When investors evaluate different bond options, they often take a look at the yield. The yield of a security is the estimated return reflected as an annual percentage. While analyzing the yield of a security is useful, investors often take it a step further and calculate the yield to maturity (YTM), which accounts for other factors that may provide a more comprehensive comparison to identical bonds.
What Is the Yield to Maturity?
The yield to maturity (YTM), also known as the redemption or bond yield, is the estimated interest rate investors earn when holding a fixed-rate investment like a bond at market value until it reaches maturity or full value. The YTM is generally stated as an annual rate and can potentially differ from the stated coupon rate.
The YTM calculation considers the following factors:
• Coupon rate: The higher a bond’s interest rate or coupon rate, the higher the yield. This means the bond will pay a higher percentage of the face value as it nears maturity.
• Market price: The higher the price of the bond, the lower the yield.
• Maturity date: The date when the issuer pays the principle is known as the maturity date.
• Face value vs. market price: If an investor keeps the security until maturity, they will receive the security’s face value. However, the price they paid might be more or less than the security’s actual face value.
The YTM formula assumes all interest and coupon payments are made as scheduled. This formula may not require dividends to reinvest; however, most calculations make that assumption. Also, the formula doesn’t account for taxes or other brokerage fees.
How to Calculate Yield to Maturity Formula
To calculate yield to maturity, investors can use the following formula:
C – Interest or coupon payment
FV – Face value of the investment
PV – Present value or price of the investment
t – Years it takes the investment to reach the full value or maturity
To better understand how the calculation works, here’s an example:
Suppose there’s a bond with a market price of $800, a face value of $1,000, and a coupon value of $150. The bond will reach maturity in 10 years, with a coupon rate of 14%.
By using this formula, the estimated YTM would calculate as follows.
The estimated YTM is 12.14%
The calculation determines the yield a bond (or other fixed-asset security) should have once it reaches its full value, based on the most recent market price and taking compound interest into account. This calculation is different from simple yield, which calculates the yield the security should have when it reaches full value but is based on dividends instead of compound interest.
It’s important for investors to remember that this formula is only an estimate of the YTM. To calculate the exact YTM, financial analysts or investors must use a trial and error method where they substitute different rates into the current value component of the calculation. The exact YTM is calculated when the price of the security matches the security’s actual market value.
The Importance of Yield to Maturity
For investors, knowing the YTM can help them compare bonds with various maturity and coupon rates. For example, when comparing a five-year bond with a 3% YTM and a 10-year bond with a 2.5% YTM, the five-year bond is more valuable.
It’s particularly useful when attempting to compare older bonds sold in a secondary market, which can be priced at a premium or discount of the face value.
The worst-case-scenario yield to maturity is known as the “yield to worst.” As long as the issuer doesn’t default, this is the lowest possible yield the investor may receive. Yield to worst assumes the issuer uses unfavorable guidelines like redeeming a bond early, which is used to calculate the YTM.
YTM can help investors decide whether to add specific securities to their portfolio; it’s one more piece of information that helps them choose the most suitable option for them that should pay the highest return.
Additionally, YTM helps investors understand how market conditions can impact their portfolio based on the investment they select. Since security yields rise when prices drop (and vice versa), investors can forecast how their investment will perform.
Yield to Maturity vs. Yield to Call
When it comes to calculating a return on a callable bond, YTM may not provide the most accurate estimate. With a callable or redeemable bond, the issuers choose to repay the principal amount before the maturity date. This means that if the bond is called, the interest will stop, reducing the interest an investor receives.
For this reason, it’s important that an investor knows the earliest date the bond may be called, according to the bond agreement. To calculate the yield to call, investors can use almost the same calculation as YTM, but substituting the maturity date for the first call date.
Typically a bond issuer will call a bond only if it will result in a financial gain. For example, if the interest rate drops below a coupon rate, the issuer may decide to recall the bond to borrow funds at a lower rate. This is similar to the idea that when interest rates drop, homeowners refinance their homes.
The Importance of Yield to Call
For investors that use callable bonds for income, yield to call is significant. Suppose the issuer decides to call the bond at any time, especially when the interest rates are lower than when the investor purchases it. In that case, a reinvestment may not yield the same return to support the investor’s lifestyle, and they may feel it necessary to take on more risk by investing in a different bond or other security.
When comparing callable bonds, investors can use yield to worst or yield to call. The yield to worst is the lower yield between the yield to call or the YTM.
Limitations of Yield to Maturity
It’s important to note that YTM calculation excludes taxes. While some bonds, like municipal bonds and U.S Treasury bonds, may be tax-exempt on a federal and state level, most bonds are taxable. In some cases, a tax-exempt bond may have a lower interest rate but ultimately offer a higher yield once taxes are factored in.
As an investor, it can be especially helpful to consider the after-tax yield rate of return.
For example, suppose an investor in the 35% federal tax bracket who doesn’t pay state income taxes is considering investing in either Bond X or Bond Y. Bond X is a tax-exempt bond and pays a 4% interest rate, while Bond Y is taxable and pays 6% interest.
While the 4% yield for Bond X remains the same, the after-tax yield for Bond Y is 3.8%. While it seemed like the less lucrative of the two options up front, Bond X should ultimately yield a higher return after taxes.
Watching the Yield Curve
Typically, bonds that have a longer maturity time frame come with a higher yield. This correlation is because the longer an investor waits for the issuer to pay the bond’s principal, the more risk they are exposed to, compared to an identical bond with a shorter maturity. Essentially, the idea is that the investor receives a greater reward for taking on more risk.
When looking at a chart that compares the yields of specific bonds such as Treasury securities, investors might see the chart’s slope moving upwards as the maturities lengthen and yields increase. Generally, a flat curve means that yield projections are stable. A steep curve may indicate that investors predict the economy to strengthen interest rates, thereby increasing compensation for the amount of time they hold the security.
Using the yield to maturity (YTM) calculation can help investors compare bond options with different maturity rates, and ultimately determine which one offers the higher yield.
But it’s not an exact science, especially when calculating a return on a callable bond, or adding the impact of taxes to the mix. YTM is just one tool investors can use to help decide which bond or fixed-rate security will best serve their financial needs and goals.
One alternative to choosing individual bonds is to invest in bond mutual funds or bond ETFs (exchange-traded funds), which are composed of similar types of issuers, maturities, and quality.
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