Yield to maturity

Definition

Yield to maturity (YTM) is the total return anticipated on a bond if it is held until it matures. It reflects the internal rate of return of the bond, taking into account all future cash flows, including coupon payments and the repayment of the face value at maturity. YTM is essential for evaluating different types of bonds, understanding their valuation, measuring yield, and assessing their risk and return characteristics.

5 Must Know Facts For Your Next Test

1. YTM is calculated by solving for the discount rate that equates the present value of all future cash flows from the bond to its current market price.
2. If a bond is purchased at a discount (below face value), the YTM will be higher than the coupon rate because the investor will receive both interest payments and a capital gain at maturity.
3. Conversely, if a bond is purchased at a premium (above face value), the YTM will be lower than the coupon rate due to the capital loss upon maturity.
4. YTM assumes that all coupon payments are reinvested at the same rate as YTM, which may not always be realistic in real-world scenarios.
5. Changes in interest rates significantly impact YTM; as interest rates rise, bond prices fall, leading to higher yields and vice versa.

Review Questions

• How does yield to maturity help investors compare different types of bonds?
  • Yield to maturity provides investors with a standardized measure to assess and compare the potential returns on different bonds. By calculating YTM, investors can evaluate bonds with varying coupon rates, maturities, and prices on a common basis. This comparison helps them make informed decisions about which bonds fit their investment strategies and risk tolerance.
• Discuss how changes in interest rates affect yield to maturity and what this means for bond valuation.
  • When interest rates rise, existing bond prices generally decline because newer bonds are issued at higher rates. As bond prices fall, their yield to maturity increases. Conversely, when interest rates decrease, existing bond prices rise and their yield to maturity falls. This inverse relationship between interest rates and bond prices is crucial for investors to understand as it directly impacts bond valuation and overall investment strategy.
• Evaluate how yield to maturity incorporates risk factors associated with bonds and their returns over time.
  • Yield to maturity considers not just the expected cash flows from a bond but also reflects the risks associated with holding it until maturity. Factors such as credit risk, interest rate risk, and reinvestment risk all influence YTM. By analyzing YTM alongside other metrics like duration and credit ratings, investors can better gauge potential returns relative to the inherent risks of different bonds, leading to more strategic investment choices.

Related terms

Coupon Rate: The annual interest payment made by a bond issuer to bondholders, expressed as a percentage of the bond's face value.

Bond Price: The current market price at which a bond can be bought or sold, which may differ from its face value due to changes in interest rates and market conditions.

Current Yield: A measure of the income (interest or dividends) generated by an investment relative to its current market price, typically expressed as a percentage.