"Yield" itself is defined as the earnings generated and realized on an investment over a defined period of time.
As mentioned above Yield to maturity is the total return anticipated on a bond at the end of tenor if held until it matures. Yield is calculated as a percentage based on the invested amount, current market value of the security and it also includes the interest earned throughout the period of the security.
It can also be termed as the internal rate of return (IRR) of a bond if the investor holds the bond until it matures considering all payments are made as scheduled. IRR is a metric used in financial analysis to estimate the profitability of investments
Yield to maturity is also defined as "book yield" or "redemption yield"
It is calculated as the coupon interest received divided by the market price of an asset. Eg: A bond purchased at par value or Rs.100 with a 5% coupon rate would provide a 5 % yield on that asset.
Par value is the value of single security assigned by the issuing company.
Calculating the Yield to Maturity:
Yield to Maturity = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]
In the above formula
- Annual interest- Annual interest payout by the bond
- FV- Face value of the bond which is also called as par value
- Price = Current Market Price of the Bond
- Maturity = Time to Maturity i.e. number of years till Maturity of the Bond
To calculate YTM some key indicators are essential :
- Face value of the bond - The price at which the issuer issued the bond
- Annual coupon rate- Rate of interest promised by the Issuer to pay the bondholder
- Maturity-The tenor or the remaining time until the bond matures and the bondholder gets the originally invested amount back
- Market value- The price at which the bond is trading on the bond markets. It is the value at which the original bondholder can sell the bond to another investor before the bond gets matured as per the price in the market.
Higher yield to maturity indicates that the scheme invests in low-quality bonds which means the bonds have low credit ratings and hence they provide higher coupon rates as compared to higher credit rating bonds.
There is always an inverse relationship between the market interest rates and bond prices. When the market interest rate rises the price for the bond declines and vice versa
A bond’s yield to maturity shows how much an investor’s money will earn if the bond is held until it matures.
For example, let us say a bond offers a 5% coupon rate, and a year later market interest rates fall to 3%. The bond will still pay a 5% coupon rate, making it more valuable than new bonds paying just a 3% coupon rate. If you sell the 5% bond before it matures, you will probably find that its price is higher than it was a year ago. Along with the rise in price, however, the yield to maturity of the bond will go down for anyone who buys the bond at the new higher price.
Yield to maturity plays a crucial role in determining the value of the security and compare them with other securities in the market
