Yield to maturity definition
/What is the Yield to Maturity?
Yield to maturity is the rate of return expected on a bond if it is held until its maturity date. It is expressed as an annual rate of return. 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. The rate of return is based on the stream of future coupon payments, the eventual return of principal, and the initial purchase price.
How to Calculate Yield to Maturity
The specific inputs to the calculation are the par value of the bond, its market value, the annual interest rate, the maturity of the bond in years, and the timing of the coupon payments (such as quarterly, semi-annually, or annually). If a bond holder sells the bond prior to its maturity date, the yield to maturity on that investment may vary from the amount that would have been realized if it had been held to the maturity date.
Several issues included in the yield to maturity calculation are as follows:
It discounts cash flows to their present value
All coupon payments are assumed to be reinvested at the same rate of return as the current yield to maturity
All coupon payments are assumed to be paid on time
There is no consideration of the transaction costs required to buy or sell a bond
There is no consideration of the tax rate paid by the investor
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How to Calculate Yield to Maturity
The calculation of yield to maturity can be performed manually, but requires a series of trial and error estimates to gradually refine the result. A much easier approach is to plug the necessary information into a formula in an electronic spreadsheet.
Example of the Yield to Maturity
Suppose you purchase a corporate bond from XYZ Corporation with the following features:
Face value (Par value): $1,000
Current Market Price: $950 (trading at a discount)
Annual coupon (interest rate): 5% (or $50 annually)
Years until maturity: 5 years
Step 1: Determine the annual coupon payment:
Annual Coupon = $1,000 × 5% = $50
Step 2: Determine annualized appreciation or depreciation on bond (capital gain/loss):
Since the bond is trading at $950 (discount) but will mature at $1,000 (par), you gain $50 in total over 5 years:
Annualized Capital Gain = ($1,000 − $950) ÷ 5 years = $10 per year
Step 3: Calculate approximate yield to maturity (YTM):
Approximate YTM = (Annual Coupon + Annual Capital Gain) ÷ Average Bond Price
Average bond price is calculated as the average of the purchase price and the maturity (par) value:
Average Bond Price = ($950 + $1,000) ÷ 2 = $975
Plugging these numbers into the formula:
Approximate YTM = ($50 + $10) ÷ $975 ≈ 0.06154 = 6.15%
The yield to maturity for this bond is approximately 6.15%. This means that, if you buy the bond at $950 today and hold it until maturity (receiving the annual $50 coupon payments and the $1,000 par value at the end), your approximate average annual return would be around 6.15%.