Yield to Maturity – YTM 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. You will see the term "spot rate" used in stocks and commodities trading as well as in bonds.
Bonds are fixed-income products that, in most cases, return a regular coupon or interest payment to the investor. 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 on the secondary market, the spot rate is the crucial number.
Yield to Maturity – YTM
Investors will consider the yield to maturity as they compare one bond offering to another. Bond listings will show the YTM as an annual rate of return (IRR) calculated from the investor holding the asset until maturity. You may also hear this called the redemption yield or the book yield. Calculating the yield to maturity is a complicated process that assumes all coupon, or interest, payments can be reinvested at the same rate of return as the bond. Luckily, there are online YTM calculators that can do the heavy math-lifting for you.
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 maturity, the investor will get the original investment principle back. As an example, you can buy a $10,000 bond that has a maturity of three years and pays annual interest. On the maturity date, your $10,000 principle is returned and can be returned to use in another investment. Also, during the time you held the bond you received interest payments.
This guaranteed value is what makes bonds a popular option for retirement savings accounts. The returns on bonds are relatively modest, a reflection of the minimal risks involved in holding the asset. However, bonds are marketable and relatively liquid securities. That's where the spot rate enters the picture.
The spot rate, also known as the spot price, represents the value of an asset at the time of a quote. The basis of the spot rate comes from the value of that asset in the marketplace at that moment and how much an investor will pay to acquire it. Spot prices change, and these changes can be significant. Besides bonds, commodities and currency assets will have spot rates. Agencies such as Morningstar and Bloomberg will list the spot price of different securities on their websites.
Buying a Bond
In their simplest form, a bond is just a loan an investor makes to the entity that offers the asset. Usually, bonds are sold by the government, such as treasury and municipal bonds, or by corporations, but there are many bond classifications. These assets may sell at a discount or premium to the par value depending on the interest rate they pay and the time until they mature. You will see some bonds listed as being callable. This term means the issuer may call back or redeem the asset before it reaches maturity. Also, different offerings will have credit ratings based on the strength of the issuer which will also affect the bond's price.
Newly issued bonds are sold at par value or face value. The buyer will receive interest payments, 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.
Selling a Bond
If it is sold, the new owner will be getting a bond that has lost part of its yield. That sold 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 and all securities that use a spot rate will fluctuate with changes in interest rates.
Bond yields move inversely, or in the opposite direction, of their prices.
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.
The spot rate is calculated by finding the discount rate that makes the present value (PV) 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.
- The YTM is the annual rate of return (IRR) calculated as if the investor will hold the asset until maturity.
- The spot rate represents the value of an asset at the time of a quote.
- 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.