Yield to Maturity

Definition

Yield to maturity (YTM) is the total return expected on a bond if it is held until it matures. It considers the bond's current market price, par value, coupon interest rate, and the time remaining until maturity. This measure is crucial for investors as it helps compare the profitability of different bonds, especially in assessing held-to-maturity securities.

5 Must Know Facts For Your Next Test

1. YTM assumes that all coupon payments are reinvested at the same rate as the YTM itself, which may not always be realistic.
2. When a bond is selling at a premium, its YTM will be lower than its coupon rate, while if it sells at a discount, the YTM will be higher than the coupon rate.
3. Calculating YTM involves solving for the interest rate in the present value equation that equates the present value of future cash flows to the bond's current price.
4. YTM provides a more comprehensive measure of return than current yield as it accounts for both interest income and any capital gain or loss that will occur if held to maturity.
5. For investors holding securities until maturity, YTM represents the effective annual rate of return they will earn over the life of the bond.

Review Questions

• How does yield to maturity (YTM) serve as a tool for comparing different bonds, particularly in assessing held-to-maturity securities?
  • Yield to maturity serves as a critical tool for comparing different bonds by providing a single measure that incorporates all expected cash flows—coupon payments and principal repayment—over time. By calculating YTM for various bonds, investors can determine which bonds offer better long-term returns based on their current market prices. This is particularly important for held-to-maturity securities, as investors need to understand what their actual return will be if they plan to hold these investments until they mature.
• Explain how yield to maturity can differ from the coupon rate and what implications this has for bond valuation.
  • Yield to maturity can differ from the coupon rate based on whether a bond is trading at a premium or a discount. When a bond sells at a premium, its YTM will be lower than the coupon rate because investors pay more upfront for the bond. Conversely, if a bond sells at a discount, its YTM exceeds the coupon rate as investors receive more interest relative to their initial investment. These differences impact how investors value bonds in their portfolios and influence their investment decisions regarding buying or selling bonds in response to changing market conditions.
• Evaluate how yield to maturity can be affected by changing interest rates in the broader economy and its significance for investors holding fixed-income securities.
  • Yield to maturity is significantly affected by changes in interest rates across the economy. When interest rates rise, existing bonds with lower yields become less attractive, causing their market prices to drop and consequently raising their YTM. Conversely, when rates fall, existing bonds with higher yields see an increase in market price, leading to a decrease in YTM. For investors holding fixed-income securities, understanding these dynamics is crucial since fluctuations in YTM can impact their overall investment returns and strategies for managing interest rate risk.

Related terms

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

Present Value:

Present value is the current worth of a future sum of money or cash flows, discounted at a specific interest rate, reflecting the time value of money.

Market Price: The market price is the current price at which a security is being bought or sold in the market, which can fluctuate based on supply and demand.