This is the yield or return you are likely to get from your bond investment or other fixed-income securities if you hold these till maturity and reinvest all interest payments at the same rate. In other words, it is the bond’s internal rate of return (IRR) if held till maturity.
YTM, also known as redemption or book yield, helps compare bonds and debt mutual funds, or calculate the potential return you can earn from bonds. Investors can also estimate the fair value of the bond using YTM and check whether it is trading at a premium or discount to its face value.The face value, or par value, of a bond is the amount that the issuer promises to pay the investor on the bond’s maturity. A bond is priced either at par, at a discount or at a premium. If it is at par, this means the interest rate is the same as coupon rate (annual interest paid on bond’s face value). If it is below par, it is at a discount, and if it above par, it is at a premium.
Limitations of YTM
Though YTM can act as a good indicator for your potential bond investment, it suffers from the following shortcomings.
Tax considerations
It does not take into account the capital gains tax if the investor were to sell the bond before maturity.
Interest rate
The calculation assumes that the interest rate will remain constant throughout the term of the bond, which does not usually happen.
Reinvestment
It assumes that coupon payments will be reinvested at the same rate, which may not take place. Besides, the investor may not want to reinvest in the bond.
Default risk
It doesn’t take into account the fact that the issuer may default, and the investor may lose the principal amount as well.
Early sale
It assumes that the bond will be held till maturity, whereas the investor may want to sell it earlier for a variety of reasons.
How is it calculated?
YTM can be calculated by considering the annual coupon payment (C), present value (PV), face value (FV) and the number of compounding periods or the number of years to maturity (n). The formula is as follows: