Pomegra Wiki

Yield to Maturity (YTM)

The yield to maturity — or YTM — is the total annual return an investor earns if a bond is purchased at the current market price and held to maturity. YTM accounts for coupon payments, the purchase price relative to face value, and the time to maturity. It is the most important metric for evaluating bond returns and is the standard by which bonds are quoted and compared.

For the annual income divided by price, see current yield. For the coupon paid semi-annually, see coupon rate. For the return if the bond is called early, see yield to call.

The calculation: discounted cash flows

YTM is the discount rate that equates the bond’s current price to the present value of all future cash flows (coupons and principal repayment).

For a 5-year bond with a 4% coupon ($40 annual coupon), $1,000 face value, purchased for $950:

  • Year 1 cash flow: $40
  • Year 2 cash flow: $40
  • Year 3 cash flow: $40
  • Year 4 cash flow: $40
  • Year 5 cash flow: $1,040 (final coupon + principal)

The YTM is the discount rate that makes the present value of these cash flows equal to $950. Using financial calculators, the YTM is approximately 4.56%.

This is higher than the 4% coupon because the bond was purchased at a discount to par. The investor receives not only the 4% coupon but also a $50 capital gain at maturity.

Bond prices and yields move inversely

This is the fundamental relationship in bond markets: When yields rise, bond prices fall; when yields fall, bond prices rise.

If market yields rise from 4% to 5%, a bond paying 4% becomes less attractive. Its price must fall to provide a 5% yield to new buyers. Conversely, if yields fall from 4% to 3%, the bond becomes more attractive. Its price must rise to maintain a 3% yield for new buyers.

This inverse relationship means:

  • Rising yield environment → bond prices fall → losses for current holders
  • Falling yield environment → bond prices rise → gains for current holders

The magnitude of the move depends on the bond’s duration — longer-duration bonds move more.

Par, premium, and discount bonds

  • Par bond (priced at $1,000 face value) has YTM equal to the coupon. If it yields 4%, the coupon is 4%.
  • Premium bond (priced above par, say $1,050) has YTM less than the coupon. If the coupon is 4% and it yields 3.5%, it is a premium bond.
  • Discount bond (priced below par, say $950) has YTM greater than the coupon. If the coupon is 4% and it yields 4.5%, it is a discount bond.

Over time, a premium bond’s price declines toward par as maturity approaches (assuming the YTM does not change). An investor holding the premium bond experiences capital loss. A discount bond’s price rises toward par, providing capital gain.

YTM vs. current yield vs. coupon

These are three different metrics:

  • Coupon = annual payment / face value. Example: $40 / $1,000 = 4%
  • Current yield = annual payment / current price. Example: $40 / $950 = 4.21%
  • YTM = total return if held to maturity. Example: 4.56% (for the scenario above)

The coupon is fixed forever. Current yield changes as the price changes. YTM accounts for the full picture — coupons plus price changes.

Reinvestment assumption

YTM calculation assumes that coupon payments are reinvested at the YTM rate itself. In the example above, the calculation assumes the $40 coupons in years 1–4 are reinvested at 4.56%.

This is often unrealistic. If yields subsequently fall to 2%, coupons will be reinvested at 2%, not 4.56%. This reinvestment risk means the actual return might differ from YTM.

Investors with short time horizons (little reinvestment) are less exposed to reinvestment risk. Investors with long time horizons (much reinvestment) face substantial risk.

Yield to call and other variations

Yield to call is the return if a callable bond is called before maturity. It is lower than YTM because the bondholder is forced to sell at the call price, losing potential upside if rates fall.

Yield to worst accounts for all possible redemption scenarios and returns the worst-case yield. It is the most conservative return estimate.

Duration and rate sensitivity

YTM determines the bond’s duration, which measures interest-rate sensitivity. A higher-YTM bond (lower price) has lower duration than a lower-YTM bond (higher price) of the same maturity.

If a bond’s YTM rises 1% (from 4% to 5%), the bond’s price falls by approximately its duration percent. A 5-year bond with a 4-year duration loses approximately 4% in price.

Cross-bond comparison

YTM is the standard metric for comparing bonds. An investor choosing between a 10-year Treasury (3.5% YTM), a 10-year corporate bond (4.2% YTM), and a 10-year municipal bond (3.0% YTM) can directly compare YTMs to understand the return differential.

The corporate bond offers 70 basis points higher yield, compensating for credit risk. The muni offers lower yield but (for a high-income taxpayer) offers tax advantages that make the after-tax yield competitive.

See also

Wider context