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. How is YTM calculated?
3. What is yield to maturity in debt mutual funds?
4. 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 (YTM) 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.

How YTM is calculated

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.

What is the 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.

Limitations of yield to maturity

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.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.