A bond is an investment that is actually used to borrow money from investors with the promise of a return. A bond has a pre-determined term and the value of that bond can fluctuate over time. When investors attempt to get an accurate view of the value of a bond, they use the yield to maturity (YTM). There are many calculations used to determine the rate of return on a bond, but YTM gives investors a more accurate figure to go by.
Yield To Maturity
Since bonds are long-term investments, most investors use yield to maturity (YTM) to establish a more accurate idea of the return they will get. The YTM shows how much the bond will yield if it is allowed to go to maturity and all payments are made.
To calculate the actual YTM, you would have to use a long formula that does an individual calculation for each year and then brings those numbers together into one percentage. But financial experts have created an approximate YTM formula that is widely used throughout the financial industry. That formula is:
Approximate YTM = (Monthly Payment + (Face Value – Price Paid) / Full Term)) / ((Face Value + Price Paid) / 2)
If we had an annual payment of $5.00 for the bond example we used earlier, the formula would be:
($5.00 + ($50.00 – $38.90) / 10)) / ((50.00 + 38.90) / 2) = 13.74 percent.
The YTM is much higher than the current yield because the YTM takes into account the entire yield of the bond. The YTM also shows the real reward for being able to buy a bond at such a discount off of its face value.
Why Use YTM?
The YTM takes into account price fluctuations and changes in interest income over the full life of the bond. The long-term nature of a bond investment makes calculating annual returns misleading. When an investor chooses to reinvest their interest back into their bond each year, which most do, then the annual calculations become unreliable.
For a bond, the face value is not going to change throughout its life. A bond can be a very steady and reliable investment, but investors always want to see how their money will do in the future based on current projections. The YTM offers the clearest picture for investors to show potential future performance based on the information currently known.
Investors use several complicated mathematical formulas to determine the true yield of bonds, but the YTM remains the one number that helps investors to get a better feel for how well their investment will truly do.