Yield to Maturity (YTM): Definition, Formula and Calculation

Yield to Maturity (YTM) is an important financial metric for bond investors. It offers a comprehensive estimate of the total return a bondholder can expect if the bond is held until maturity. Unlike current yield, which only considers annual coupon payments, YTM accounts for the bond’s purchase price, face value, coupon payments, and the time value of money. This makes it a more accurate tool for assessing and comparing bonds with varying maturities and interest rates.

This article tells you more about what YTM is, how it is calculated, and its importance in investing.

Table of contents

1. What is Yield to Maturity (YTM)?
2. Yield to Maturity example
3. How is YTM calculated?
4. Why is Yield to Maturity important for investors?
5. What is Yield to Maturity in debt mutual funds?
6. Limitations of Yield to Maturity

What is Yield to Maturity (YTM)?

Yield to Maturity is the yield you earn upon holding onto a security until its maturity, with respect to one such fixed-income asset – a bond or debenture. The YTM includes the amount paid as interest while also considering gains or losses incurred due to changes in the bond price.

Important Points:

• Consideration of coupon payments: YTM considers the bond's regular yield payments and any possible cash gains or losses if kept until expiry.
• YTM vs. current yield: YTM is a more complete way to measure return than current yield because it considers the value of money over time and the effect of reinvesting coupon payments.
• Things that can change YTM: YTM can also vary with respect to interest rate movement, credit rating. As a result, rising Yields to Maturity occur when the bond prices depreciate due to an upward shift in interest rates in the market. On the other hand, if interest rates fall, then the market value increases, and thus YTM goes down.

Considerations:

• Risk and YTM: The YTM displays the value of earnings, but it does not consider all potential risks. When analyzing bonds, investors need to look for credit risk, interest rate risk, and the soundness of the issuers' financial health.
• Callable Bonds: The YTM formula might need to consider call events where the owner can repay the bonds before they mature.
• Investment strategy: YTM is especially useful for buy-and-hold buyers who want to hold on to the bond until it matures. Different types of investors may use other metrics for research. For example, investors who trade bonds on the secondary market may use different metrics.

Yield to Maturity (YTM) is a crucial metric for bond buyers, providing a comprehensive measure of a bond's overall return potential. Unlike the current yield, which simply divides the annual coupon payment by the current market price, YTM considers the time value of money, the timing of coupon payments, and the bond's maturity date. This makes YTM a more accurate and reliable tool for comparing bonds with different maturities and coupon rates.

Read Also: Target Maturity Funds (TMFs): Meaning, Benefits and How it Works?

Yield to Maturity example

YTM calculations typically require iterative methods, but a simplified formula is:

YTM = [coupon payment + (face value - current price) / years to maturity] / [(face value + current price) / 2]

Explanation

The numerator estimates the average annual return, accounting for both coupon payments and the capital gain or loss from the difference between the face value and current price. The denominator approximates the average investment value over the bond’s life.

How is YTM calculated?

Consider a bond with the following key details:

Face value: ₹1,000

Coupon rate: 8% per annum

Current market price: ₹950

Time to maturity: 5 years

Interpretation of the YTM

Since the current market price (₹950) is less than the face value (₹1,000), the bond is trading at a discount. This discount means the investor will potentially earn two sources of return:

Fixed interest income: The 8% coupon payment each year (₹80).

Capital gain: A ₹50 gain realized at maturity (₹1,000 received - ₹950 invested).

Because of this capital gain at maturity, the current YTM will be higher than the coupon rate. In this specific example, the calculated YTM is approximately 9.3%.

This means that if you buy the bond for ₹950 and hold it for five years, your anticipated annualised return, including all coupon payments and the capital gain, is 9.3%.

The figures shown are for illustrative purpose only.

Why is Yield to Maturity important for investors?

The Yield to Maturity (YTM) may be a helpful metric because it provides a forward-looking estimate of the total annualised return that the underlying bond portfolio may generate. It is much more comprehensive than simply looking at the bond's fixed interest rate (coupon rate).

• Estimating potential returns: YTM serves as an indicator of the potential return an investor can expect from a bond or a debt fund's existing portfolio, assuming the bonds are held until maturity and there are no credit defaults.
• Standardised comparison tool: YTM is critical because it allows investors to make a like-for-like comparison across different debt instruments that may have varying coupon rates, maturity periods, and market prices.
• Indicator of portfolio risk: A very high YTM in a debt portfolio may sometimes indicate exposure to lower-credit-quality bonds (for example, lower-rated issuers). Such issuers generally need to offer higher yields to compensate investors for taking on additional credit risk, including the possibility of delayed payments or default. Investors should check the credit rating of the scheme’s debt instruments to make an informed choice.

What is Yield to Maturity in debt mutual funds?

Since a debt mutual fund holds multiple bonds, the YTM displayed is the weighted average of all the individual bond YTMs.

YTM estimates the total potential return an investor may receive from a debt mutual fund if its bond portfolio is held until maturity. It is expressed as an annualized percentage. It factors in the market price of the bonds in the fund, their face value, coupon rates, and the time left until maturity.

Read Also: What is average maturity?

Limitations of Yield to Maturity

YTM has certain limitations.

Limitations for corporate bonds:

• Reinvestment risk: YTM assumes that future payments will be reinvested at the same YTM rate. If interest rates decline, reinvesting at that rate may not be feasible, potentially lowering overall returns.
• Default risk: YTM does not fully factor in the possibility of the issuer defaulting. While credit ratings provide some indication, they are not guarantees. If the issuer defaults, losses can be significant.
• Call/put provisions: Many corporate bonds come with call or put options. YTM calculations typically assume these options will not be exercised, but if they are, the bond's effective maturity and yield change.
• Liquidity risk: Some corporate bonds have lower liquidity than others. If an investor sells before maturity, the price may not match expectations, affecting actual returns.

Limitations for debt mutual funds:

• Fund portfolio turnover: Debt mutual funds actively manage their portfolios, frequently buying and selling bonds. YTM assumes bonds are held until maturity, which is not the case in such funds.
• Impact of expense ratio: YTM does not account for the fund's expense ratio, which reduces the returns that investors actually receive.
• Changes in portfolio composition: A fund’s YTM is not fixed, as fund managers frequently adjust holdings. The YTM displayed today may not remain the same over time.
• Taxation: YTM does not consider after-tax returns. In India, debt mutual funds are taxed at the investor’s applicable slab rate, meaning post-tax returns can vary depending on the tax bracket.

Conclusion

Yield to Maturity (YTM) is a useful metric for Indian investors evaluating corporate bonds and debt mutual funds. However, investors should be aware of YTM’s limitations, including its sensitivity to interest rate movements, assumptions about reinvestment, and inability to fully capture credit risk. Additionally, factors like the fund’s expense ratio and applicable taxes will lower the actual returns received. While YTM offers valuable insight into potential returns, it should not be the sole factor in investment decisions.

FAQs:

What is Yield to Maturity (YTM)?

Yield to maturity is the estimated annualised return an investor may earn if a bond is held until it matures, assuming all interest payments are received on time and reinvested at the same rate. It helps assess the bond’s potential return but does not guarantee outcomes, as market conditions and risks may influence actual performance.

How do you calculate Yield to Maturity?

Yield to maturity is calculated by solving a formula that equates the bond’s current market price with the present value of all future coupon payments and the principal repaid at maturity. Because this involves trial-and-error or financial calculators, investors typically rely on market data or disclosures provided by debt-oriented mutual funds.

What is the difference between YTM and current yield?

Current yield measures annual coupon income divided by the bond’s current price, offering a snapshot of income. YTM considers total expected cash flows, including coupons and capital gains or losses if held to maturity. YTM therefore provides a more comprehensive estimate of potential return, while current yield focuses only on income.

Why is Yield to Maturity important for bond investors?

Yield to Maturity helps investors understand the bond’s estimated return if held until maturity. It may support comparisons between bonds with different coupons or prices. However, YTM is based on assumptions and does not account for market volatility.

Does YTM consider the risk of default?

Yield to Maturity does not directly account for default risk. It assumes all payments will be received on schedule. Bonds with higher credit risk may display higher YTM to compensate for perceived uncertainty. Investors may review credit ratings, issuer financials, and scheme disclosures to understand potential risks beyond the YTM figure.

How does interest rate affect YTM?

When interest rates rise, bond prices typically fall, causing YTM to increase. When rates decline, bond prices generally rise, reducing YTM. These movements reflect market adjustments to align older bonds with prevailing rates.

Can Yield to Maturity be relied upon for mutual fund returns?

Yield to Maturity is an estimate and not a prediction of mutual fund returns. Debt funds actively buy and sell securities, so portfolio YTM changes regularly. Actual outcomes depend on market conditions, fund strategy, and interest rate movements. YTM should be viewed as an informational, not predictive, indicator.

Past performance may or may not be sustained in future.

What does a higher or lower YTM indicate?

A higher YTM generally suggests the bond is priced lower relative to its cash flows, or that its coupon rate is higher compared to similar bonds. This may reflect higher perceived risk or rising interest rates in the market. A lower YTM indicates the opposite. These signals help investors assess potential returns, though they still need to review credit quality, maturity profile, and broader market conditions carefully.