Published Sep 8, 2024 Redemption Yield, also known as Yield to Maturity (YTM), is the total return anticipated on a bond if it is held until it matures. It is essentially the internal rate of return (IRR) for a bond, assuming that the bond will be held to maturity and that all interest payments will be made as scheduled. The redemption yield accounts for the bond’s current market price, its par value, coupon interest rate, and the time remaining until maturity. Consider an investor who purchases a 10-year bond with a face value of $1,000 and a coupon rate of 5%, which is paid annually. Suppose the current market price of the bond is $950. The investor will receive $50 each year in interest payments for the next 10 years, plus the $1,000 face value at the end of the 10-year period. To calculate the redemption yield, you would solve for the discount rate that equates the present value of the bond’s future cash flows (both the annual coupon payments and the final principal payment) to its current market price. This involves solving the following equation: $$950 = \sum_{t=1}^{10} \frac{50}{(1 + r)^t} + \frac{1000}{(1 + r)^{10}}$$ Where \( r \) is the redemption yield. Given its complexity, this calculation is typically performed using financial calculators or spreadsheet software. Redemption Yield is a critical measure for bond investors because it provides a comprehensive view of the bond’s potential return, encompassing both the income from coupon payments and any capital gains or losses. It offers a means to compare bonds with different prices, maturities, and coupon rates on an equal footing. The redemption yield differs from the current yield in that it includes the total return of the bond if held to maturity, accounting for both the coupon payments and any capital gains or losses due to changes in the bond’s market price. The current yield only considers the annual coupon payment relative to the bond’s current market price and does not account for the capital gains or losses at maturity. The redemption yield varies with market interest rates because bond prices move inversely to changes in interest rates. When market interest rates rise, the price of existing bonds falls, leading to a higher redemption yield. Conversely, when market interest rates decline, the price of existing bonds increases, resulting in a lower redemption yield. This relationship ensures that newly issued bonds and existing bonds offer similar returns in a changing interest rate environment. Yes, redemption yield can be negative, which typically occurs in situations where the bond price is significantly higher than the face value and the coupon payments do not compensate for the loss incurred by holding the bond to maturity. Negative yields often indicate strong investor demand for perceived safe-haven assets, especially during times of economic uncertainty or deflationary pressures. Investors might accept negative yields either because they expect capital gains from further price increases or to preserve capital. While redemption yield is a useful metric for comparing bonds, it has limitations. It assumes that all coupon payments are reinvested at the same rate, which may not be realistic. Additionally, it does not account for the risk of default, changes in tax laws, or other factors that might affect the bond’s return. Lastly, for bonds with embedded options, such as callable or convertible bonds, the redemption yield might not accurately reflect the bond’s complexities or potential adjustments in cash flow.Definition of Redemption Yield
Example
Why Redemption Yield Matters
Frequently Asked Questions (FAQ)
How does the redemption yield differ from the current yield?
Why does the redemption yield vary with market interest rates?
Can redemption yield be negative, and what does it signify?
What are the limitations of using redemption yield for bond comparison?
Economics