What is Yield to Maturity (YTM)?
Understanding Yield to Maturity and how it determines the true return of a bond investment
Table of Contents
1Definition of YTM
YTM, or Yield to Maturity, is the total return an investor can expect to earn if a bond is held until it matures, assuming all payments are made as scheduled.
YTM is expressed as an annual rate and incorporates all future coupon payments and the difference between the bond's purchase price and its face value.
YTM helps investors evaluate whether a bond is fairly valued, undervalued, or overvalued compared to other fixed income instruments.
2The YTM Equation
The YTM of a bond is the rate r that solves the following equation:
Since this equation cannot be solved algebraically, we typically use numerical methods like the Newton-Raphson method to calculate the YTM.
3Example Calculation
YTM Example
Suppose you buy a bond with a face value of €100, 5 years to maturity, a 5% annual coupon, and a current price of €98.
We solve the present value equation iteratively using the Newton-Raphson method to find the YTM that equates the bond's price to the discounted cash flows.
4Why YTM Matters
True Total Return
YTM accounts for all future payments, including coupons and capital gain/loss, offering a complete view of expected return.
Price Comparison Tool
It allows you to compare bonds with different coupons, prices, and maturities on an equal footing.
Market Expectations
YTM reflects current market rates and helps estimate future interest rate expectations.
Helps Valuation
It's a crucial input when modeling or valuing fixed-income portfolios.
5Limitations of YTM
YTM is useful, but comes with important assumptions:
- Reinvestment Assumption: Assumes all coupons are reinvested at the YTM rate, which is often unrealistic.
- No Default Risk: It assumes the issuer won't default and all cash flows will be paid.
- Constant Yield: Assumes the yield remains unchanged until maturity, ignoring interest rate fluctuations.
- Callable Bonds: Doesn't account for early redemption, which alters actual returns.
Related Financial Terms
Frequently Asked Questions
YTM assumes that all coupon payments are reinvested at the same rate as the YTM itself. However, this assumption may not hold in fluctuating interest rate environments, introducing reinvestment risk. If reinvestment rates are lower than the YTM, the actual realized return will be less than the YTM, potentially impacting the bond's attractiveness to investors.
YTM does not account for certain bond features such as call provisions or sinking funds. For callable bonds, the issuer may redeem the bond before maturity if interest rates decline, leading to a lower actual return than the YTM suggests. Therefore, YTM may overstate the potential return for bonds with such features, and investors should consider metrics like Yield to Call or Yield to Worst in these cases.
The yield curve's shape—whether normal, inverted, or flat—affects the YTM of bonds across different maturities. In a normal yield curve, longer-term bonds have higher YTMs, reflecting higher expected returns for increased risk. An inverted yield curve, where short-term YTMs exceed long-term ones, may signal economic downturns. Thus, analyzing YTM in the context of the yield curve provides insights into market expectations and economic conditions.
YTM is closely related to a bond's duration and convexity, which measure the bond's sensitivity to interest rate changes. Duration estimates the percentage change in a bond's price for a 1% change in interest rates, while convexity accounts for the curvature in this relationship. Bonds with higher durations and convexities are more sensitive to interest rate fluctuations, affecting their YTM and overall risk profile.