Definition
Yield to Maturity (YTM) is the total expected return on a bond, assuming that the bond is held until its maturity date. YTM accounts for the bond’s current market price, its par value, the coupon interest rate, and the time remaining until maturity. YTM is considered a long-term bond yield but is expressed as an annual rate. It’s a comprehensive measure as it considers both the annual coupon payments and any capital gain or loss felt when the bond matures.
Examples
Discount Bond: Consider a bond with a face value of $1,000, a coupon rate of 5%, which is currently trading at $950 and matures in 5 years. Here, the YTM will be higher than the current coupon yield because the bond is bought at a discount.
Premium Bond: Conversely, consider a bond trading at $1,050 with a face value of $1,000, a coupon rate of 5%, and matures in 5 years. Here, the YTM will be lower than the current coupon yield because the bond is bought at a premium.
Frequently Asked Questions (FAQ)
Q1: How is Yield to Maturity (YTM) calculated? A1: YTM is calculated using a complex financial formula that equates the present value of all future bond cash flows (coupon payments and face value at maturity) to the bond’s current price.
Q2: Why is YTM important in bond investing? A2: YTM gives investors a thorough view of the potential return of a bond, allowing for better comparison among different bonds by standardizing the expected yield.
Q3: Can YTM be negative? A3: No, YTM cannot be negative. If the return on a bond is less than 0, the bond would not be considered a viable investment option traditionally.
Q4: How does YTM differ from Current Yield? A4: Current Yield only considers the bond’s annual coupon payment and current price, ignoring the capital gain or loss upon maturity. YTM, however, incorporates both the coupon payment and the price appreciation/depreciation.
Q5: What is the relationship between market interest rates and YTM? A5: When market interest rates rise, bond prices fall, increasing the YTM. Conversely, when market rates fall, bond prices rise, decreasing the YTM.
Related Terms
- Current Yield: Annual coupon payment divided by the bond’s current price.
- Coupon Yield: Fixed interest rate paid by a bond.
- Coupon Payment: Periodic interest payment from a bond.
- Capital Gain: Profit from selling the bond at a price higher than the purchase price.
- Capital Loss: Loss from selling the bond at a price lower than the purchase price.
- Discount Bond: Bond sold below its par value.
- Premium Bond: Bond sold above its par value.
Online References
Suggested Books for Further Studies
- “The Bond Book” by Annette Thau
- “Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi
- “Fixed Income Analysis” by Barbara S. Petitt and Jerald E. Pinto
Fundamentals of Yield to Maturity (YTM): Finance Basics Quiz
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