Understanding Bond Yield and Return

As a result, the bond’s yield to maturity will fluctuate, while the coupon rate for a previously existing bond will remain the same. In comparison, the current yield on a bond is the annual coupon income divided by the current price of the bond security. The Yield to Maturity (YTM) represents the expected annual rate of return earned on a bond under the assumption that the debt security is held until maturity. For bonds with multiple coupons, it is not generally possible to solve for yield in terms of price algebraically. A numerical root-finding technique such as Newton’s method must be used to approximate the yield, which renders the present value of future cash flows equal to the bond price.

This is done by using a variety of rates that are substituted into the current value slot of the formula. The true YTM is determined once the price matches that of the security’s actual current market price. Many brokerages will automatically calculate yield to maturity for you, which makes it easy to compare potential investments.

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

• If an investor purchases a bond at par or face value, the yield to maturity is equal to its coupon rate.
• The higher the yield to maturity, the less susceptible a bond is to interest rate risk.
• Calculating the YTM on each can give you an idea of what they’re getting for their money.
• 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.
• To the bond trader, the potential for gains or losses is generated by variations in the bond’s market price.

If you can determine that a premium is worth the risk, you may have found a great fixed-income investment for your portfolio that can pay consistently and appreciate in value. Therefore, the price of bonds will fall, naturally resulting in a rise in the yield to maturity rate. Alternatively, as interest rates fall, the bonds become more attractive due to their fixed rates, their prices increase due to demand, and their yield falls. If an investor purchases a bond at par or face value, the yield to maturity is equal to its coupon rate.

What is the Yield to Maturity (YTM)?

The coupon rate is the stated periodic interest payment due to the bondholder at specified times. The bond’s yield is the anticipated rate of return from the coupon payments alone, calculated by dividing the annual coupon payment by the bond’s current market price. If the bond’s price changes and is no longer offered at par value, the coupon rate and the yield will no longer be the same. This is because the coupon rate is fixed, and yield is a derivative calculation based on the bond price.

• A bond’s yield will often stray from the original yield at the time of issue.
• Yield to maturity (YTM) is one of the most frequently used returns metrics for evaluating potential bond and fixed-income investments by investors.
• In practice, the rates that will actually be earned on reinvested interest payments are a critical component of a bond’s investment return.[9] Yet they are unknown at the time of purchase.

First and foremost is the impact of interest rate changes on realized returns. Yield to maturity assumes an investor can reinvest all of the coupon payments at the same rate as the calculated yield to maturity. This is typically not the case, as market fluctuations make it difficult to get the exact same yield from one day to the next.

Calculating yield to maturity (YTM)

However, the benefits related to comparability tend to outweigh the drawbacks, which explains the widespread usage of YTM across the debt markets and fixed-income investors. Alternatively, this process can be sped up by utilizing the SOLVER function in Excel, which determines a value based on conditions that can be set. This means that an analyst can set the present value (price) of the security and solve for the YTM which acts as the interest rate for the PV calculation. 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. Yield to maturity can be useful for investors trying to decide between multiple investment options. Calculating the YTM on each can give you an idea of what they’re getting for their money.

Yield to maturity is similar to a discounted cash flow model for valuing stocks. In the case of calculating yield to maturity, all future cash flows can be known. Bonds have fixed coupon rates that pay on fixed schedules, and they have a certain face value paid at maturity on a certain date. 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.

Figuring Bond Return

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 term yield to maturity (YTM) refers to 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.

Understanding Yield to Maturity (YTM)

A bond’s yield to maturity rises or falls depending on its market value and how many payments remain. 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 prices. 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.

Example of a YTM Calculation

Interest rates regularly fluctuate, making each reinvestment at the same rate virtually impossible. While helpful, it’s important to realize that YTM and YTC may not be the same as a bond’s total return. Such a figure is only accurately computed when you sell a bond or when it matures. The relationship between the current YTM and interest rate risk is inversely proportional, which means the higher the YTM, the less sensitive the bond prices are to interest rate changes. The relationship between the yield to maturity and coupon rate (and current yield) are as follows.

That last assumption makes yield to maturity purely theoretical since market conditions are constantly in flux. Yield to Maturity (YTM) – otherwise referred to as redemption or book yield – is the speculative rate of return or interest rate of a fixed-rate security, such as a bond. In practice, the rates that will actually be earned on reinvested interest payments are a critical component of a bond’s investment return.[9] Yet they are unknown at the time of purchase.