- What is Yield?
- What is Yield To Maturity (YTM)?
- Yield To Maturity (YTM) Formula
- How to Calculate Yield To Maturity (YTM)?
- Variations of Yield to Maturity
- Why Yield to Maturity Keeps Changing in Debt Funds?
- How to Interpret YTM for Your Debt Funds?
- How to Calculate Future Returns for your Debt Funds?
- Terms Related to Yield to Maturity
- YTM vs Current Yield
- Uses of Yield to Maturity
- Limitations of Yield to Maturity
- Frequently Asked Questions
What is Yield?
Yield is the measure of cash flow of an investment over a period of time. It is expressed as a percentage. It considers all dividends or interest received from the investment during the term of the investment.
Yield is different from the total return. Yield is a complete measure of return of an investment as it includes all cash flows from an investment. It can be calculated based on cost and current price.
Yield on cost: When the yield is calculated on the purchase price, it is called the yield on cost.
Current yield: When the yield is calculated on the current market price, it is called the current yield.
In the Case of Stocks– Yield in case of stocks is the return the stockholder earns on the dividend. It does not include the profit from selling the shares. Below is the general formula for yield on stocks – Yield in case of stocks = (Price increase + Dividend Paid)/Price
In the Case of Bonds– Bond yield is the return one earns on the interest. Interest is also known as the coupon rate. Hence bond yields depend on the coupon rate. In the case of bonds, it is called normal yield. This is the annual return from investing in fixed income securities. Normal yield = Annual interest earned/Face value of the bond
What is Yield To Maturity (YTM)?
Yield to Maturity (YTM) is nothing but the internal rate of return of a bond. However, the investment must be held until maturity, and all the proceeds must be reinvested at a constant rate. YTM is similar to the current yield where it determines the return one can expect by holding the security for a year. However, YTM is slightly advanced and accounts for the time value of money.
Yield to maturity (YTM) is the total expected return for an investor if the bond is held to maturity. YTM factors all the present values of future cash flows from an investment which equals the current market price. However, this is based on the assumption that all the proceeds are reinvested back at a constant rate, and the investment is held until maturity. The price of the bond, the coupon payments and maturity value are known to an investor. However, the discount rate has to be computed. This discount rate is the yield to maturity. Often a trial and error basis is used to calculate this. Below is the formula for yield to maturity.
Yield To Maturity (YTM) Formula
Below is the YTM formula-
bond price = the current price of the bond.
Coupon = Multiple interests received during the investment horizon. These are reinvested back at a constant rate.
Face value = The price of the bond set by the issuer.
YTM = the discount rate at which all the present value of bond future cash flows equals its current price.
One can calculate yield to maturity only through trial and error methods.
However, one can easily calculate YTM by knowing the relationship between bond price and its yield. When the bond is priced at par, the coupon rate is equal to the bond’s interest rate. If the bond is selling at a premium (above par value), then the coupon rate is higher than the interest rate. And if the bond is selling at discount, the coupon rate is lower than the interest rate. This information will help an investor to calculate yield to maturity easily.
How to Calculate Yield To Maturity (YTM)?
To calculate YTM, let’s take an example of a corporate bond with a face value of INR 1,000. The current market price of the bond is INR 950. The bond pays a coupon of 4% annually. The bond matures in 3 years.
The details of the corporate bond are shown in the table below:
|Face Value||INR 1000|
|Coupon rate||4% or INR 40|
|Time to Maturity||3 years|
|Current market value||INR 950|
Since the bond is selling at a discount, the interest rate or YTM will be higher than the coupon rate. Using the YTM formula, the required yield to maturity can be determined.
INR 950 = 40/(1+YTM)^1 + 40/(1+YTM)^2 + 40/(1+YTM)^3+ 1000/(1+YTM)^3
We can try out the interest rate of 5% and 6%. The bond prices for these interest rates are INR 972.76 and INR 946.53, respectively. Since the current price of the bond is INR 950. The required yield to maturity is close to 6%. At 5.865% the price of the bond is INR 950.02
Hence, the estimated yield to maturity for this bond is 5.865%.
Variations of Yield to Maturity
Yield to Call
Yield to Call is the return from a callable bond. However, the bondholder must redeem the bond before maturity at the earliest call date. The YTC measure suggests that a callable bond was redeemed before its stated maturity date. The most common reason for an issuer to call a bond early is to refinance during low-interest rates or reduce the percentage of debt in the capital structure.
Yield to Worst
The yield to worst (YTW) is the lowest possible yield on a bond, assuming that the issuer will not default on any of its payments. YTW is especially appropriate for bonds in which the issuer exercises options such as calls, prepayments, and sinking funds.
This return makes sense when the issuer pays back the bond early. Or where the put option is included in terms of issue. A YTW estimate provides investors with a reasonable understanding of how their future income may be impacted in the worst-case situation and what they can do to mitigate such risks.
Yield to Put
Yield to put (YTP) is identical to yield to call (YTC), except that the holder of a put bond has the option to sell it back to the issuer at a fixed rate depending on the terms of the bond. YTP is computed with the expectation that the bond will be returned to the issuer as soon as it is possible and financially viable to do so.
Why Yield to Maturity Keeps Changing in Debt Funds?
Yield to Maturity is a return metric for Debt Funds. However, it fluctuates with changing market conditions. Thus, in practice, the YTM of an open-ended Debt Fund is different from the scheme’s actual returns.
Furthermore, since debt funds invest in multiple funds, a change in the YTM of a single bond will have an impact on the YTM of the debt fund. However, the magnitude of this change will be proportionate to the weightage of the bond in the debt mutual fund portfolio.
Taking the above example, let us understand how the changing market conditions impact the bond’s YTM. Let’s assume that the bond’s rating has been downgraded due to its poor performance after one year. As a result, the market value of the bond is now INR 700. Based on the changes, the details of the corporate bond after one year shown below:
|Face Value||INR 1000|
|Coupon rate||4% or INR 40|
|Time to Maturity||2 years|
|Current market value||INR 700|
Using the YTM formula, the required yield to maturity can be determined.
700 = 40/(1+YTM)^1 + 40/(1+YTM)^2 + 1000/(1+YTM)^2
The Yield to Maturity (YTM) of the bond is 24.781%
After one year, the YTM of the bond is 24.781% instead of 5.865%. Hence changing market conditions like inflation, interest rate changes, downgrades etc affect the YTM. An increase in YTM of the bond due to change in market conditions indicates the bond or debt fund is of low quality. Whereas, a decrease in the YTM due to change in market conditions shows the bond or debt fund is of high quality.
How to Interpret YTM for Your Debt Funds?
Yield to Maturity helps in only determining the potential returns of a debt mutual fund. However, it also gives a fair idea of the risks associated with the investments. For example, a debt fund having a high YTM means that the scheme has substantial investments in bonds with low credit ratings. Bonds with low credit ratings offer higher coupon rates in comparison to bonds with higher credit ratings.
However, it is important to note that these bonds have a downside as well. Low credit rating bonds have a greater level of credit and liquidity risk. Credit risk is when the bond issuer defaults on interest payments. At the same time, liquidity risk is when the fund manager is unable to exit their position on the bond quickly.
Therefore, while investing in debt funds, one should consider their risk profile. High-risk investors can consider investing in debt funds with higher YTM to generate greater returns. While low-risk investors can opt for funds with lower YTM that invest primarily in bonds with high credit rating.
How to Calculate Future Returns for your Debt Funds?
YTM of debt funds changes over time. However, one can estimate their future returns from Debt investments. Estimating the future returns helps in many ways, such as how much one should invest to reach their target amount, pay for a future expense, etc.
The calculations are only an estimate of potential returns and do not guarantee any returns. To compute the potential future returns, one should know the following details of a fund:
- Yield to Maturity (YTM)
- Expense Ratio
- Modified Duration
Also, one should take into account the interest rate cycle of the Reserve Bank of India (RBI).
The below formula can be used to estimate one year return from a debt fund investment:
Expected 1 Year Return = YTM + (Interest Rate Change x Modified Duration ) – Expense Ratio
Let’s understand the calculation with an example. A debt fund has its modified duration as five years, YTM 9%, and an expense ratio of 1.25%. The anticipated interest rate change is 0.5% (decrease), and the expected one year return is 10.25%.
Expected 1 Year Return = 9 + (5*(0.5)) – 1.25 = 10.25%.
Now, instead of a decrease in interest rate, if there is an increase (0.5), then the Expected return would be:
9 + (5*(-0.5)) – 1.25 = 5.25%.
Therefore, from the above example, the bond’s expected one-year return was the same when the interest rates have decreased by 0.5%.
Following are few important terms in yield to maturity formula
Face value/ Par value
Face value or par value is the value of the bond upon maturity. In other words, this is the price paid to the bondholder at the maturity date.
Present value/ Market value
Present value or market value of the bond is the current market price. The bond prices are subject to fluctuations on the basis of the interest rate changes. Both price and yield have an inverse relationship.
The coupon rate is the interest rate paid to the bondholder by the bond issuer. The coupon rate is paid on the bond’s face value and not on the market value.
The interest rate of a bond is not the same as its coupon rate. Let’s understand this with an example. Mr Ananth buys a bond at INR 1,000 (face value), and the coupon rate is 10%. Mr Ananth gets INR 100 (10% of INR 1,000) every year for his investment as annual coupon payments. The effective interest rate for him is 10%.
On the other hand, Ms Sushma buys a bond at INR 2,000 (at a higher price to its face value). The face value of the bond is INR 1,000, and the coupon rate is 10%. Here, Ms Sushma also gets a yearly payment of INR 100 (10% of INR 1,000) as annual coupon payments. However, since she bought the bond at INR 2,000, the rate of interest for her investment is 5% (INR 100 of INR 2,000).
Similarly, had an investor bought the bond below its face value, the interest rate would be higher than the coupon rate.
Discount and Premium
Bonds trade either at discount or premium. When,
Market value = Face value, the bond is trading at par
Face value < Market value, the bond is trading at a premium
Face value > Market value, the bond is trading at a discount
Time to maturity
Maturity is the duration or date when a bond’s principal amount is repaid with interest. For example, a 10-year government bond matures in 10 years. The bondholder receives the principal amount along with interest at that time. Most commonly, maturity is referred to as time to maturity. This depicts the amount
YTM vs Current Yield
The current yield is the actual yield an investor would receive. In contrast, Yield to Maturity is the yield the investor will receive when the bond matures.
The current yield of a bond is the annual income from the bond investment, including both interest and dividend payments, divided by the current price of the asset. The current yield is used to evaluate the link between the current price of bonds and their yearly yield. On the other hand, yield to maturity (YTM) is the expected rate of return on bonds when they are held to maturity.
Uses of Yield to Maturity
Following are the uses of Yield to Maturity:
- It aids the investor in determining if the purchase of a bond is a good investment. You can compare the yield-to-maturity to the required rate of return to evaluate if the bond is worth purchasing.
- You can use this information to compare the maturity terms of various bonds. This will allow you to understand what to expect from each security.
- You can utilize YTM to anticipate future market changes and how such changes may affect the investments by paying close attention to the underlying assumptions. For instance, when the price of a bond falls, the yield rises, and when the price rises, the yield falls.
- Additionally, you can use YTM to compute risk statistics. You can use different duration and convexity to measure the bond price’s susceptibility to market fluctuations.
Limitations of Yield to Maturity
Following are the limitations of YTM:
- YTM estimates do not account for the taxes an investor pays on a bond.
- YTM makes future-related assumptions that cannot be understood in advance. An investor may be unable to reinvest all coupons, the bond may not be kept to maturity, and the issuer of the bond may default.
- The majority of the results from YTM computations are approximated, making them less dependable.
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Frequently Asked Questions
YTM assists in estimating the potential returns. Thus, you can compare the expected returns from different assets. Furthermore, you can use YTM to understand how changes in market circumstances may affect your portfolio, as yields rise when security prices fall and vice versa.
A higher YTM indicated high returns. However, it also implies that the bonds are more volatile. In other words, higher YTM means that the bond is a high-risk investment.
If YTM is higher than the coupon rate, it means that the bond is sold at a discount to its par value. On the other hand, if YTM is lower than the coupon rate, then the bond is sold at a premium.
The yield to maturity (YTM) is the rate of return on a bond based on the assumption that the investor holds it to maturity. On the other hand, the coupon rate is the annual interest rate that the bond owner will receive.
A bond’s price has an inverse relationship to its yield to maturity rate. As interest rates rise, there is a demand for greater returns. Therefore, the price of bonds will fall, and subsequently, the yield to maturity rate will increase.
The yield of an investment is its earnings over a specified period. The interest rate is the proportion that a lender charges for a loan. The interest rate can also refer to the amount of recurring return an investor can anticipate from a financial instrument such as a bond.
Bond yield is the projected return from a fixed-income investment over a specific period of time. The bond’s yield to maturity is the interest rate at which the present value of all future cash flows is equal to the bond’s current price. These cash flows consist of all coupon payments and the security’s maturity value.