What is Yield to Maturity (YTM)
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but it is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.
Yield to maturity is also referred to as "book yield" or "redemption yield."
Bond Yields: Current Yield And YTM
BREAKING DOWN Yield to Maturity (YTM)
Yield to maturity is similar to current yield, which divides annual cash inflows from a bond by the market price of that bond to determine how much money one would make by buying a bond and holding it for one year. Yet, unlike current yield, YTM accounts for the present value of a bond's future coupon payments. In other words, it factors in the time value of money, whereas a simple current yield calculation does not. As such, it is often considered a more thorough means of calculating the return from a bond.
The YTM of a discount bond that does not pay a coupon is a good starting place in order to understand some of the more complex issues with coupon bonds. The formula to calculate YTM of a discount bond is as follows
n = number of years to maturity
Face value = bond’s maturity value or par value
Current price = the bond's price today
Because yield to maturity is the interest rate an investor would earn by reinvesting every coupon payment from the bond at a constant interest rate until the bond's maturity date, the present value of all the future cash flows equals the bond's market price. An investor knows the current bond price, its coupon payments and its maturity value, but the discount rate cannot be calculated directly. However, there is a trial-and-error method for finding YTM with the following present value formula:
Or this formula:
Each one of the future cash flows of the bond is known, and because the bond's current price is also known, a trial-and-error process can be applied to the YTM variable in the equation until the present value of the stream of payments equals the bond's price.
Solving the equation by hand requires an understanding of the relationship between a bond's price and its yield, as well as of the different types of bond pricings. Bonds can be priced at a discount, at par or at a premium. When the bond is priced at par, the bond's interest rate is equal to its coupon rate. A bond priced above par, called a premium bond, has a coupon rate higher than the realized interest rate, and a bond priced below par, called a discount bond, has a coupon rate lower than the realized interest rate. If an investor were calculating YTM on a bond priced below par, she would solve the equation by plugging in various annual interest rates that were higher than the coupon rate until finding a bond price close to the price of the bond in question.
Calculations of yield to maturity (YTM) assume that all coupon payments are reinvested at the same rate as the bond's current yield and take into account the bond's current market price, par value, coupon interest rate and term to maturity. The YTM is merely a snapshot of the return on a bond because coupon payments cannot always be reinvested at the same interest rate. As interest rates rise, the YTM will increase; as interest rates fall, the YTM will decrease.
The complex process of determining yield to maturity means that it is often difficult to calculate a precise YTM value. Instead, one can approximate YTM by using a bond yield table, financial calculator or other software, such as Investopedia's Yield to Maturity Calculator.
Although yield to maturity represents an annualized rate of return on a bond, coupon payments are usually made on a semiannual basis, so YTM is calculated on a six-month basis as well.
Example: Calculating Yield to Maturity Through Trial and Error
For example, say an investor currently holds a bond whose par value is $100. The bond is currently priced at a discount of $95.92, matures in 30 months and pays a semi-annual coupon of 5%. Therefore, the current yield of the bond is (5% coupon x $100 par value) / $95.92 market price = 5.21%.
To calculate YTM here, the cash flows must be determined first. Every six months (semi-annually), the bondholder would receive a coupon payment of (5% x $100)/2 = $2.50. In total, he would receive five payments of $2.50, in addition to the face value of the bond due at maturity, which is $100. Next, we incorporate this data into the formula, which would look like this:
Now we must solve for the interest rate "YTM," which is where things get tough. Yet, we do not have to start simply guessing random numbers if we stop for a moment to consider the relationship between bond price and yield. As was mentioned above, when a bond is priced at a discount from par, its interest rate will be greater than the coupon rate. In this example, the par value of the bond is $100, but it is priced below the par value at $95.92, meaning that the bond is priced at a discount. As such, the annual interest rate we are seeking must necessarily be greater than the coupon rate of 5%.
With this information, we can calculate and test several bond prices by plugging various annual interest rates that are higher than 5% into the formula above. Using a few different interest rates above 5%, one would come up with the following bond prices:
Taking the interest rate up by one and two percentage points to 6% and 7% yields bond prices of $98 and $95, respectively. Because the bond price in our example is $95.92, the list indicates that the interest rate we are solving for is between 6% and 7%. Having determined the range of rates within which our interest rate lies, we can take a closer look and make another table showing the prices that YTM calculations produce with a series of interest rates increasing in increments of 0.1% instead of 1.0%. Using interest rates with smaller increments, our calculated bond prices are as follows:
Here, we see that the present value of our bond is equal to $95.92 when the YTM is at 6.8%. Fortunately, 6.8% corresponds precisely to our bond price, so no further calculations are required. At this point, if we found that using a YTM of 6.8% in our calculations did not yield the exact bond price, we would have to continue our trials and test interest rates increasing in 0.01% increments.
It should be clear why most investors prefer to use special programs to narrow down the possible YTMs rather than calculating through trial and error, as the calculations required to determine YTM can be quite lengthy and time consuming.
Uses of Yield to Maturity (YTM)
Yield to maturity can be quite useful for estimating whether buying a bond is a good investment. An investor will determine a required yield (the return on a bond that will make the bond worthwhile). Once an investor has determined the YTM of a bond he or she is considering buying, the investor can compare the YTM with the required yield to determine if the bond is a good buy.
Because YTM is expressed as an annual rate regardless of the bond's term to maturity, it can be used to compare bonds that have different maturities and coupons since YTM expresses the value of different bonds in the same annual terms.
Variations of Yield to Maturity (YTM)
Yield to maturity has a few common variations that account for bonds that have embedded options.
Yield to call (YTC) assumes that the bond will be called. That is, a bond is repurchased by the issuer before it reaches maturity, and thus has a shorter cash flow period. YTC is calculated with the assumption that the bond will be called at soon as it is possible and financially feasible.
Yield to put (YTP) is similar to YTC, except the holder of a put bond can choose to sell the bond back to the issuer at a fixed price based on the terms of the bond. YTP is calculated based on the assumption that the bond will be put back to the issuer as soon as it is possible and financially feasible.
Yield to worst (YTW) is a calculation used when a bond has multiple options. For example, if an investor was evaluating a bond with both call and put provisions, she would calculate the YTW based on the option terms that give the lowest yield.
Limitations of Yield to Maturity (YTM)
YTM calculations usually do not account for taxes that an investor pays on the bond. In this case, YTM is known as the gross redemption yield. YTM calculations also do not account for purchasing or selling costs.
YTM also makes assumptions about the future that cannot be known in advance. An investor may not be able to reinvest all coupons, the bond may not be held to maturity, and the bond issuer may default on the bond.
Yield to Maturity (YTM) Summary
A bond's yield to maturity (YTM) is the internal rate of return required for the present value of all the future cash flows of the bond (face value and coupon payments) to equal the current bond price. YTM assumes that all coupon payments are reinvested at a yield equal to the YTM and that the bond is held to maturity. Calculating the YTM can be done through a trial and error process or more commonly with financial calculators like Investopedia's Yield to Maturity Calculator.
Some of the more known bond investments include municipal, treasury, corporate and foreign. While municipal, treasury and foreign bonds are typically acquired through local, state, or federal governments, corporate bonds are purchased through brokerages. If you have an interest in corporate bonds then you will need a brokerage account. Checking out Investopedia's list of the best online brokers will give you a good start in choosing a broker that is right for your investment needs.