What is yield to maturity (YTM)? | Learn more
One of the most popular measures of bond yield is yield to maturity (YTM). Also called book yield Where redemption yieldis the estimated rate of return an investor can expect from a bond when it is held to maturity. Because it takes into account the time value of money, it is often considered the most accurate measure of return for those who wish to hold onto their bonds.
Yield to maturity is a useful comparison tool when it comes to evaluating potential bond investments. Investors can anticipate expected returns on different maturities and coupon rates to better understand the best option for their time horizon.
Here’s an overview of yield to maturity in the context of bond investing and how it compares as a measure of return against other measures.
How to calculate the yield to maturity
Yield to maturity is a complex calculation because it involves forward-looking and compound values. Most investors will use a bond maturity calculator to determine the YTM; however, there is a formula that can express the yield:
YTM = (Face value / Current price)(1 / Time to maturity) – 1
Calculating YTM manually can be difficult as investors need to determine whether the face value is at par, discounted, or premium. The formula also assumes that all coupon payments are reinvested at the same rate as the bond’s current yield. There may be trial and error to determine which interest rate closest to the price of the bond. Often times, YTM is a calculation best left to a preprogrammed calculator.
YTM bond vs coupon rate
An important fact to remember is that an obligation the yield to maturity is not the same as its coupon rate. The YTM is the estimated annualized rate of return on a bond held to maturity. The coupon rate is simply the stated interest rate of the bond. Although different, there is an important correlation between the two:
- If the coupon rate is higher than the YTM of the bond, it is a premium.
- When the YTM is greater than the coupon rate of the bond, it is discounted.
- If the YTM and the coupon rate are relatively similar, the bond is valued at its fair value.
Because YTM is a representation of present value, it is often used as a more accurate measure of the value of bonds, as opposed to the given coupon rate. And, because bonds can trade for a premium or a discount, YTM offers a more accurate view of the bond’s true value, as opposed to simply comparing coupon rates.
Yield to maturity compared to current yield
Investors who compare bonds often accumulate current yield against YTM as a way to compare bond values. This is useful for understanding the impact of the investment time horizon.
- Current yield is the interest it pays annually, divided by the current price of the bond. It approximates what a bond holder could earn over a year; however, as bond values ââfluctuate, this is not a guarantee. If an investor buys a $ 1,000 five-year bond with a coupon of $ 50, its current yield is 5%. Selling this bond after two years for $ 950 meant the yield was only $ 50.
- Yield to maturity helps investors see the expected return on the bond if it is held to maturity. Using the same example, the investor with the five-year $ 1,000 bond at a coupon of 5% could see a yield to maturity of 6.2%, or a total return of $ 310 when they is held for five years.
The big difference here is that YTM takes into account the present values ââof a bond’s future payments. Current yield does not take into account the time value of money, which may give an incomplete measure of bond yield.
YTM vs other types of yield
Because yield to maturity is an optimal representation of a bond’s yield over its lifetime, it is often used as a benchmark. Here’s a look at other performance metrics it benchmarks against:
- Yield to Worst (YTW). The lowest potential yield available on a bond at risk of default. This type of return measures the total return of a bond over a short period of time and is typically compared to YTM to show best and worst case scenarios.
- Yield on call (YTC). The measurement of the bond’s yield at the time of its call date. It is similar to YTW in that it examines the performance of a bond before its last maturity date. It is also compared to YTM and YTW to gauge value.
Disadvantages of reviewing yield to maturity
Yield to maturity is an assumption-based formula, which means it is subject to error, volatility and other unforeseen circumstances. For example, the bondholder may not reinvest all coupon payments. Or, the bond issuer can redeem the bond earlier. In addition, the formula does not take into account taxes and selling costs related to the deposit. While it does a great job of contextualizing anticipated returns, YTM is more of an assessment tool than anything else.
YTM is the internal rate of return on bonds
For those who invest in securities, yield to maturity may sound more familiar by another name: internal rate of return. This metric helps investors and analysts estimate the future profitability of an investment based on its expected annual growth rate. This is also akin to net present value.
Regardless of how investors identify with it, YTM is an important metric used to discern the future value of a bond based on current variables. This information can give investors everything they need to make an informed and confident decision when selecting a bond that matches their investment horizon.
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