Yield to Maturity (YTM)
What it is:
How it works/Example:
P = price of the bond
n = number of periods
C = coupon payment
r = required rate of return on this investment
F = maturity value
t = time period when payment is to be received
To calculate the lien, the investor then uses a financial calculator or software to find out what percentage rate (r) will make the present value of the bond's cash flows equal to today's selling price. For example, let's assume you own a Company XYZ bond with a $1,000 par value and a 5% coupon that matures in three years. If this Company XYZ bond is selling for $980 today on the market, using the formula above we can calculate that the YTM is 2.87%.
Note that because the coupon payments are semiannual, this is the YTM for six months. To annualize the rate while adjusting for the reinvestment of interest payments, we simply use this formula:
Why it matters:
YTM allows investors to compare a bond's expected return with those of other securities. Understanding how yields vary with market prices (that as bond prices fall, yields rise; and as bond prices rise, yields fall) also helps investors anticipate the effects of market changes on their portfolios. Further, YTM helps investors answer questions such as whether a 10-year bond with a high yield is better than a 5-year bond with a high coupon.
Although YTM considers the three sources of potential return from a bond (coupon payments, capital gains, and reinvestment returns), some analysts consider it inappropriate to assume that the investor can reinvest the coupon payments at a rate equal to the YTM.
It is important to note that callable bonds should receive special consideration when it comes to YTM. Call provisions limit a bond's potential price appreciation because when interest rates fall, the bond's price will not go any higher than its call price. Thus, a callable bond's true yield, called the yield to call, at any given price is usually lower than its yield to maturity. As a result, investors usually consider the lower of the yield to call and the yield to maturity as the more realistic indication of the return on a callable bond.