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Yield to Maturity YTM Overview, Formula, and Importance

It is difficult to calculate a precise YTM, but you can approximate its value by using a bond yield table or one of the many online calculators for YTM. When a bond’s market price is above par, which is known as a premium bond, its current yield and YTM are lower than its coupon rate. Conversely, when a bond sells for less than par, which is known as a discount bond, its current yield and YTM are higher than the coupon rate. Only on occasions when a bond sells for its exact par value are all three rates identical. It’s important to understand that the formula above is only useful for an approximated YTM. In order to calculate the true YTM, an analyst or investor must use the trial and error method.

The rate that normalizes this difference is the yield to maturity. The pricing of a bond is therefore critically dependent on the difference between the coupon rate, which is a known figure, and the required rate, which is inferred. The long-term bond was set to mature 15 years from the date it was issued. Well, lucky for Sarah, there is a way to see if the bond is worth hanging on to. The yield is usually quoted without making any allowance for tax paid by the investor on the return, and is then known as “gross redemption yield”. It also does not make any allowance for the dealing costs incurred by the purchaser (or seller).

How do I calculate the yield to maturity of a bond?

Doug is a Chartered Alternative Investment Analyst who spent more than 20 years as a derivatives market maker and asset manager before “reincarnating” as a financial media professional a decade ago. In such a situation, even a negative bond YTM is still better than storing cash since hyperinflation might happen. This situation adp benefits normally happens when inflation is out of control and the market is unstable. Now that we know the YTM definition, let’s look at some examples to understand how to find the YTM of a bond. For the following problems, you will be advising Sam, who has a bond with face value $150 at 6.5% interest and a 20-year maturity.

• This is an important concept for investors to understand so that they can calculate their returns on their investments.
• They are fixed-income investments that many investors use for a steady stream of income in retirement.
• Using YTM, one could, for instance, compare the relative attractiveness of bonds from different issuers, among coupon and zero-coupon bonds, and those with different maturity.

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. To get a better understanding of the YTM formula and how it works, let’s look at an example. Kiplinger is part of Future plc, an international media group and leading digital publisher. Jennifer Agee has been editing financial education since 2001, including publications focused on technical analysis, stock and options trading, investing, and personal finance.

Price elasticity of demand

At face value, when the bond is first issued, the coupon rate and the yield are usually exactly the same. The yield to maturity (YTM), as mentioned earlier, is the annualized return on a debt instrument based on the total payments received from the date of initial purchase until the maturation date. Even for bonds consisting of different maturities and coupon rates, the YTM enables comparisons to be made since the YTM is expressed as an annualized rate regardless of the bond’s years to maturity. The complex process of determining yield to maturity means it is often difficult to calculate a precise YTM value. Instead, one can approximate YTM by using a bond yield table, financial calculator, or online YTM calculator.

The IRS mandates a zero-coupon bondholder owes income tax that has accrued each year, even though the bondholder does not actually receive the cash until maturity. In this way, the time until maturity, the bond’s coupon rate, current price, and the difference between price and face value all are considered. YTM represents the average return of the bond over its remaining lifetime. Calculations apply a single discount rate to future payments, creating a present value that will be about equivalent to the bond’s price.

For bond investors, yield is the interest and capital gains earnings. Current yield and yield to maturity are two common metrics bond investors use to compare bonds. The actual yield depends in large part on where interest rates stand the day the bond is purchased. Because of this relationship, the vocabulary of the bond market needs more than one definition for yield.

What Is Yield to Maturity (YTM)?

No matter what price the bond trades for, the interest payments will always be $20 per year. For example, if interest rates go up, driving the price of IBM’s bond down to $980, the 2% coupon on the bond will remain unchanged. The yield-to-maturity calculator (YTM calculator) is a handy tool for finding the rate of return that an investor can expect on a bond. As this metric is one of the most significant factors that can impact the bond price, it is essential for an investor to fully understand the YTM definition.

When the bond matures, the investor receives $1,000, the par value, which is considerably less than the $1,250 purchase price. A price below 100% is considered a discount, and a price above 100% is considered a premium. Interest payments to the investor are based on the “coupon rate” and par value.

Approximated YTM

Thus, yield to maturity includes the coupon rate within its calculation. This formula and the whole calculation process become more complex when calculating reinvested coupon earnings. A coupon rate is the interest rate earned on a bond, and investors have the option to cash out those returns or reinvest. An investor would take the same above formula but add the coupon rate that was reinvested on top of the value of the bond. They would have to do this by using a trial-and-error method again to find the accurate coupon rate when adjusted for reinvestments.

Therefore, the current yield of the bond is (5% coupon x $100 par value) / $95 market price. Yield to maturity is the rate of return of the entire bond cash flow, including the return of principal at the end of the bond term. Yield to maturity is a way to compare bonds with different market prices, coupon rates, and maturities.

This website is using a security service to protect itself from online attacks. There are several actions that could trigger this block including submitting a certain word or phrase, a SQL command or malformed data. If the yield curve trends upwards, it means that the long-term YTM is greater than the short-term YTM. Now that we know the YTM definition let’s take a look at some examples to understand the YTM equation and its calculation.

Investors should consider engaging a qualified financial professional to determine a suitable investment strategy. In effect, if coupons were to be reinvested at lower rates than the YTM, the calculated YTM is going to turn out to have been inaccurate, as the return on the bond would have been overstated. Considering yields rise when prices drop (and vice versa), investors can project yield-to-maturity (YTM) on portfolio investments to guide better decision-making. An important distinction between a bond’s YTM and its coupon rate is the YTM fluctuates over time based on the prevailing interest rate environment, whereas the coupon rate is fixed. Some of the more known bond investments include municipal, treasury, corporate, and foreign.

• Bond yield will equal bond YTM if you hold to the bond until its maturity and reinvest at the same rate as the bond YTM.
• YTM is an annualized rate that assumes an investor holds a bond to maturity if it is purchased at its current market price.
• Get instant access to video lessons taught by experienced investment bankers.
• Here, we see that the present value of our bond is equal to $95.92 when the YTM is at 6.8%.
• Suppose we’re tasked with calculating the yield to maturity (YTM) on a corporate bond issuance using the following set of assumptions.

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. The current yield of a bond is easily calculated by dividing the coupon payment by the price.

Since a zero-coupon bond does not have this risk, the YTM will differ accordingly. Sarah can calculate what is known as yield to maturity (YTM) for the bond. Yield to maturity, also known as book yield or redemption yield, is the approximate interest rate that a fixed-interest investment will return based on its current price. Fixed-interest investments are investments that have an interest rate that does not change over the life of the security. The calculation for yield to maturity assumes that each year all interest earned on the bond will be kept or compounded so it is paid out once the bond matures.

Because this formula is based on the purchase price rather than the par value of a bond, it more accurately reflects the profitability of a bond, relative to other bonds on the market. The current yield calculation helps investors drill down on bonds that generate the greatest returns on investment each year. Yield to maturity is the rate of return expected on a bond if it is held until its maturity date. The concept is used by investors to evaluate the returns on different bond investments that may have a range of maturities and different coupon amounts.