Yield to maturity
From Wikipedia, the free encyclopedia
Yield to maturity (YTM) is the internal rate of return on cash flows of a fixed income security, often a bond, if the security were to be held until maturity. It is a measurement of the return of the bond. This technique in theory allows investors to calculate the fair value of different financial instruments.
The calculation of YTM is identical to the calculation of internal rate of return.
- If a bond's current yield is less than its YTM, then the bond is selling at a discount.
- If a bond's current yield is more than its YTM, then the bond is selling at a premium.
- If a bond's current yield is equal to its YTM, then the bond is selling at par.
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[edit] Variants of Yield to maturity
Given that many bonds have different characteristics, there are some variants of YTM:
- Yield to Call: when a bond is callable (can be repurchased by the issuer before the maturity), the market looks also to the Yield to Call, which is the same calculation of the YTM, but assumes that the bond will be called, so the cashflow is shortened.
- Yield to Put: same as Yield to Call, but when the bond holder has the option to sell the bond back to the issuer at a fixed price on specified date.
- Yield to Worst: when a bond is callable, "puttable" or has other features, the yield to worst is the lowest yield of Yield to Maturity, Yield to Call, Yield to Put, and others.
[edit] Example
Consider a 30-year zero coupon bond with a face value of $100. If the bond is priced at a yield-to-maturity of 10%, it will cost you $5.73 today. Over the coming 30 years, the price will advance to $100, and your annualized return will be 10%.
But what happens in the meantime? Suppose that over the first 10 years of your holding period, interest rates decline, and the yield-to-maturity on your bond falls to 7%. With 20 years remaining to maturity, the price of the bond will be $25.84. Even though the yield-to-maturity for the remaining life of the bond is just 7%, and the yield-to-maturity you bargained for when you bought the bond was only 10%, the return you have earned over the first 10 years is 16.26%.
Over the remaining 20 years of the bond, you will not earn 16.26% annually, but 7% annually. If you do the math, you will find that over the entire 30 year holding period, you will have made 10% annually.
