MSG Team's other articles

12204 Retail Banking: Time Deposit Products

In the previous article we studied that there are two types of deposits that banks use to fund their lending operations. We studied in detail about the different types of demand deposits. However, demand deposits are considered to be vulnerable sources of finance. Depositors are likely to pull out the funds that form a part […]

12120 How to Incorporate Ethical and Social Elements in Financial Modelling

What is Financial Modelling and how it is extremely critical for High Finance In the world of banking and high finance, modelling or financial modelling is a term used to describe the process of forecasting and estimating risk and return as well as predict how the future would be in financial aspects. Financial Modelling is […]

10956 Remote Deposit Capture (RDC)

Commercial banks have been relying on a wave of digitization in order to provide the best-in-class service to their customers. They provide several services which allow their customers to shorten their credit to cash cycle. One such service which has been enabled by the advent of technology is called remote deposit capture (RDC). Remote deposit […]

12918 What is Corporate Finance? – Meaning and Important Concepts

Corporate finance is one of the most important subjects in the financial domain. It is deep rooted in our daily lives. All of us work in big or small corporations. These corporations raise capital and then deploy this capital for productive purposes. The financial calculations that go behind raising and successfully deploying capital is what […]

12273 Advantages and Limitations of a Budget

In the previous article, we learned about the three financial statements. We also learned how income statements and balance sheets are backward-looking financial statements. We also understood that the budget is the only forward-looking financial statement in the personal finance domain. It is the only statement that can be used to prevent economic mistakes from […]

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