Yield to Maturity

Yield to Maturity

Yield to maturity (YTM) is the yield promised by the bondholder on the assumption that the bond will be held to maturity, that all coupon and principal payments will be made and coupon payments are reinvested at the bond's promised yield at the same rate as invested. The YTM s 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.

Influencing Factors

"The yield to maturity, or discount rate, is the rate of return required by the bondholders. The bondholder, or any investor, will allow three factors to influence his or her required rate of return." (Block, 2005, p.11)

1. Real rate of return - This is the rate of return the investor demands for giving up the current use of funds. It is the financial rent the investor charges for using his or her funds for any given period.

2. Inflation Premium - The investor requires a premium to compensate for the eroding effect of inflation on the value of a dollar. The inflation premium added to the real rate of return ensures that an investor receives their risk free rate of return.

3. Risk Premium - There are two types of risks: business risk and financial risk. (Block, 2005)

As inflation premiums increase the required rate of return will rise as well. This will cause the new value of the bond to be less that its current value. The same effect would occur if the business risk increased or the demanded level for the real rate of return became higher. The opposite effect would occur if the information premiums decreased (or fell) because of lower inflation, less risk, or other factors. This would cause the bond to increase above par value. "The further the yield to maturity on a bond changes from the state interest rate on the bond, the greater the price change effect will be." (Block, 2005, p.20)

Example

Once investors have bought a bond they do not need to hold it until maturity. They may sell it on the open market but may receive more or less than they paid depending upon the market conditions. The yield to maturity is simply the market price sold of a bond. The yield to maturity indicates the price the investor is willing to pay today in return for receiving money later in the form of the regular coupon rate payments and the principle at maturity.