Case: A coworker of yours was discussing her investments with a broker. Your coworker was confused because she had purchased a 10% bond but the broker kept repeating that it had a 9% yield to maturity. What is 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.
YTM also assumes 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.
YTM is a measurement of the return of the bond and its calculation is identical to the calculation of internal rate of return (IRR).
Applying to the situation mentioned, the coworker purchased a bond with a coupon rate of 10 percent.
The 9 percent YTM applies if she holds on to that bond until it matures while reinvesting all interest payments she received from the instrument.
The significance of YTM is that it allows comparison of bonds with different coupon rates and prices.
1) Calculator: enter n, M, PMT, PV and VL and request k
2) Trial and Error: find k such that VL = INT({PVIFAM n) + M(PVIF M n)
3) Yield approximation formula:
YTM = INT + (M- VL)/ n
--------------------
(M + VL)/2
Where:
VL = the value of the bond
kc = the fixed coupon interest
n= the number of periods until maturity
M = the dollar principal payment at maturity
INT = periodic dollar coupon payment = kc x M
kd = discount rate on the bond
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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