The yield to maturity is the income return an investor can expect to receive if he holds his fixed-interest security such as a bond, until its maturity date. When calculating the yield to maturity, analysts make the assumption that investors will hold their fixed interest security until it matures. Investors also assume that all interest payments earned are reinvested at the same yield to maturity rate.
Yield to Maturity
Calculating the yield to maturity helps investors decide which debt security to purchase. Investors will not always opt to purchase a debt security with a higher yield to maturity over one with a lower yield. They will consider other factors such as credit risk, duration and credit ratings, along with yield to maturity before making a final decision. The maturity dates on debt securities can range anywhere from 30-days for money market investments to 30 years for government bonds.
Maturity Date Assumption
When an investor purchases a debt security such as a bond, the amount paid for the bond is the principal. In return, the investor receives a stream of interest payments until the bond matures. On the maturity date, the interest payments stop and the bond issuer must pay back the principal amount of the bond to the investor. There is no way to predict when investors will sell their bonds, which is why in yield to maturity calculations the assumption is made that they will hold it until its maturity date.
The reinvestment assumption for yield-to-maturity calculations is that when an investor receives interest payments on debt securities, those payments are reinvested in the same debt security or other securities that have the exact same yield to maturity rate. For example, an investor purchases a bond with an 8 percent yield to maturity. Once the investor receives his interest payment on the bond, the assumption is made that he will reinvest that payment in a security that also has an 8 percent yield to maturity.
To estimate the yield to maturity of a debt security, you can use the following equation: Yield to maturity = interest income + (par value -- current price) / number of years to maturity)) / ((par value + current price) / 2)). You then multiply the number you get from that equation by 100 to change it into a percentage. This equation gives the approximate yield to maturity you can expect from a debt security if you hold it to maturity, and if you reinvest your interest income payments at the same yield to maturity rate.
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