Definition
Yield to Maturity (YTM) is the total expected return on a bond, assuming that the bond is held until its maturity date. YTM accounts for the bond’s current market price, its par value, the coupon interest rate, and the time remaining until maturity. YTM is considered a long-term bond yield but is expressed as an annual rate. It’s a comprehensive measure as it considers both the annual coupon payments and any capital gain or loss felt when the bond matures.
Examples
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Discount Bond: Consider a bond with a face value of $1,000, a coupon rate of 5%, which is currently trading at $950 and matures in 5 years. Here, the YTM will be higher than the current coupon yield because the bond is bought at a discount.
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Premium Bond: Conversely, consider a bond trading at $1,050 with a face value of $1,000, a coupon rate of 5%, and matures in 5 years. Here, the YTM will be lower than the current coupon yield because the bond is bought at a premium.
Frequently Asked Questions (FAQ)
Q1: How is Yield to Maturity (YTM) calculated?
A1: YTM is calculated using a complex financial formula that equates the present value of all future bond cash flows (coupon payments and face value at maturity) to the bond’s current price.
Q2: Why is YTM important in bond investing?
A2: YTM gives investors a thorough view of the potential return of a bond, allowing for better comparison among different bonds by standardizing the expected yield.
Q3: Can YTM be negative?
A3: No, YTM cannot be negative. If the return on a bond is less than 0, the bond would not be considered a viable investment option traditionally.
Q4: How does YTM differ from Current Yield?
A4: Current Yield only considers the bond’s annual coupon payment and current price, ignoring the capital gain or loss upon maturity. YTM, however, incorporates both the coupon payment and the price appreciation/depreciation.
Q5: What is the relationship between market interest rates and YTM?
A5: When market interest rates rise, bond prices fall, increasing the YTM. Conversely, when market rates fall, bond prices rise, decreasing the YTM.
- Current Yield: Annual coupon payment divided by the bond’s current price.
- Coupon Yield: Fixed interest rate paid by a bond.
- Coupon Payment: Periodic interest payment from a bond.
- Capital Gain: Profit from selling the bond at a price higher than the purchase price.
- Capital Loss: Loss from selling the bond at a price lower than the purchase price.
- Discount Bond: Bond sold below its par value.
- Premium Bond: Bond sold above its par value.
Online References
Suggested Books for Further Studies
- “The Bond Book” by Annette Thau
- “Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi
- “Fixed Income Analysis” by Barbara S. Petitt and Jerald E. Pinto
Fundamentals of Yield to Maturity (YTM): Finance Basics Quiz
### Which of the following accurately describes Yield to Maturity (YTM)?
- [ ] The bond’s annual coupon rate.
- [ ] The bond’s yield if sold today.
- [x] The bond’s total expected return if held until maturity.
- [ ] The bond's yield with no consideration of market price.
> **Explanation:** Yield to Maturity (YTM) is the bond’s total anticipated return if it is held until it matures, accounting for the current market price and any gains or losses.
### What does YTM account for that Current Yield does not?
- [ ] Annual coupon payments.
- [ ] The bond’s par value.
- [ ] The bond’s time to maturity.
- [x] Capital gains or losses.
> **Explanation:** YTM considers potential capital gains or losses at the bond's maturity, unlike Current Yield, which only looks at the annual coupon payments and the current price.
### When a bond is bought at a premium, how does YTM compare to the coupon yield?
- [ ] YTM is higher than the coupon yield.
- [ ] YTM is equal to the coupon yield.
- [x] YTM is lower than the coupon yield.
- [ ] YTM is not related to coupon yield.
> **Explanation:** For a premium bond, YTM will be lower than the coupon yield because the purchase price exceeds its par value, reducing the overall return.
### If a bond’s YTM is higher than its coupon rate, what does this imply?
- [ ] The bond is likely sold at a premium.
- [ ] The bond’s principal has increased.
- [x] The bond is likely sold at a discount.
- [ ] The bond’s coupon payments have increased.
> **Explanation:** If a bond’s YTM is higher than its coupon rate, it suggests the bond is sold at a discount, as the investors expect higher overall returns.
### Which concept explains the significance of YTM in bond valuation?
- [x] The time value of money.
- [ ] The market interest rate changes.
- [ ] The fixed coupon rate.
- [ ] The bond’s maturity date.
> **Explanation:** YTM emphasizes the time value of money, assessing the present value of future cash flows from the bond, reflecting changes in interest rates.
### When comparing two bonds with different YTMs, which bond is generally more attractive?
- [x] The one with the higher YTM.
- [ ] The one with the lower YTM.
- [ ] The one with the longer time to maturity.
- [ ] The one with the shorter time to maturity.
> **Explanation:** Generally, a bond with a higher YTM is more attractive to investors because it indicates a higher potential return.
### Who is more likely to use YTM when making investment decisions?
- [x] Bond investors looking for comprehensive returns.
- [ ] Stock traders looking for capital gains.
- [ ] Real estate investors analyzing property value.
- [ ] Foreign currency traders examining exchange rates.
> **Explanation:** Bond investors are interested in YTM as it provides a comprehensive measure of expected returns, factoring in market price, interest payments, and capital gains or losses.
### If interest rates in the market rise, what happens to the YTM of existing bonds?
- [ ] YTM falls.
- [ ] YTM stays the same.
- [x] YTM rises.
- [ ] YTM becomes irrelevant.
> **Explanation:** When market interest rates rise, the prices of existing bonds fall, which increases their YTM.
### What factor does not directly affect the YTM of a bond?
- [ ] Coupon rate.
- [ ] Par value.
- [ ] Market price.
- [x] The bondholder’s tax rate.
> **Explanation:** YTM calculations do not consider the bondholder’s tax rate, focusing instead on coupon rate, par value, and current market price.
### Why might an investor prefer a bond with a lower YTM?
- [ ] It indicates better credit quality.
- [x] It may have a shorter maturity with lower risk.
- [ ] It has higher coupon payments.
- [ ] It offers higher capital appreciation.
> **Explanation:** Investors might prefer bonds with lower YTM if they have shorter maturities and hence lower risks, providing more certainty in preserving capital.
Thank you for learning about Yield to Maturity (YTM) and testing your understanding with these quiz questions. Keep refining your financial comprehension for successful investing!
