What Is Yield To Maturity? And How Is It Calculated With An Example?
Finance, Investment, Money

What Is Yield To Maturity? And How Is It Calculated With An Example?

Yield to maturity or YTM is a phrase that is frequently used in conjunction with bond. As a result, YTM becomes an important term for debt mutual funds. The yield to maturity calculator (YTM calculator) is a useful tool for calculating the rate of return on a bond. As this metric is one of the most important aspects that might affect bond prices, an investor must properly understand the YTM concept. So, in this post, we will discuss what YTM is, how to calculate it, and demonstrate examples to help you understand the concept better. Let’s get started!

What Is Yield To Maturity?

What Is Yield To Maturity?

YTM is a bond’s rate of return. Therefore, the investment must be held until maturity, with all proceeds reinvested at a steady rate. YTM, like current yield, determines the return that may be expected by holding the security for a year. YTM  is significantly more advanced and takes into consideration the time value of money. The total expected return for an investor if the bond is held to maturity is referred to as the yield to maturity (YTM). The present value of all future cash flows from an investment that equals the current market price is factored into YTM. However, this assumes that all proceeds be reinvested at a constant rate and that the investment is held until maturity. An investor knows the bond’s price, coupon payments, and maturity value. On the other hand, the discount rate must be calculated. So, this discount rate is the yield to maturity. This is often calculated through trial and error.

How Is Yield To Maturity Calculated?

How Is Yield To Maturity Calculated?

YTM is commonly expressed as an annual percentage rate. It is calculated using the formula below. The formula below focuses on computing the approximate yield to maturity, however calculating the actual YTM will involve trial and error by evaluating different rates in the present value of the bond until the price matches the actual market price of the bond. There are now computer applications that make it simple to calculate the YTM of a bond.  

Yield to Maturity Formula = [C + (FV-PV)/t] / [(FV+PV)/2]

Where:

  • C is the Interest/coupon payment
  • FV is the Face value of the bond
  • PV is the Present value/price of the bond
  • t is How many years it takes the security to reach maturity

The goal of the formula is to calculate the yield on a bond or other fixed-asset securities based on its most recent market price. The YTM calculation is designed to demonstrate the effective yield a security should have after it reaches maturity based on compounding. It differs from basic yield, which estimates the yield a security should have at maturity but which is based on dividends rather than compounded interest.

Example Of Yield to Maturity 

Let us consider a single Bond— Bond X. However, because a Debt Fund portfolio would comprise numerous Bonds, the YTM calculation for a fund will require calculating the weighted average of the YTM of each Bond in which the Fund has invested. 

Details about Bond X are shown in the below table:

Face Value₹1000
Coupon Rate6% or INR 60
Time to Maturity10 years
Current Market Value₹900

The Yield to Maturity of this bond, calculated using the YTM formula, is:

YTM= [60 + (1000-900)/10] / [(1000+900)/2] = 7.4%

The YTM estimated here is 7.4 percent for a single bond. Debt mutual funds, on the other hand, invest in a variety of bonds. As a result, the Yield to Maturity of a Debt Fund provided in the Factsheet will represent the weighted average yield of all the bonds in the scheme’s portfolio.

What Are The Importance Of Yield To Maturity?

What Are The Importance Of Yield To Maturity?

The major significance of yield to maturity is that it allows investors to compare different securities and the profits they can expect out of each. It is crucial in deciding which securities to include in their portfolios. 

Yield to maturity is also beneficial since it allows investors to obtain an idea of how changes in market circumstances may affect their portfolio because when securities decline in price, yields increase and vise – versa.

Yield to maturity is more important since it takes into account the time value of money when calculating bond returns.

Why Yield To Maturity Keeps Changing?

Why Yield To Maturity Keeps Changing?

Yield to Maturity is a return metric for Debt Funds, although it fluctuates with market conditions. In fact, the YTM of an open-ended Debt Fund is frequently different from the scheme’s actual returns. Because Debt Funds invest in a variety of Bonds, a change in the YTM of a single Bond will result in a change in the YTM of the Debt Fund overall. Though, the level of this YTM change for the fund will be determined by the weightage of the specific Bond in the Debt Fund’s portfolio.

Let’s utilize Bond X from the previous example to see how the YTM of a Bond can alter owing to changing market conditions.Assume Bond X was issued two years ago. and its Credit Rating has been reduced due to poor performance. Its Market Price has now reduced to Rs. 600 as a result of the lower rating. Bond X’s new details will be as follows:

Face Value₹1000
Coupon Rate6% or INR 60
Time to Maturity8 years
Current Market Value₹600

Based on the information presented above and the YTM Formula, the new YTM of Bond X is:

So, two years after its issue, Bond X’s new YTM is 13.8 percent, up from 7.4 percent previously. And that is how changing market conditions like inflation, interest rate changes, rating downgrades, and so on can cause the YTM of a Debt Fund to rise.

How To Interpret Yield To Maturity For Debt Funds?

How To Interpret Yield To Maturity For Debt Funds?

You can estimate the possible rewards as well as the risk connected with your investment by looking at the Yield to Maturity (YTM) of a Debt Fund. A high YTM of a Debt Fund often indicates that the plan has significant investments in Low-Quality Bonds, i.e. Bonds having a Low Credit Rating. These Low-Quality Bonds have higher Coupon Rates than comparable Bonds with higher Credit Ratings and can possibly yield higher returns for the investor. However, there is a disadvantage: bonds with lower credit ratings have a higher level of liquidity and credit risk than high-quality bonds. 

As a result, Debt Funds with a higher exposure to Low-Quality Bonds provide a greater risk to investors than schemes that invest predominantly in High-Quality Bonds. As a result, while investors with a high risk tolerance may think about investing in Debt Funds with a high YTM to obtain potentially large returns, investors with a lower risk appetite will be probably more suited investing in Debt Funds with a lower YTM and predominantly in High-Quality Bonds. 

Bottom Line

Understanding YTM can help determine the best decision about whether a certain Debt Fund is a good investment for you. The YTM of a Debt Fund is more than simply an estimate of the prospective returns from your investment. It can also serve as an indicator of the Debt Fund’s credit risk and liquidity risk. You can compare a bond’s YTM to evaluate whether one has a better path to maturity. So, make an informed choice while also considering the other aspects.

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