Covered Bonds
February 12, 2025
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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.
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.
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.
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.
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.
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:
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.
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