The internal rate of return required for the present value of all future cash flows of the bond (face value and coupon payments) to equal the current bond price is known as the yield to maturity (YTM). All coupon payments are reinvested at a yield equal to the YTM, and the bond is held to maturity, according to YTM.
Is it better to have a higher or lower YTM?
- The low-yield bond is a preferable choice for investors looking for a virtually risk-free asset or for hedging a mixed portfolio by keeping a portion of it in a low-risk asset.
- The high-yield bond is ideal for investors who are willing to take on some risk in exchange for a larger return. The corporation or government issuing the bond runs the risk of defaulting on its debts.
What effect does YTM have on bond prices?
Given the bond’s price, the yield-to-maturity is the implied market discount rate.
- The price of a bond is inversely proportional to its yield to maturity (YTM). A rise in YTM lowers the price, while a fall in YTM raises the price of a bond.
- The price of a bond and its YTM have a convex connection. When the discount rate falls, the percentage price change is greater than when it rises by the same amount.
- When the coupon rate is higher than the market discount rate, a bond is offered at a premium over par value.
- When the coupon rate is less than the market discount rate, a bond is priced at a discount below par value.
- A lower-coupon bond’s price is more volatile than a higher-coupon bond’s price, all else being equal.
- In general, the price of a longer-term bond is more volatile than the price of a shorter-term bond, all else being equal.
- As maturity approaches, premium and discount bond prices are “drawn to par” assuming no default.
Importance of Yield to Maturity
The most important aspect of yield to maturity is that it allows investors to compare different securities and the profits they may expect from each. It is crucial in deciding which securities to include in their portfolios.
Yield to maturity is also valuable since it allows investors to get a sense of how changes in market circumstances can effect their portfolio because yields rise when assets fall in price and vice versa.
Additional Resources
Thank you for taking the time to read CFI’s Yield to Maturity guidance. Check out some of the CFI resources below if you want to learn more about fixed income securities.
How is YTM determined?
Multiple interests received across the investment horizon are referred to as a coupon. These funds are re-invested at a steady rate.
YTM is the discount rate at which the present value of all future bond cash flows equals the current price of the bond.
However, knowing the link between bond price and yield makes it simple to calculate YTM. The coupon rate is equal to the bond’s interest rate when the bond is valued at par. The coupon rate is higher than the interest rate if the bond is selling at a premium (above par value). The coupon rate is lower than the interest rate if the bond is sold at a discount. This data will make it simple for an investor to compute yield to maturity.
Is a high YTM beneficial to bonds?
High-yield bonds are neither good nor bad investments on their own. A high yield bond is one that has a credit rating that is below investment grade, such as below S&P’s BBB. The higher yield compensates for the higher risk associated with a lower credit grade on the bonds.
Higher-quality bonds’ performance is less associated with stock market performance than high-yield bonds’ performance. Profits tend to drop as the economy suffers, as does the ability of high yield bond issuers to make interest and principal payments (in general). As a result, high yield bond prices are falling. Declining profits also tend to decrease stock values, so it’s easy to understand how good or negative economic news could drive equities and high yield bonds to move in lockstep.
What will happen if YTM rises?
Bond A’s price is $2,845.33 (250 / 0.06 * (1- (1 / 1.0615) + 1,000 / 1.0615). (Premium Bond)
Bond B’s price is equal to 50 / 0.06 * (1- (1 / 1.065) + 1,000 / 1.0615 = $957.88. (Discount Bond)
Bond A’s price is $2,766.05 (250 / 0.06 * (1- (1 / 1.0614) + 1,000 / 1.0614). (Premium Bond)
Bond B price =50/0.06 * (1- (1/1.064)+ 1,000/1.064 =$965.35 (Discount Bond)
Use the above formula with YTM=7% in your computations. Assume we’re figuring out the pricing for the first year:
Bond A’s price is $2,574.18 (250 / 0.07 * (1- (1 / 1.0714) + 1,000 / 1.0714). (Premium Bond)
Bond B price =50/0.07 * (1- (1/1.074)+ 1,000/1.074 =$932.26 (Discount Bond)
Bond A’s price is 250 / 0.05 * (1- (1 / 1.0514) + 1,000 / 1.0514, which is $2,979.73. (Premium Bond)
Bond B’s price is 50 / 0.05 * (1- (1 / 1.054)+ 1,000 / 1.054 = $1,000. (Par Bond)
(Note that for this pricing, you don’t need to make any calculations because the YTM is equal to the couponrate.)
Without any calculations, a bond with a longer time to maturity and a smaller coupon rate is more vulnerable.
Bond A reduces by 6.94 percent with a 1% increase in the YTM (2,766.05 – 2,574.18) / 2,766.05
Bond B drops (965.35 – 932.26) / 965.35= 3.43 percent for a 1% increase in the YTM.
Bond A rises by 7.73 percent when the YTM falls by 1% (2,979.73 – 2,766.05) / 2,766.05=
Bond B increases by (1,000 – 965.35) / 965.35= 3.59 percent for a 1% fall in the YTM.
Bond A clearly has a higher interest rate sensitivity, and thus a higher interest rate risk, than Bond B.
The average maturity of a bond is measured by its duration. Interest rate sensitivity is stronger when the period is longer. Calculating the duration of a 15-year bond is time-consuming and not something that would be asked on an exam. The following duration for year 0 can be calculated using a spreadsheet, financial calculator, or patience:
If everything else stays the same, the duration must be reduced. We all know that a bond with a longer term to maturity is more interest rate sensitive. As the time to maturity decreases over time, the sensitivity decreases, which should be represented in a shorter length.
Is YTM the same as the rate of interest?
While yield to maturity is a measure of a bond’s total return, an interest rate is just the annual percentage return offered.
Can YTM have a negative value?
Because the dividend upon maturity is factored into the YTM calculation, the bond must have a negative total return to have a negative yield. To have a negative YTM, a premium bond must sell for a price so much higher than par that all future coupon payments would not be enough to cover the initial investment. The bond in the preceding example, for example, has a YTM of 16.207 percent. If it were to sell for $1,650 instead, its YTM would be negative, falling to -4.354 percent.
What is the relationship between YTM and price?
The YTM rate of return on a bond, note, or other fixed income asset is the percentage rate of return paid assuming the investor buys and keeps the security until its maturity date. Bond prices and yields are negatively connected. When a result, as the bond price rises, the yield decreases, and as the bond price falls, the yield rises.
Why does a discount bond’s YTM exceed the bond’s current yield?
Why is a discount bond’s yield-to-maturity (YTM) higher than its current yield? The capital gain from the price decrease is not included in the current yield. If a bond pays 5% yearly coupons and has a $1,000 par value and costs $943.82, which of the following spreadsheet functions may be used to compute the YTM?