What Is Yield to Maturity (YTM)?
Yield to maturity is expressed as an annual rate and is the estimated total return a bond will generate if you hold it to maturity. Let me explain it directly: Yield to maturity (YTM) is the internal rate of return (IRR) that equates all future cash flows of a bond to its current price. This assumes you hold the bond until maturity and can reinvest at the same yield.
Key Takeaways
You should know that yield to maturity is also referred to as book yield or redemption yield. Remember, YTM may fluctuate, while a bond's coupon rate or the interest paid annually on the bond's face value remains fixed. As interest rates rise, YTM increases; as interest rates fall, YTM decreases. Investors use YTM to compare bonds with different coupon rates and maturity dates.
YTM Formula
A bond's YTM can be calculated using this formula: YTM = [C + (FV - PV) ÷ t] ÷ [(FV + PV) ÷ 2]. Here, C is the coupon payment, FV is the face value, PV is the present value or current price, and t is the years to maturity.
Fast Fact on Bond Pricing
Bonds are priced at a discount, par, or a premium. At par, the bond's interest rate equals its coupon rate. Above par, it's a premium bond with a coupon rate higher than the realized interest rate. A bond priced below par is a discount bond, with a coupon rate lower than the realized interest rate.
YTM vs. Coupon Rate
Unlike stock investments, bond issuers promise to pay you the full face value once it matures. Bonds come with two metrics: YTM and coupon rate. YTM is the total return expected on a bond if you hold it until maturity. The coupon rate is the total amount the bond pays in income to you for as long as you hold it—it's the interest paid annually on the bond's face value. A bond's YTM fluctuates over time while the coupon rate remains fixed.
Calculating YTM
To calculate YTM on a bond priced below par, you plug in various annual interest rates higher than the coupon rate to find a bond price close to the researched bond price. Calculations of yield to maturity assume that all coupon payments are reinvested at the same rate as the bond's current yield and account for the bond's current market price, par value, coupon interest rate, and term to maturity. The YTM is 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. You can approximate YTM by hand or by using a bond yield table, financial calculator, or online YTM calculator.
The annual rate of a bond must be calculated via trial and error. Imagine you hold a bond whose par value is $100. The bond is priced at a discount of $95.92, matures in 30 months (2.5 years), and pays a semi-annual coupon of 5%. The current yield is calculated using the formula: Annual Cash Flow ÷ Market price. Therefore, the current yield is (5% coupon x $100 par value) / $95.92 market price = 5.21%. This is the value to which you compare the next calculations.
To calculate YTM, determine the cash flows first. Every six months, you receive a coupon payment of (5% x $100) / 2 = $2.50. Incorporate this into the formula: YTM = [$2.50 + ($100 - $95.92) ÷ 2.5] ÷ [($100 + $95.92) ÷ 2] = 0.0422, or 4.22%. This bond's YTM is less than its coupon rate, so estimate higher rates. Trying 6% gives YTM = 4.73%; trying 7% gives 5.24%. Because 7% has a YTM more than the current yield and 6% less, the rate is between 6% and 7%.
Taking the interest rate up by one and two percentage points to 6% and 7% yields bond prices of $98 and $95, respectively. Since the bond price is $95.92, the interest rate is between 6% and 7%. You can then make a table with rates increasing in 0.1% increments. The present value equals $95.92 when YTM is 6.8%, so that's the rate. If not exact, continue with 0.01% increments.
Variations of YTM
Yield to maturity has variations that account for bonds with embedded options. Yield to Call (YTC) assumes the bond will be called and repurchased by the issuer before maturity, with a shorter cash flow period, calculated assuming it's called as soon as possible and feasible. Yield to Put (YTP) is similar, but you can sell the bond back at a fixed price; it's calculated assuming return as soon as feasible. Yield to Worst (YTW) is used when a bond has multiple options, calculated based on the terms giving the lowest yield.
Explain Like I'm 5
A bond's maturity date is when the issuer must pay you back. Yield to maturity is the estimated total return you get if you hold it until then. It's calculated using different interest rates to find the best estimated return at current prices.
What Is Meant By Yield to Maturity?
Yield to maturity is the total return you should expect from a bond if you hold it until it matures.
Is Higher or Lower YTM Better?
It depends on market conditions. If the YTM is higher than the current yield, the bond might be undervalued, indicating a possible buy. If lower, it might be overvalued and could be sold.
How Is YTM Calculated?
Yield to maturity is calculated using its current value, coupon payment, years to maturity, and face value.
The Bottom Line
A bond's yield to maturity is the internal rate of return required for the present value of all future cash flows, including 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 you hold the bond to maturity.
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