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How to Calculate Yield to Maturity?

Writer # Indiabonds | November 25, 2022

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Introduction

Investing in fixed-income instruments is a great way to secure a passive income while reducing portfolio risk. Bonds are one of the best examples when it comes to investing in fixed-income securities. The interest that bonds pay to the bondholder is often represented as the coupon rate. For instance, if a corporate bond has a coupon rate of 10%, that means the bond will pay us interest coupon payments of @10% per annum. But is it always the actual interest that we earn?

Not every time! That’s why you calculate yield to know your actual returns. If you want to calculate returns from a bond, IndiaBonds’ Bond Calculator is a convenient way to calculate your actual returns. The new age yield-to-maturity calculator (YTM calculator) is easy to use and freely available on sign-up. Calculate the exact yield for any bond in a matter of minutes. The YTM calculator helps provide investors with an estimate of the bond’s value thereby helping them make prudent investment decisions.

This article aims to decode yield-to-maturity, how to calculate YTM through a statistical formula, and what causes YTM to increase or decrease.

However, before that, let’s understand the concept of current yield!

What is the Current Yield?

Current yield is the rate at which an investment generates income. It is represented in percentage. All dividends and interest earned on an investment over its lifetime are factored in.

However, it is important to remember that total return and yield are not the same. Since yield considers all cash flows generated by an investment, it is the most comprehensive measure of return.

Calculating the current yield is simple. The formula for calculating the current yield is:

The current yield of the bond = (annual interest of the bond / current market value of the bond) * 100

What is Yield to Maturity (YTM)?

The Yield to Maturity (YTM) of a bond is the total amount of returns generated by a bond. It’s the total returns that a bondholder can expect if the bond is held till maturity. Thus, YTM is the total expected rate of return from a bond held till maturity. But how is bond yield calculated?

Here’s the simple formula on how to calculate YTM:

Yield to Maturity = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]

In the formula above,

Annual Interest = Annual interest payout provided by the bond

FV = Bond’s Face value

Price = Bond’s current market price

Maturity = no. of years until the bond matures

Current Yield and Yield to Maturity Calculation: How to Do It?

While the formula for calculating yield to maturity might seem tricky, it actually makes sense. Understanding how Yield to Maturity (YTM) is calculated gives us an insight into how it affects the returns of the bonds we choose. YTM serves as a predictor of possible returns from a bond. Let’s understand how to calculate yield to maturity as well as current yield with a simple example:

Suppose the current market price of the bond is Rs. 900. The face value of the bond is Rs. 1000. This is the price at which the bond will be redeemed. Now, let us assume that the periodicity of the payment is once a year and the bond will mature in 5 years. Also, the bond pays an annual interest at the coupon rate of 8%. Therefore, the annual interest payout is Rs. 80 [Rs. 1000 * 8%]. In this case, the current yield as well as the yield to maturity will be calculated as follows:

Current Yield = (annual interest of the bond / current market value of the bond) * 100

= (Rs. 80 / Rs. 900) * 100

= 8.88% per annum

Now,

Ytm = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]

Ytm = [Rs. 80 + {(Rs. 1000-900) / 5}] / [(1000+900)/2]

= 10.52% per annum

Here’s how to calculate the bond yield, the current yield and yield to maturity for a bond.

Critical Role of Yield to Maturity

We should learn how to compare the expected yields from bonds. The returns do not include the interest that we are paid but also the difference between the purchase price and the redemption value of the bond. It’s a must-have for picking out the best investments for our portfolios. Because yields rise when security prices fall and vice-versa, we can use the YTM formula to anticipate how market fluctuations might affect our portfolios. We can check the YTM of a bond and decide whether to add it to our portfolio.

Yield to Maturity: All that we need to know to interpret it

Yield to maturity is essentially a bond’s IRR (internal rate of return). It shows the total returns generated by a bond after it pays all the interest and repays the principal. It assumes that all the interest is reinvested into the bond at the same interest rate. If the yield to maturity is much higher than the bond’s current interest rate, then it can be said that the bond is currently trading at a much lower price. However, if the yield to maturity is near the coupon rate, then it can be said that the bond is trading at a price close to its face value. Thus, the gains through capital appreciation will be negligible.

Conclusion

The Yield-to-Maturity (YTM) of a bond helps in more ways than one. Besides allowing us to size up the return prospects of our investments, it also measures the credit risk and liquidity risk of the debt fund. To make a smart investment decision, we must know whether a bond is a good fit for us. A firm grasp of YTM can help with that. Understanding the Average Maturity, Macaulay Duration, and Modified Duration is also important. In addition to YTM, these factors help us get a full picture of the risks associated with our bond investments.

FAQs

1. Does YTM correspond to the yield on the bond?

In a technical sense, absolutely. If we keep our bond until maturity and reinvest the proceeds at the same rate as the YTM, our yield will be the same as the YTM.

2. What is the definition of a yield curve?

The yield curve is a graph generated for YTM against time. It graphically represents how YTM has changed over time. A rising yield curve indicates that long-term yields are higher than short-term yields.