Yield to Maturity (YTM)

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 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."

KEY TAKEAWAYS

 Yield to maturity (YTM) is the total rate of return that will have been
earned by a bond when it makes all interest payments and repays the
original principal.
 YTM is essentially a bond's internal rate of return (IRR) if held to maturity.
 Calculating the yield to maturity can be a complicated process, and it
assumes all coupon or interest, payments can be reinvested at the same
rate of return as the bond.
Understanding 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.

Calculating YTM
Because YTM 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.

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 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, they 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 it is often difficult to

calculate a precise YTM value. Instead, one can approximate YTM by using a bond
yield table, financial calculator, or online yield to maturity calculator.

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, they 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.

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 mentioned earlier, 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 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 they
are 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 calls and put provisions, they
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.1  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.

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.2  If you have an interest in corporate bonds then you will need a brokerage
account.

What Is a Bond’s Yield to Maturity (YTM)?

The YTM of a bond is essentially the internal rate of return (IRR) associated with
buying that bond and holding it until its maturity date. In other words, it is the
return on investment associated with buying the bond and reinvesting its coupon
payments at a constant interest rate. All else being equal, the YTM of a bond will
be higher if the price paid for the bond is lower, and vice-versa.

What Is the Difference Between a Bond’s YTM and Its Coupon Rate?
The main difference between the YTM of a bond and its coupon rate is that the
coupon rate is fixed whereas the YTM fluctuates over time. The coupon rate is
contractually fixed, whereas the YTM changes based on the price paid for the
bond as well as the interest rates available elsewhere in the marketplace. If the
YTM is higher than the coupon rate, this suggests that the bond is being sold at
a discount to its par value. If, on the other hand, the YTM is lower than the
coupon rate, then the bond is being sold at a premium.

Is It Better to Have a Higher YTM?

Whether or not a higher YTM is positive depends on the specific circumstances.
On the one hand, a higher YTM might indicate that a bargain opportunity is
available since the bond in question is available for less than its par value. But
the key question is whether or not this discount is justified by fundamentals such
as the creditworthiness of the company issuing the bond, or the interest rates
presented by alternative investments. As is often the case in investing, further
due diligence would be required.