How to Calculate Redemption Yield with Examples

Definition of Redemption Yield

Redemption yield, also known as the yield to maturity (YTM), is an important financial metric for investors, especially those in the bond market.

 

It helps investors evaluate the potential returns from holding a bond until maturity – ie the end date of the bond, when you get your initial investment back, plus any interest.

 

The interest paid comes from the bond’s coupon rate, which is how much you earn annually from the bond.

 

For example, if a bond has a 5% coupon rate and you invest £1,000 in it, you’ll get £50 every year as interest until the bond matures.

 

Therefore, the redemption yield can provide a more accurate picture of the bond’s profitability than just looking at its coupon rate.

The Redemption Yield Formula

The redemption yield formula is as follows:

Redemption Yield = (C + ((F – P) / n)) / ((F + P) / 2)

Where:

 

C = Annual Coupon Payment

F = Face Value of the Bond

P = Current Market Price of the Bond

n = Number of Years to Maturity

 

Calculating redemption yield can seem a bit daunting and complex at first, but with a solid understanding of the formula and by working through a few examples (see below), it does become a lot more straightforward.

 

Redemption Yield Formula

Example Calculation of the Redemption Yield (Step-by-Step)

Let’s explore the redemption yield calculation by breaking the process down into easy to follow steps using an example.

 

Imagine a 5-year bond, with a face value of £1,000, a current market price of £950, and an annual coupon payment of £50:

 

Step 1: Determine the Values

C

Annual Coupon Payment

£50

F

Face Value

£1,000

P

Current Market Price

£950

n

Number of Years to Maturity

5 years

Step 2: Insert Numbers in to Formula

 

Numerator = C + ((F – P) / n)

Numerator = £50 + ((£1,000 – £950) / 5)

Numerator = £50 + (£50 / 5)

Numerator = £50 + £10

Numerator = £60

 

Denominator = (F + P) / 2

Denominator = (£1,000 + £950) / 2

Denominator = £1,950 / 2

Denominator = £975

 

Step 3: Calculate the Redemption Yield

 

Redemption Yield = Numerator / Denominator

 

Redemption Yield = £60 / £975

 

So, the redemption yield for this bond is approximately 0.0615, or 6.15%.

Interpretation of Redemption Yield

Now we know how to calculate the redemption yield, we need to know what the output actually means.

 

A Redemption Yield of 6.15% means that if you purchase this bond at its current market price of £950 and hold it until maturity, you can expect an annual return of 6.15% on your investment.

 

This is particularly useful for investors when comparing one investment to another.

 

For example, the investor might be looking to decide between investing in a bond, dividend stocks or commercial property, and so, the yield comparison between the three choices might be evaluated as part of that decision.

Factors Affecting Redemption Yield

Several factors can impact the redemption yield of a bond:

 

  • Current Market Price: As the market price of the bond changes, the redemption yield will also change.
  • Face Value: A higher face value will generally result in a lower redemption yield.
  • Coupon Payments: Bonds with higher coupon payments tend to have higher redemption yields.
  • Time to Maturity: The number of years to maturity directly affects the redemption yield. Longer maturities tend to result in higher yields.