MSG Team's other articles

12225 Why Government Should Not Invest Public Money in Sports Stadiums Used by Professional Franchises

In the previous article, we have already come across some of the reasons why the government should not encourage funding of stadiums that are to be used by private franchises. We have already seen that the entire mechanism of government funding ends up being a regressive tax on the citizens of a particular city who […]

10804 Pros and Cons of Convertible Notes

In the previous article, we studied what convertible notes are and how they are used in the context of financing a startup firm. The various terms and conditions which are generally a part of the convertible notes agreement were also explained along with the working of the note. However, before investors and founders make a […]

10454 Neo Banks and Commercial Banking

Traditionally, the commercial banking industry was largely controlled by commercial banks which had a huge brick-and-mortar presence. However, over the past few decades, customers have gone digital. In response to that, the banks were also compelled to go digital. This digital wave led to a dramatic increase in competition for commercial banks. Many types of […]

10981 Retail Inventory Method (RIM)

Inventory is a very important part of the retail business. This is because the stock which retail stores hold on their books is their most important asset. The quality of this asset allows them to generate higher profits as compared to their peers. Hence, the valuation of inventory which is held by the retailer is […]

10455 Net Present Value Calculations

The net present value (NPV) is the most important concept in corporate finance. It is on the basis of this concept that investment decisions are made or not made. It is on the basis of this concept that stocks and bonds are valued. Thus, it is an absolute imperative for any student of corporate finance […]

Search with tags

  • No tags available.

Yield to maturity is a fundamental concept which every bond investor must be aware of. The term yield to maturity might sound complex and intimidating. However, in reality, the concept is quite simple. In this article, we will have a closer look at what yield to maturity is as well as the manner in which it is calculated.

What is Yield to Maturity?

Yield to maturity is just a complex way of stating the percentage return that a bond investor will obtain between the current date and the maturity date of the bond. It is important to note that the yield to maturity is dependent upon the market price of the security. Since the market price changes in real-time, so do the yield to maturity.

The formula for calculating yield to maturity is as follows:

Yield To Maturity = Coupon Payments/Market Price of the Bond

Please note that the denominator is mentioned as the market price of the bond and not the book value or the face value of the bond. Also, please note that the coupon payments are paid on the face value of the bond and not the market value.

  • Hence, if the market value of the bond is the same as the book value, then the bond is said to be trading at par. In the case of bonds that are trading at par, the yield to maturity is the same as the coupon rate of the bond.

  • In cases where the market value of the bond is greater than the book value of the bond, then the bond is said to be trading at a premium. In such cases, the yield to maturity is lower as compared to the coupon rate.

  • Lastly, if the market value of the bond is lesser than the book value of the bond, then it is said to be trading at a discount. In such cases, the yield to maturity is greater than the coupon rate.

It can be said that the yield to maturity is quite similar to the concept of internal rate of return which is often used in the case of equity investments.

Components of Yield to Maturity

The yield to maturity measures the total return which any fixed-income security provides to an investor. Since the return is provided in more than one way, yield to maturity has to take all these multiple ways into account.

  1. Coupon Payments: Firstly, yield to maturity takes into account the dollar value of the coupon payments being received vis-a-vis the market value of the bond.

  2. Discount or Premium Payment: Secondly, if the bond is trading at a premium or at a discount, the difference between the face value and the market price of the bond also needs to be taken into account. This is because, at the end of the investment period, the bond will pay back the face value to the investor. Hence, if they buy a bond at a discount today and get the entire amount later, that too would be included in the return earned by the investor.

  3. Reinvestment Interest: Lastly, it is common for bonds to make coupon payments through the life of the bond. Here the yield to maturity model assumes that the coupon payment can once again be reinvested at the same rate as the yield to maturity.

Use of Yield to Maturity Concept

Investors often invest in debt funds that have a portfolio of debt securities instead of having a single one. In such cases, the yield to maturity is a very important number. This is because this number can be used to gauge the quality of assets in the portfolio. For instance, if the YTM of a particular portfolio is very high as compared to the market interest rate, then it is likely that the portfolio has a lot of low-quality securities. These securities do pay high interest in the short run. However, they also carry a lot of risks. Portfolios with high-quality debt securities will generally provide yields that are in line with the overall market.

Limitations of Yield to Maturity

There are some limitations of the yield to maturity concept as well. These limitations are related to the reinvestment assumption and have been listed below:

  • Reinvestment Assumption: Bonds tend to have a significantly long maturity. It is not uncommon for bonds to have a maturity date that is greater than a decade. It is also common for interest rates to vary significantly within a ten-year period. Hence, the assumption that investors will be able to invest their coupon payments at the same rate as the yield to maturity is unrealistic, to say the least.

  • Lower Term Rates are Different: There is one more reason as to why the reinvestment assumption in the yield to maturity model is faulty. This is because the yields provided for long-term investment and short-term investment in the market are quite different from each other. The bonds themselves will be subject to long-term yield whereas the coupons will be subject to short-term yield. Hence, once again, it will be impossible for the coupon payments to be reinvested at the same rate as yield to maturity.

The bottom line is that yield to maturity is a very important concept. It is essential for every bond investor to be aware of this concept since this knowledge is critical when it comes to investment decision-making.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Covered Bonds

MSG Team

Conditional Pass-Through Covered Bond

MSG Team

Common Restrictive Covenants in Fixed Income Securities

MSG Team