Yield to maturity

What it means

Yield to maturity is the total annual return an investor earns by buying a bond at its current market price and holding it until maturity. It takes into account the coupons received while holding it and the difference between the purchase price and the nominal value repaid at maturity.

If a bond is bought below its nominal value, the yield to maturity is higher than the coupon rate, because the investor also gains the price difference at maturity. If it is bought above nominal value, the yield is lower than the coupon, since part of the price paid will not be returned at maturity.

Mathematically it is an internal rate of return, as with IRR, meaning the discount rate at which the present value of all future bond payments equals today's price. Yield to maturity makes it possible to compare bonds with different coupons, prices and maturities.

How it works in practice

When investing a company's spare cash in bonds, yield to maturity is a better indicator than the coupon alone. A low-coupon bond bought well below nominal value can deliver a higher total return than a high-coupon bond bought above it.

For a company issuing bonds, the market yield to maturity shows what it would have to pay for new financing. If the yields on its existing bonds rise, the market sees higher risk or general interest rates are increasing, which will make further issues more expensive.

In the accounts, bonds held to maturity are often measured at amortised cost using the effective interest rate, which at purchase is essentially the yield to maturity. Any premium or discount is thus released gradually over the holding period.

What to watch out for

Yield to maturity assumes the investor holds the bond to the end and the issuer pays all coupons and principal on time. If the issuer defaults or the investor sells early, the actual return may differ considerably, so the issuer's creditworthiness must also be assessed.

Bond prices fall when market interest rates rise, which is interest rate risk. When selling before maturity the investor may suffer a loss even if the issuer meets its obligations. A longer maturity usually means greater price sensitivity to rate changes.