A bond’s yield to maturity (YTM) is the total return an investor would get on the bond if it is held to maturity. A bond’s YTM is in effect the internal rate of return of a bond that indicates such discount rate at which the present value of the bond’s coupon payments and maturity value matches the bond’s current market price. To put it more precisely, the bond's YTM is the effective rate of return that reflects the bond’s actual market value.
However, this rests on the assumption that all the coupon proceeds are reinvested back at a constant rate, and the bond is held until maturity.
YTM is usually expressed as an annual percentage rate, and calculated with the following formula:
C – Interest/coupon payment
FV – Face value of the bond
PV – Present value/price of the bond
t – How many years it takes the bond to reach maturity
To get a better understanding of how the YTM formula works, let us look at an example.
Assume that a bond with a face value of $1,000 is trading on the market at $850. The annual coupon rate for the bond is 15%, which means the annual coupon payments are $150. The bond’s maturity period is 7 years.
The approximated YTM on the bond is 18.53%
It is important to understand that this formula provides only approximated YTM. Since the bond’s PV may fluctuate over the bond’s life term, the true YTM is typically calculated by the trial-and-error method that implies using a variety of PVs and plugging them into the current value slot of the formula.
Knowing the YTM can help investors compare bonds with various maturity and coupon rates. For example, when comparing a ten-year bond with a 2.5% YTM and a five-year bond with a 3% YTM, the five-year bond is more lucrative.
It is also a practical way of comparing prices of older bonds sold at a premium or discount of the face value in a secondary market.
In addition, if a bond issuer’s financial standing goes down and there is a chance he may redeem a bond early, investors may make use of the worst-case scenario yield to maturity known as the “yield to worst”, which is the lowest possible yield the investor may receive.
Stay tuned with Wolfline Capital and you will learn more interesting peculiarities about bonds and other capital markets instruments.