Why Is Yield To Maturity Important?

Yield to Maturity (YTM) – otherwise referred to as redemption or book yield – is the speculative rate of return or interest rate of fixed-rate security, such as a bond.

The YTM is based on the belief or understanding that an investor purchases the guard at the current market price and holds it until the security has matured (reached its full value), and that all interest and coupon payments are made in a timely fashion.

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."

When investors consider buying bonds, they need to look at two vital pieces of information: the yield to maturity (YTM) and the coupon rate.

Investment-quality bonds are low-risk investments that generally offer a rate of return slightly higher than a standard savings account. They are fixed-income investments that many investors use for a steady stream of income in retirement. Investors of any age may add some bonds to a portfolio to lower its overall risk profile.

• The yield to maturity (YTM) is the percentage rate of return for a bond, assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond's yield to maturity rises or falls depending on its market value and how many costs remain to be made.
• The coupon rate is the annual amount of interest that the owner of the bond will receive. To complicate things, the coupon rate may also be referred to as the yield from the bond.

Generally, a bond investor is more likely to base a decision on an instrument's coupon rate. A bond trader is more likely to consider its yield to maturity.

The yield to maturity is a fancy way of saying the rate of return that a bond delivers if held from the current date to the date the bond matures. In order to expand on this definition, there are some terms that a person should know.

Par Value - The is the original value that a bond is issued at and is pre-determined by the company or organization issuing the bond.

This does not mean that a bond won't sell for more or less than the par value at issuance, as the market will determine what the bond sells for.

Maturity - This is the date that a bond matures or in other words, is redeemed. The maturity date is also pre-determined by the organization that issued the bond.

When redemption of a bond occurs, the par value of the bond is returned to the person owning the bond, and in exchange, the organization that issued the bond no longer has an obligation to the former bond owner.

Market Value - While a bond is issued, and until maturity, it will have a market value. This is the price that "the market" is willing to pay for the bond.

This price may be higher or lower than the par value depending on several factors, including but not limited to the organization's financial strength and performance, and interest rates.

Coupon Rate - The rate of interest that the organization that issued the bond will pay to the bondholder in regular increments. The coupon rate is stated as a rate relative to the par value.

The coupon rate can be paid at different time periods depending on how the bond was issued...or the organization issuing the bond can pay no coupon at all.

Beginning bond investors have a significant learning curve ahead of them, which can be pretty daunting, but they can take heart in knowing that the learning can be broken down into manageable steps.

A good place to start is with learning the difference between a bond's "coupon" and its "yield to maturity." It's onward and upward after you master this.

In order to understand the Yield to Maturity calculations, it is critical to realize that the formula assumes all coupon payments the issuer makes will be exactly reinvested for the rate of the current yield of the bond.

The formula similarly considers the bond's par value, current price on the market, term to maturity, and coupon interest rate. All of this makes the YTM a complicated yet good formula for determining the return of a bond.

It allows investors to effectively compare and contrast those bonds which possess varying coupon rates and maturity dates.

There are several different ways to figure out the Yield to Maturity. It is a complicated formula, so many investors simply fall back on pre-printed and -figured bond yield tables.

Determining the exact YTM requires either a software program or the use of a financial or business calculator. This is because the value for a basis point drops as the price for a bond increases in an inverse manner.

Many firms actually calculate YTM for six-month time frames as well as on an annual basis. They do this because most coupon payments take place twice per year.

A significant difference between Yield to Maturity and the current yield lies in the fact that the YTM takes into account money's time value, while the simplified current yield computations will not.

This is why investors often prefer to utilize the YTM instead of the current yield when they are crunching numbers on bond returns to compare and contrast with other bond issues and different types of investments.

There are several similar yet still variations on the classical Yield to Maturity figure. These should never be confused with the true YTM. Among these is the yield to call (YTC), yield to put (YTP), and the yield to worst (YTW). Yields to call go with the assumption that the bond issuer will recall the bond by repurchasing it in advance of it reaching maturity.

This assumes that the resulting cash flow period will be shortened. Yield to put is much like the YTC, only the seller is allowed to and may sell the bond back to its issuer on a specific date for a predetermined price.

Finally, yield to worst means that the bonds in question can be put, called, or even exchanged. This is why YTW bonds usually have the smallest yields from the three variations on YTM and the YTM rate itself.

As you assess your financial goals and risk tolerance, a financial advisor can help you tailor a plan that not only protects your assets but also promotes long-term growth

There are some important limitations to the utility of Yield to Maturity as a measurement for comparing and contrasting various bonds against other bonds and other forms of investment classes as well.

With YTM, these calculations never take into account the actual taxes which investors will have to pay on the bonds. This is why YTM is sometimes called the gross redemption yield.

These calculations for yield also do not factor in either selling or buying costs for the bonds themselves.

It is also important to keep in mind that YTM is limited by the fact that both it and current yields are estimated calculations. They can not ever be 100 percent accurate or reliable.

The true returns will vary with the realized price of a bond when a holder sells it. The prices of such bonds can vary significantly as the market actually determines them (and not the issuer).

Such variations in the value of a bond and the price for which it is sold may impact the YTM substantially. The more drastically impact the current yield calculations and measurement in the end.

In short, "coupon" tells you what the bond paid when it was issued. The yield—or "yield to maturity"—tells you how much you will be paid in the ​future. Here's how it works.

Yield to maturity is the total return that will be earned by someone who purchases a bond and holds it until its maturity date.

The yield to maturity might also be referred to as yield, internal rate of return, or the market interest rate at the time that the investor purchased the bond. The yield to maturity is expressed as an annual percentage rate.

To illustrate, let's assume that a 5% $100,000 bond will mature in 5 years and will pay interest each June 1 and December 1. Hence the bond will pay interest of $2,500 every six months until it matures.

If the current market interest rate for this type of bond is 6%, the bond's current market value will be less than $100,000. The market value of a 5% bond in a 6% bond market will be approximately $95,735.

This is the present value of the $2,500 of interest that will be received every six months for five years plus the present value of the $100,000 that will be received at the end of 5 years. (The market interest rate discounts all of the cash amounts. However, the 6% annual market rate will be restated to be 3% per semiannual period, and the 5 years will be translated to be 10 semiannual periods.)

The investor's yield to maturity will be the market rate of 6% (even though the bond's stated rate is 5%) consisting of the following two components:

• The current yield is more than 5.2% because the investor is receiving cash of $2,500 every six months ($5,000 per year) on an investment of only $95,735.
• a gain of $4,265 because the investor bought the bond for $95,735 but will receive cash of $100,000 at maturity.

Yield to Maturity (YTM) provides a benchmark for evaluating different investment instruments. Yield refers to the percentage rate of return paid on a stock in the form of dividends, or the effective rate of interest paid on a bond or note. There are many different kinds of yields, depending on the investment. Yield to maturity is the most popular measure of yield in the Debt Markets.

YTM refers to the percentage rate of return paid on a bond, note or other fixed-income security if the investor buys and holds the security till its maturity date.

How Yield-to-Maturity Works?

Bonds are usually issued by large companies or governments, as a way to borrow money from investors to fund expansion or capital expenditure. The issuer promises to repay the loan on a future date, known as the maturity date.

Let's look at a bond with a $1,000 par value, a 5% coupon rate and 3 years to maturity. The investor will receive a $50 coupon in year 1 and another $50 coupon in year 2. When the bond matures in year 3, the investor will receive another $50 coupon, plus $1,000 capital, which was the original cost of the bond.

This $1,150 payment is agreed when the bond is issued, with the investor receiving annual coupons and par value when the bond matures.

However, bond prices are decided by the market and will fluctuate due to changes in credit ratings and current and future interest rates.

Yield to Maturity, or YTM, measures a bond's rate of return when buying it at different times when the price may vary from the original par value.

Let's again look at our bond with a par value of $1,000, 5% coupon rate and 3 years to maturity.

If you buy this bond at $950, your YTM would be 6.9%, higher than the 5% on offer if you bought it at par value of $1,000. If you buy it at $1,100, the YTM would be 1.6%.

As you can see, the lower the bond price, the higher the YTM.

Our bond with a $1,000 par value, 5% coupon and 3-year maturity is scheduled to pay out $1,150 in 3 years. As these payment amounts are fixed, you would want to buy the bond at a lower price to increase your earnings, which means a higher YTM. On the other hand, if you buy the bond at a higher price, you will earn less - a lower YTM.

Fidelity offers a range of fixed income funds which invest in a portfolio of bonds offering a range of risk and return outcomes.

Coupon vs. Yield to Maturity

A bond has a variety of features when it's first issued, including the size of the issue, the maturity date, and the initial coupon. For example, the U.S. Treasury might issue a 30-year bond in 2019 that's due in 2049 with a coupon of 2%. This means that an investor who buys the bond and owns it until 2049 can expect to receive 2% per year for the life of the bond, or $20 for every $1000 they invested.

However, many bonds trade in the open market after they're issued. This means that this bond's actual price will fluctuate over the course of each trading day throughout its 30-year lifespan.

Let's fast-forward 10 years down the road and say that interest rates go up in 2029. That means new Treasury bonds are being issued with yields of 4%. If an investor could choose between a 4% bond and a 2% bond, they would take the 4% bond every time. As a result, if you want to sell the bond with a 2% coupon, the basic laws of supply and demand force the price of the bond to fall to a level where it will attract buyers.

To put all this into the simplest terms possible, the coupon is the amount of fixed interest the bond will earn each year—a set dollar amount that's a percentage of the original bond price. Yield to maturity is what the investor can expect to earn from the bond if they hold it until maturity.

Importance of Yield Maturity

The primary importance of yield to maturity is the fact that it enables investors to draw comparisons between different securities and the returns they can expect from each.

It is critical for determining which securities to add to their portfolios. It's also useful in that it also allows the investors to gain some understanding of how changes in market conditions might affect their portfolio because when securities drop in price, yields rise, and vice versa.

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.

If it isn't clear yet, the yield to maturity is important because it is that rate of return that a bond purchaser gets when they purchase a bond and if they hold the bond until maturity. And if that isn't important to someone, they aren't going to make a very good bond investor. You see, a person can't just look at the coupon rate and decide that that is the rate of return that they will get.

Let's say Peggy is evaluating the purchase of a bond and wants to know the yield to maturity.After all, she wants to hold it until maturity. She knows that the par value is $1,000, and the coupon payment is 5% with the coupon payment being paid annually. That is to say, and the bond will pay an annual coupon payment of $50 every year. The market value of the bond is $900 at the moment because the interest rates have risen sharply since the bond was issued. The bond is set to mature in 10 years from now...what is the yield to maturity?

For this problem, we need to identify the important parts and filter out the noise. The important parts are the cash flows, so let's identify those for our YTM calculation. The initial cash flow will be the $900 purchase of the bond. The cash flow for 10 years while the bond is held will be $50 per year. The final cash flow at maturity is the par value of $1,000.

If we plug that into a yield to maturity calculator, or IRR calculator, we get the yield to maturity equals 6.38 percent. By understanding how yield to maturity works, we could have guessed that the YTM would be higher than the coupon rate of 5 percent because we bought the bond at a discount to par.

Yield to maturity will be equal to coupon rate if an investor purchases the bond at par value (the original price). If you plan on buying a new-issue bond and holding it to maturity, you only need to pay attention to the coupon rate.

If you bought a bond at a discount, however, the yield to maturity will be higher than the coupon rate. Conversely, if you buy a bond at a premium, the yield to maturity will be lower than the coupon rate.