Yield to Maturity
Yield to Maturity: The entire return expected on a bond if it is kept to maturity is known as yield to maturity (YTM). Although it is presented as an annual rate, yield to maturity is regarded as a long-term bond yield. It is, thus, the internal rate of return (IRR) of a bond investment assuming the investor retains the bond to maturity, with all scheduled payments paid and reinvested at the same pace.
The present value of all the future cash flows matches the market price of the bond because yield to maturity is the interest rate that an investor would receive by reinvesting every coupon payment from the bond at a constant interest rate until the bond’s maturity date. Investors are aware of the bond’s current price, coupon payments, and maturity amount, but they are unable to immediately determine the discount rate.
An alternative method of determining Yield to Maturity
Since all of the bond’s future cash flows are known and its current price is likewise known, the YTM variable in the equation may be tested until the present value of the stream of payments matches the bond’s price.
Understanding the link between a bond’s price and yield as well as the various bond pricing models is necessary in order to manually solve the problem. Bond prices may be discounted, set at par, or set at a premium. When a bond is valued at par, its interest rate and coupon rate are the same.
A bond priced over par is referred to as a premium bond, while a bond priced below par is referred to as a discount bond. Both have coupon rates that are greater than the actual interest rate. When determining YTM on a bond that is trading below par, an investor would solve the equation by substituting several annual interest rates that were greater than the coupon rate until they reached a bond price that was roughly equivalent to the price of the bond in question.
Yield to maturity (YTM) calculations use the bond’s current market price, par value, coupon interest rate, and term to maturity as well as the assumption that all coupon payments will be reinvested at the same rate as the bond’s current yield. Given that coupon payments are not always investable at the same interest rate, the yield to maturity (YTM) is only a snapshot of the return on a bond. The YTM will grow as interest rates rise and fall as interest rates decline.