Yield to Maturity (YTM)

What is the Yield to Maturity (YTM)?

Yield to Maturity (YTM) – otherwise referred to as redemption or book yieldYieldYield is defined as an income-only return on investment (it excludes capital gains) calculated by taking dividends, coupons, or net income and dividing them by the value of the investment. Expressed as an annual percentage, the yield tells investors how much income they will earn each year relative to the cost of their investment. – is the speculative rate of returnRate of ReturnThe Rate of Return (ROR) is the gain or loss of an investment over a period of time copmared to the initial cost of the investment expressed as a percentage. This guide teaches the most common formulas or interest rate of a fixed-rate security, such as a bondBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period.. The YTM is based on the belief or understanding that an investor purchases the security at the current market price and holds it until the security has matured (reached its full value), and that all interest and coupon payments are made in a timely fashion.

How YTM is Calculated

YTM is typically expressed as an annual percentage rate (APR)Annual Percentage Rate (APR)The Annual Percentage Rate (APR) is the yearly rate of interest that an individual must pay on a loan, or that they receive on a deposit account. Ultimately, APR is a simple percentage term used to express the numerical amount paid by an individual or entity yearly for the privilege of borrowing money.. It is determined through the use of the following formula:

Where:

• C – Interest/coupon payment
• FV – Face valuePar ValuePar Value is the nominal or face value of a bond, or stock, or coupon as indicated on a bond or stock certificate. It is a static value determined at the time of issuance and, unlike market value, it doesn’t fluctuate on a regular basis. of the security
• PV – Present value/price of the security
• t – How many years it takes the security to reach maturity

The formula’s purpose is to determine the yield of a bond (or other fixed-asset security) according to its most recent market price. The YTM calculation is structured to show – based on compounding – the effective yield a security should have once it reaches maturity. It is different from simple yield, which determines the yield a security should have upon maturity, but is based on dividends and not compounded interestCompound InterestCompound interest refers to interest payments that are made on the sum of the original principal and the previously paid interest. An easier way to think of compound interest is that is it "interest on interest," where the amount of the interest payment is based on changes in each period, rather than being fixed at the original principal amount..

Approximated YTM

It’s important to understand that the formula above is only useful for an approximated YTM. In order to calculate the true YTM, an analyst or investor must use the trial and error method. This is done by using a variety of rates that are substituted into the current value slot of the formula. The true YTM is determined once the price matches that of the security’s actual current market price.

Alternatively, this process can be sped up by utilizing the SOLVER functionExcel SolverExcel Solver is an optimization tool that can be used to determine how the desired outcome can be achieved by changing the assumptions in a model. It is a type of what-if analysis and is particularly useful when trying to determine the “best” outcome, given a set of more than two assumptions. in Excel, which determines a value based on conditions that can be set. This means that an analyst can set the present value (price) of the security and solve for the YTM which acts as the interest rate for the PV calculation.

Learn more about how to use SOLVER with CFI’s free Excel Modeling Fundamentals Course!

Example of a YTM Calculation

To get a better understanding of the YTM formula and how it works, let’s look at an example.

Assume that there is a bond on the market priced at $850 and that the bond comes with a face value of $1,000 (a fairly common face value for bonds). On this bond, yearly coupons are $150. The coupon rateCoupon RateA coupon rate is the amount of annual interest income paid to a bondholder, based on the face value of the bond. for the bond is 15% and the bond will reach maturity in 7 years.

The formula for determining approximate YTM would look like below:

The approximated YTM on the bond is 18.53%.

Importance of Yield to Maturity

The primary importance of yield to maturity is the fact that it enables investors to draw comparisons between different securities and the returns they can expect from each. It is critical for determining which securities to add to their portfolios. It’s also useful in that it also allows the investors to gain some understanding of how changes in market conditions might affect their portfolio because when securities drop in price, yields rise, and vice versa.

Additional Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™FMVA® CertificationJoin 350,600+ students who work for companies like Amazon, J.P. Morgan, and Ferrari certification program, designed to transform anyone into a world-class financial analyst. If you are looking to learn more about fixed income securities, check out some of the CFI resources below!

• Fixed Income Fundamentals
• Equity vs Fixed IncomeEquity vs Fixed IncomeEquity vs Fixed Income. Equity and fixed income products are financial instruments that have very important differences every financial analyst should know. Equity investments generally consist of stocks or stock funds, while fixed income securities generally consist of corporate or government bonds.
• Held to Maturity SecuritiesHeld to Maturity SecuritiesHeld to maturity securities are securities that companies purchase and intend to hold until they mature. This is unlike trading securities or available for sale securities, where companies don't usually hold on to securities until they reach maturity.
• Matrix PricingMatrix PricingMatrix pricing is an estimation technique used to estimate the market price of securities that are not actively traded. Matrix pricing is primarily used in fixed income, to estimate the price of bonds that do not have an active market. The price of the bond is estimated by comparing it to corporate bonds with an active market