Most time value of money formulas require some interest rate figures for each point in time. This makes the yield to maturity easier to calculate for zero coupon bonds, because there are no coupon payments to reinvest, making it equivalent to the normal rate of return on the bond.
The formula for calculating the yield to maturity on a zero coupon bond is:
Yield to Maturity = (Face Value / Current Price of Bond) ^ (1 / Years to Maturity) - 1
For example, consider a $1,000 zero coupon bond that has two years until maturity. The bond is currently valued at $925 (the price it could be purchased at today). The formula would look like: (1000 / 925) ^ (1 / 2) - 1. When solved, this equation produces a value of 0.03975, which would be rounded and listed as a yield of 3.98%.
How Do I Calculate Yield To Maturity Of A Zero Coupon Bond?
The yield to maturity may change from year to year for any bond, depending on changes in the overall demand for bonds in the market. Consider what would happen if investors become more willing to hold bonds due to economic uncertainty. Bond prices would probably rise, which would increase the denominator in the yield to maturity formula, thereby reducing the yield.
Yield to maturity is a basic investing concept that is used to compare bonds of different coupons and time until maturity. Without accounting for any interest payments, zero coupon bonds always have a yield to maturity equal to their normal rate of return. The yield to maturity for zero coupon bonds is sometimes referred to as the spot rate.