YTM is nothing but the internal rate of return (IRR) of a bond. It is also known as redemption yield. Yield to maturity is the rate of return that an investor can expect to earn if they hold the bond till maturity.
The YTM is based on the belief or understanding that an investor purchases the security at the current market price and holds it until its maturity and that all interest and coupon payments are made timely.
IMPORTANCE OF YIELD TO MATURITY
Yield to maturity helps in estimating whether buying bonds (fixed income securities) is a good investment or not. It enables investors to draw comparisons between different securities and the returns they can expect from each. It also helps the investors in understanding the impact of changing market conditions on their portfolio because when securities drop in price, yields rise and vice versa.
HOW TO CALCULATE YIELD TO MATURITY ?
Calculation of YTM is a complex process which takes into account the following key factors:
1. Current Market Price
2. Par Value
3. Coupon Interest Rate
4. Time to maturity
Yield to maturity can be calculated only through trial and error method. Its approximate value can be calculated by using the following formula :
YTM = (C + (F-P ) / n ) / ((F + P)/2)
C = coupon/interest payment
F = face value
n= years to maturity
However, one can easily calculate YTM by knowing the relationship between bond price and its yield.
If yield to maturity is equal to the coupon rate the bond is trading at par.
If the yield to maturity is lower than the coupon rate, the bond will be trading above par (which means trading at premium).
If the yield to maturity is higher than the coupon rate ,the bond will be trading below par (which means trading at discount)
LIMITATIONS OF YIELD TO MATURITY :-
- YTM makes assumptions about the future that cannot be known in advance. An investor may not be able to reinvest all coupons, the bond may not be held to maturity, and the bond issuer may default on the bond.
- Taxes paid are not accounted in the yield to maturity (YTM) calculations
- It does not consider the costs involved in purchasing or selling the bonds.
Thus, in simple words, Yield to maturity means the annual return that an investor would receive if he or she held a particular bond until maturity. It is essentially the internal rate of return on a bond and it equates the present value of bond future cash flows to its current market price.