Yield to Maturity (YTM)
Yield to maturity (YTM), commonly referred to as redemption or book yield, is the speculative rate of return or interest on a fixed-rate investment, such as a bond. The YTM is based on the premise that an investor purchases a security at the current market price and holds onto it until it matures (reaches its full value), as well as the presumption that all interest and coupon payments are made on time.
Yield to maturity is similar to current yield, which works by dividing annual cash inflows from a bond by its market price to determine how much money would be made by buying and holding that bond for a year. YTM, as contrast to current yield, considers the present value of a bond's future coupon payments. In other words, it considers the value of money over time, whereas a simple calculation of present yield does not. As a result, many people consider it to be a more precise method of calculating a bond's return.
The following equation can be used to determine a discount bond's YTM:
Yield To Maturity = C + ( FV - PV / n) / ( FV + PV / 2 )
C – Interest/coupon payment
FV – Face value of the security
PV – Present value/price of the security
n – Number of years it takes the security to reach maturity
The yield to maturity can be quite useful in determining whether buying bonds is a sensible investment. The necessary yield will be chosen by an investor (the return on a bond that will make the bond worthwhile). By contrasting the YTM and the required yield of a bond, an investor can determine whether it is a good investment.
As YTM expresses the value of multiple bonds in the same annual terms regardless of the bond's term to maturity, it can be used to compare bonds that have varying maturities and coupons.
Bonds with embedded options are taken into account by a few standard versions of yield to maturity:
- Yield to call (YTC) - YTC anticipates the bond being called. That is, a bond has a shorter cash flow term since the issuer buys it back before it matures. The bond will be called as soon as it is practical and financially reasonable, according to the YTC calculation.
- Yield to put (YTP) - YTP is comparable to YTC, with the exception that the holder of a put bond has the option to sell the bond back to the issuer at a set price in accordance with the bond's conditions. The assumption used to compute YTP is that the bond will be returned to the issuer as soon as it is physically and financially viable.
- Yield to worst (YTW) - The YTW computation is utilized when a bond has numerous alternatives. The investor would calculate the YTW if a bond contained both calls and puts using the option terms that offer the lowest yield.
- The overall rate of return that a bond will have earned after all interest payments are made and the principal is repaid is known as yield to maturity (YTM).
- YTM essentially denotes the internal rate of return (IRR) on a bond when it is kept until maturity.
- It might be difficult to calculate yield to maturity since it makes the assumption that all interest or coupon payments can be reinvested at the same rate of return as the bond.