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Yield maintenance is a form of prepayment fee or premium that is calculated on the movement of interest rates during the period of time that the security or securities in question are held. The borrower is assessed the yield maintenance by the lender. Generally, the anticipation if that the security will provide a higher yield as a result.
Perhaps the best illustration of how yield maintenance works is in the market of commercial mortgage. The institution that underwrites the mortgage will base the rate of the yield maintenance on both current interest rates as well as projected rates that may apply during the course of the life of the mortgage. The formula for determining the applicable yield maintenance involves considering the current or present value of outstanding payments associated with the mortgage. This figure is multiplied by the difference between the current rates for Treasury notes of the same duration, and the bond interest rate involved with the mortgage.
The value to the investors is that the yield maintenance helps to ensure that the yield on the investment will remain the same, even if the borrower chooses to engage in some sort of repayment process that is different from the scheduled payment structure. From this perspective, the yield maintenance makes it possible for the investor to be assured of a reasonable rate of return on the commercial mortgage.
Because the calculation of the yield maintenance has to do with interest rates, the strategy is often used in the valuation of securities. Making projections of the yield maintenance on a given security investment is one of the ways that potential investors can evaluate the feasibility of getting involved with the security, since the calculation will help to reveal the potential for generating a return. While the yield maintenance will fluctuate slightly given shifts in the amount of outstanding payments, adjusting to show the current rate of yield maintenance is relatively easy to accomplish, and helps to provide evidence that an investment is proceeding as expected.
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