Here is a simple truth that many people miss. Two bonds with the same coupon can give very different returns if their prices are different. That is why serious investors look at yield to maturity. YTM tells you the true annual return if you buy now and hold till the end.
What is yield to maturity
Yield to maturity is the single rate that sets the present value of all future cash flows equal to today’s market price. Cash flows include every coupon plus the face value you get back at maturity. If all payments come on time and you hold the bond to maturity this rate is your real yearly return. YTM helps you compare bonds that have different coupons and different prices in one clear number.
The idea in one line
If price is below face value YTM will be higher than the coupon. If price is above face value YTM will be lower than the coupon. This simple rule is the heart of how bonds behave.
The practical YTM formula
Finding the exact YTM needs a calculator or spreadsheet because you are solving for a rate inside a present value equation. For quick work many investors use this handy approximation
YTM is approximately
annual coupon plus face value minus price divided by years to maturity
all divided by
average of face value and price
In symbols
YTM ≈ [C plus (F minus P) divided by n] divided by [(F plus P) divided by 2]
Here C is the annual coupon. F is the face value. P is the clean price. n is the years left. This shortcut is very close for most plain bonds that pay regular coupons.
Step by step example
Say a five year bond has face value 1000 and an 8 percent annual coupon. The current clean price is 950.
Step 1. C is 8 percent of 1000 which is 80
Step 2. F minus P is 1000 minus 950 which is 50
Step 3. Divide by n which is 5 so 50 divided by 5 is 10
Step 4. Add coupon and the annual pull to par so 80 plus 10 is 90
Step 5. Average of F and P is 1000 plus 950 divided by 2 which is 975
Step 6. YTM is 90 divided by 975 which is about 9.23 percent
This is higher than the 8 percent coupon because you bought below face value. The example shows why YTM is a better guide when you compare bonds.
What moves YTM
When market price rises YTM falls. When market price falls YTM rises. Longer time to maturity makes YTM more sensitive to price. Higher coupons give more cash early which can push YTM closer to the coupon. Interest rate moves in the economy change bond prices and that in turn changes YTM for many bonds at once.
Common slips to avoid
Do not confuse coupon with YTM. Coupon is fixed on face value. YTM depends on price and time. Check if the bond pays semi annual or quarterly coupons because the exact math then uses period rates. Always use the clean price for calculations. Read the offer terms for call or put options because early redemption can change your return on bonds.
Bottom line
YTM turns a complex stream of cash into one simple rate. Use it to compare bonds across issuers and maturities and coupons. With a little practice you will read price and coupon together and make stronger fixed income decisions.
Comments
0 comment