Yield to Maturity

What is Yield to Maturity?

Yield to Maturity (YTM) is the total return of a bond. It’s the rate of return of a bond if held to maturity and all payments are made as scheduled. In other words YTM is the discount rate at which the present value of a bond’s cash flows equals its current price. This is a big deal for investors as it’s a way to compare expected returns of different bonds.

How to calculate Yield to Maturity

In the case of a Bond, YTM is defined as the total rate of return that a Bond Holder expects to earn if a Bond is held till maturity. The YTM formula for a single Bond is:

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

Where:

• FV is the face value of the bond.
• Price is the current price of the bond.
• Maturity is the number of years to maturity.
• Annual Interest is the annual coupon.

Consider a two-year bond with a 2.5 percent coupon that sells for USD 102. The solution is the yield y (expressed with semi-annual compounding).

$ 102=\frac{1.25}{1+y/2}+(\frac{1.25}{1+y/2})_{2}+(\frac{1.25}{1+y/2})_{3}+(\frac{1.25}{1+y/2})_{4} $

$ 102= \frac{1.25}{1+0.0074}+(\frac{1.25}{1+0.0074})_{2}+(\frac{1.25}{1+0.0074})_{3}+(\frac{1.25}{1+0.0074})_{4} $

Why is YTM important?

Comparing Securities

YTM is important for investors because it allows them to standardize the comparison of different bonds. By converting the different interest rates, payment schedules and prices into one number investors can compare the expected returns of different bonds. This helps in deciding which securities to include in their portfolio.

Risk and Return

YTM also helps investors to assess the risk and return of a bond. Bonds with higher YTM are riskier, either due to longer duration, lower credit rating or other factors. Bonds with lower YTM are safer. Knowing the YTM helps investors to balance their portfolio according to their risk tolerance and investment goals.

Market Price and Interest Rates

YTM of a bond is inversely proportional to its market price. When interest rates rise, the market price of existing bond falls and YTM increases. When interest rates fall, bond price rises and YTM decreases. This shows the impact of interest rate changes on bond investments and helps investors to know how their bond holdings will perform under different economic conditions

Practical Application of YTM

Portfolio Management

For portfolio managers YTM is a key tool for building and managing bond portfolios. By looking at the YTM of different bonds they can optimize their portfolios to get the returns they want while managing risk. This means selecting bonds with the right maturities, credit ratings and interest rates to match the investment strategy.

Bond Valuation

YTM is also used in bond valuation. When pricing a bond the YTM is used to discount the bond’s future cash flows to today’s value. This tells you if the bond is overpriced or underpriced in the market. Investors can use this information to decide to buy or sell based on their expectations of future interest rates and economic conditions.

Factors Affecting YTM

Several things can affect YTM:

• Interest Rates – As mentioned above interest rates affect bond prices and therefore YTM. Central bank policies, inflation expectations and overall economic conditions are the main drivers of interest rates.
• Credit Risk – The creditworthiness of the bond issuer affects YTM. Bonds issued by entities with lower credit ratings will have higher YTMs to compensate for the higher risk of default. Bonds from highly rated issuers will have lower YTMs because they are seen as safer.
• Time to Maturity – The time to maturity of a bond also affects YTM. Longer term bonds have higher YTMs because they are more exposed to interest rate risk and other uncertainties over time. Shorter term bonds have lower YTMs because they are less affected by these.
• Inflation – Inflation expectations can affect YTM. Higher inflation means higher interest rates and therefore higher YTMs. Lower inflation means lower interest rates and YTMs.

YTM and Investment Strategies

Investors use YTM to build various investment strategies:

Laddering

Bond laddering is buying bonds with staggered maturities. This strategy manages interest rate risk and provides regular income streams as bonds mature at different times. By reinvesting the proceeds from maturing bonds investors can maintain a balanced portfolio.

Barbell Strategy

In the barbell strategy investors hold short term and long term bonds and avoid intermediate maturities. This strategy benefits from the higher yields of long term bonds and the liquidity of short term bonds. YTM analysis helps you find the right bonds for this strategy.

Bullet Strategy

The bullet strategy is buying bonds that all mature at the same time. This is used when investors have a specific future cash flow need. By looking at YTM investors can find bonds that meet their target maturity date and yield requirements.

Conclusion

Yield to Maturity is a key concept for bond investors, a way to measure the total return of a bond. By understanding and using YTM investors can make informed decisions on their bond investments, compare different securities and build investment strategies. Whether you have a diversified portfolio or specific goals, YTM is the metric to achieve financial success in the bond market.