YTM indicative of a greater chance of default by the issuer. Investors can look at YTM as a proxy for risk and evaluate which bonds they wish to consider adding to their portfolio. Another scenario where YTM comes in handy is when identifying mispriced bonds, which present arbitrage opportunities that may be exploited by fund managers or bond traders.
YTM also offers bond issuers a way to price fresh bond issues by providing them with market rates for similar bonds in terms of parameters such as credit quality and maturity. This allows them to ensure their bonds are priced attractively to investors without increasing their cost of borrowing significantly. Similarly, this metric can be used when deciding whether to refinance existing debt by evaluating whether the YTM of existing bonds is higher than that at which new bonds can be issued.
Conclusion
Yield to maturity (YTM) is a valuable tool for bond investors. It provides a more comprehensive picture of the potential return you can expect by considering the bond's current market price, coupon rate, and time to maturity. However, it's crucial to remember the limitations of YTM and combine it with other factors like creditworthiness and market conditions to make informed investment decisions.
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