Fixed Income Securities
Covered Bonds
February 12, 2025
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.
- 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.
- 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.
- 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.