Why use YTM for cost of debt?
Using YTM for cost of debt has some advantages and disadvantages. On the positive side, YTM reflects the current market conditions and the riskiness of your company's debt. It also captures the effect of any premium or discount on the bond price.
The fact that YTM is expressed as an annual rate irrespective of the time taken by the bond to mature, can be used to compare bonds even when they have different maturities and coupons, which makes it a useful parameter to take into account while calculating bond price and returns.
The YTM formula is used to calculate the bond's yield in terms of its current market price and looks at the effective yield of a bond based on compounding. This differs from the simple yield using a dividend yield formula.
The YTM is a snapshot of the return on a bond because coupon payments cannot always be reinvested at the same interest rate. As interest rates rise, the YTM will increase; as interest rates fall, the YTM will decrease.
Estimating the Cost of Debt: YTM
There are two common ways of estimating the cost of debt. The first approach is to look at the current yield to maturity or YTM of a company's debt. If a company is public, it can have observable debt in the market.
YTM allows the investor to better compare the present value of the bond's future payments to future cash flows for various investment options. Unlike current yield, it accounts for the time value of money and assumes that the interest payments are reinvested at that YTM.
It takes into account all future cash flows and provides a comprehensive estimate of expected return, facilitating comparison between different bonds. However, it is important to note that YTM has its limitations, such as assuming a constant interest rate, ignoring reinvestment risk, and credit risk.
The yield to maturity is the interest rate for which the total present value of all returns, including the face value paid at maturity and the series of coupon payments, is equal to the actual price of the bond.
The most noteworthy drawback to the yield-to-maturity (YTM) measure is that YTM does NOT account for a bond's reinvestment risk. The bond's coupon payments are assumed to be reinvested at the same rate as the YTM, which may not be an option in the future given uncertainties regarding the markets.
The YTM is the discount rate that equates the cash flows to the current market price; it is a bond equivalent yield, not an effective annual yield. To compare them, you have to convert the EAY to a BEY, or convert the YTM to an EAY.
How does YTM affect price?
The yield-to-maturity is the implied market discount rate given the price of the bond. A bond's price moves inversely with its YTM. An increase in YTM decreases the price and a decrease in YTM increases the price of a bond.
As these payment amounts are fixed, you would want to buy the bond at a lower price to increase your earnings, which means a higher YTM. On the other hand, if you buy the bond at a higher price, you will earn less - a lower YTM.
Yield to maturity (YTM) is the overall interest rate earned by an investor who buys a bond at the market price and holds it until maturity. Mathematically, it is the discount rate at which the sum of all future cash flows (from coupons and principal repayment) equals the price of the bond.
The YTM is the rate at which the coupon payments and the face value at maturity are discounted to get the current price of the bond. So, YTM is the required return while coupon rate is the annual interest rate.
YTM does not take into account the risk of early redemption, so it may overstate the expected return on a callable bond. YTM also assumes that interest rates will remain constant over the life of the bond. In reality, interest rates can fluctuate, which can have a significant impact on the value of a bond.
A bond's yield to maturity (YTM) is the percentage rate of return for a bond, assuming that the investor holds the asset until its maturity date and receives all its remaining coupon payments and return of the principal (par value) at maturity.
The cost of debt formula is expressed as: Cost of Debt = (Total Interest Expense / Total Debt) x 100. These elements must cover the same accounting period for accurate calculation. The After Tax Cost of Debt accounts for the tax deductibility of interest expenses, reducing the overall cost of debt.
The yield to maturity is a reasonable proxy for the pre-tax cost of debt for companies with debt that is rated as investment grade. That yield can be expressed as a spread over a risk-free rate.
While high-yield bonds do offer the potential for more gains compared to investment-grade bonds, they also carry a number of risks, like default risk, higher volatility, interest rate risk, and liquidity risk.
The yield to maturity predicts a bond's value once it reaches the end of its term. That includes all interest payments and the return of the principal. The current yield communicates a bond's present cash flow, or how much income it's generating based on the current bond price.
What happens to YTM when interest rates rise?
now suppose market interest rates rise from 3% to 4%, as the table below illustrates. If you sell the 3% bond, it will be competing with new treasury bonds that offer a 4% coupon rate. The price of the 3% bond may be more likely to fall. The yield to maturity, however, will rise as the price falls.
How is the yield-to-maturity (YTM) different from the interest rate? “Interest rate” is a general term, “yield to maturity” is a specific interest rate. A bond, for example, has a coupon rate, a current yield and a yield to maturity.
The YTM calculation formulates certain stability conditions of the security, its owner, and the market going forward: The owner holds the security to maturity. The issuer makes all interest and principal payments on time and in full.
Practical Example: Calculating Yield to Maturity for a Bond
Consider a bond with a face value of ₹1,000, an annual coupon rate of 6%, a market price of ₹900, and a time to maturity of 10 years. To calculate the YTM for this bond, we can use the formula provided above: Annual Interest = 6% x ₹1,000 = ₹60.
A bond's current yield is an investment's annual income, including both interest payments and dividends payments, which are then divided by the current price of the security. Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until its maturation date.
