Defining yield to maturity (YTM), reviewing factors which determine a bond’s YTM and how investors can use a bond’s YTM to make investment decisions.
As clients enter into retirement, fixed income instruments such as bonds and preferred stocks become a crucial part of their portfolio. Holding individual bonds can have several benefits including protection against market risk as well as generating current income through coupon payments. When held to maturity, a bond’s annual rate of return is known as its yield to maturity or YTM. In addition to an issuer’s credit rating and the credit risk of the issuer, a bond’s YTM is one of the most important features of bond analysts consider when deciding to include a bond in a portfolio. This article will define yield to maturity as well as discuss the factors which determine a bond’s YTM and how investors can use a bond’s yield to maturity to make investment decisions.
Yield to Maturity: What is it?
Yield to maturity is the promised rate of return generated by a bond assuming the bond issuer is able to meet its debt obligations (does not default), the bond is held to maturity and the investor is able to reinvest the coupons generated by the bond at the same rate of return they were originally invested at. For example, if a bond is purchased with 4 years to maturity and a yield to maturity of 5%, the bond’s total annualized return for the 4-year period will be 5% per year, assuming the three assumptions stated above hold true.
Determinants of Yield
The calculation for a bond’s yield to maturity is an internal rate of return calculation and can be fairly complicated, however, it is important to understand the variables of the calculation and their effect on a bond’s yield. First, a bond’s annual coupon rate is used when calculating its yield to maturity. All else equal, a bond with higher coupon payments will have a higher yield than a similar bond with a lower coupon payment. The second determinant of a bond’s yield is the current price of the bond. A few key terms to know when discussing a bond’s price are its par value, a discount and a premium. Par value, or face value, refers to the amount an investor will receive upon the bond maturing and is almost always equal to $1,000. A discount simply refers to when a bond is priced below its par value and a premium refers to a bond trading above its par value. There is an inverse relationship between a bond’s price and its yield, meaning that as a bond’s price rises, its yield decreases. It is important to note that bonds trading at a discount to their par value will often carry more risk than bonds trading at a premium or have lower coupons than other comparable bonds.
Using Yield to Maturity
There are several key points about a bond’s yield to maturity investors need to keep in mind when investing in bonds. First, they should remember that if held to maturity, changes in a bond’s current market price will not impact the yield realized by the investor. For example, if an investor purchases a bond at 102 with a yield of 5% and the price falls to 96, as long as the investor holds onto the bond until maturity they will realize an annualized return of 5% at maturity. Second, investors must remember a bond’s yield directly correlates with its riskiness. For example, when comparing a bond yielding 8% to a bond yielding 4%, the 8% bond likely carries more risk the issuer will default on their debts than the 4% bond. This means instead of making investment decisions solely on a bond’s yield, it is important to consider the issuer's financial position, debt schedule, and credit rating. At Mersberger Financial Group we use a combination of internal analysis and external third-party research to determine if a bond’s yield adequately compensates investors for the level of credit risk taken on by purchasing the bond.
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Note: Investing in the bond market is subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low-interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.