Yield to Maturity vs. Spot Rate: An Overview
There are two main ways to determine the value of a bond: yield to maturity (YTM) and spot rate. The method chosen depends on whether the investor wants to hold on to the bond or sell it on the open market.
- Yield to maturity is the total rate of return that will have been earned by a bond when it expires, and the original investment is repaid.
- The spot rate is what the bond is worth at any given moment if it were to be cashed in or sold on the secondary market. (Spot rate is a term used in stocks and commodities trading as well as in bonds.)
If an investor bought a bond with the intention of keeping it until its maturity date and reaping the regular returns it generates, yield to maturity is the price that matters. If the investor wants to sell the bond, the spot rate is the crucial number.
Yield to Maturity
Individual investors most often buy bonds to generate a guaranteed regular income in the form of interest payments on the bond. Thus, they intend to keep the bond until it matures. At that point, they get the original investment back. A $1,000 bond will be worth $1,000 when it reaches maturity, and the investor received regular interest payments during the time they held the security.
This guaranteed value is what makes bonds a popular option for retirement savings, or a portion of a retirement account. The returns on bonds are relatively modest, but so are the risks.
However, bonds are marketable and relatively liquid securities. That's where the spot rate enters the picture.
To understand why and how bond values change over time, consider the basics. Newly issued bonds are sold at par value, or face value, such as $1,000. The buyer will receive interest payments, also known as the coupon, at set periods until the bond reaches its maturity date.
A bond's yield represents its cash flow to its owner. However, as time progresses, there are fewer payments to be made before the bond matures.
The owner who keeps the bond will enjoy its full yield to maturity. If it is sold, the new owner will be getting a bond that has lost part of its yield.
That bond still has a par value of $1,000, but its effective yield to maturity has fallen due to the passing of time. If the original owner sells it, it may be sold at a spot price that is discounted to compensate for the lost yield.
That is just one complicating factor in bond trading. Interest rates cause a more significant complication. The spot rates of bonds fluctuate with changes in interest rates. It is important to know that a bond's yield moves inversely with its price.
Special Considerations on Yield to Maturity and Spot Rate
A bond's yield to maturity is based on the interest rate the investor would earn from investing every coupon payment at an average interest rate until the bond reaches its maturity.
Thus, bonds trading at below par value, or discount bonds, have a yield to maturity that is higher than the actual coupon rate, while bonds trading above par value, or premium bonds, have a yield to maturity lower than the coupon rate.
[Important: Bond yields move inversely with their prices.]
The spot rate is calculated by finding the discount rate that makes the present value of a zero-coupon bond equal to its price. These are based on future interest rate assumptions, so spot rates can use different interest rates for different years until maturity, whereas year to maturity rates use an average rate throughout.
Essentially, this means that spot rates use a more dynamic and potentially more accurate discount factor in a bond's present valuation.
- An investor who buys a bond gets a set amount of interest in a set number of payments. The total paid is its yield to maturity.
- If the bond is sold to a new owner after some interest payments have been made, it will now have a lower yield to maturity.
- That is one factor that determines bond prices in the secondary market.