What is Yield to Maturity (YTM) and Why Should You Care?
YTM is essentially the total return you can expect if you hold a bond until it matures. It takes into account all the coupon payments made during the bond's life and the difference between its current price and face value.
YTM helps you compare different bonds - those with varying coupon rates, market prices, and maturities - on a level playing field. Think of it as your go-to metric for figuring out which bond will give you the best return.
How to Calculate Yield to Maturity (YTM)
The YTM formula is:
[\text{YTM} = \frac{\text{Annual Interest Payment} + \left(\frac{\text{Face Value} - \text{Current Price}}{\text{Years to Maturity}}\right)}{\frac{\text{Face Value} + \text{Current Price}}{2}}]
Where:
- Annual Interest Payment is the periodic interest you receive from holding the bond
- Face Value is the bond's value at maturity
- Current Price is how much you pay to buy the bond today
- Years to Maturity is the time remaining until the bond's maturity
Calculation Example
Given:
- Annual Interest Payment: $100
- Face Value: $1,000
- Current Price: $950
- Years to Maturity: 5
Plugging into the formula:
[\text{YTM} = \frac{100 + \left(\frac{1000 - 950}{5}\right)}{\frac{1000 + 950}{2}}]
First, calculate the price adjustment:
[\frac{1000 - 950}{5} = \frac{50}{5} = 10]
Then complete the calculation:
[\text{YTM} = \frac{100 + 10}{\frac{1950}{2}} = \frac{110}{975} \approx 0.1128]
The YTM is approximately 11.28%.