Yield to Maturity

Definition

Yield to maturity (YTM) is the total return anticipated on a bond if it is held until it matures, reflecting the bond's annual interest payments and the difference between its current market price and its face value. It is a key measure in assessing the attractiveness of bonds, as it allows investors to compare the potential returns of different bonds regardless of their price or coupon rates.

5 Must Know Facts For Your Next Test

1. YTM is often expressed as an annual percentage rate and considers all cash flows, including coupon payments and any capital gains or losses.
2. If a bond is purchased at a premium, the YTM will be lower than the coupon rate, while if it's purchased at a discount, the YTM will be higher than the coupon rate.
3. Calculating YTM requires solving for the interest rate in the present value equation of a bond, which can be complex and often involves iterative methods or financial calculators.
4. YTM assumes that all coupon payments are reinvested at the same rate as the YTM itself, which may not always be realistic.
5. Changes in interest rates in the broader economy can affect YTM; typically, as rates rise, existing bond prices fall and their yields increase.

Review Questions

• How does yield to maturity help investors compare different bonds with varying prices and coupon rates?
  • Yield to maturity provides a standardized measure of expected returns that accounts for differences in bond prices and coupon rates. By calculating YTM, investors can evaluate bonds based on their total anticipated returns rather than just their nominal yields. This allows for more informed decisions when choosing between bonds that may have different characteristics but offer comparable potential for profit.
• Discuss how yield to maturity is affected when a bond is bought at a premium versus a discount.
  • When a bond is bought at a premium, its YTM will be lower than its coupon rate because the investor pays more than its face value, and the bond will amortize down to its face value at maturity. Conversely, when purchasing a bond at a discount, the YTM will exceed the coupon rate since the investor pays less than face value and stands to gain from both interest payments and capital appreciation. This relationship highlights how YTM reflects market conditions and investor expectations.
• Evaluate how changes in market interest rates impact yield to maturity and bond pricing.
  • Changes in market interest rates inversely affect yield to maturity and bond pricing. When interest rates rise, existing bonds with lower fixed coupon rates become less attractive, leading to a decline in their market prices. As prices drop, YTM rises to reflect increased potential returns. Conversely, when rates fall, existing bonds become more valuable, resulting in higher prices and lower yields. This dynamic showcases how YTM acts as an indicator of market conditions and investment attractiveness.

Related terms

Coupon Rate: The annual interest rate paid by the bond issuer on the bond's face value, expressed as a percentage.

Current Yield: The bond's annual coupon payment divided by its current market price, providing a snapshot of the income generated by the bond relative to its price.

Discount Rate: The interest rate used to determine the present value of future cash flows, which can impact bond pricing and yield calculations.