What is Yield to Maturity?
Yield to Maturity (YTM) is the annualized return an investor will receive for holding the investment until it matures.
YTM is primarily used to calculate expected returns for:
- Individual Bonds
- Bond Funds
- Preferred Stocks
Yield to Maturity Vs Current Yield
What is the difference between current yield and yield to maturity? If you invest $1,000 into a bond that have a current yield of 5%, won’t your total annualized return be 5% if you hold the bond until maturity?
Yield to maturity takes into account any gains (or losses) on the investor’s principal that will be realized when the bond matures, is redeemed, or called. This will differ from the stated current yield of the bond if the bond was purchased above or below its redeemed value (usually its par value).
Yield to Maturity Formula
The formula for calculating YTM is as follows:
YTM = (C + ((F – P) / n)) / ((F + P) / 2)
YTM = Yield to Maturity
C = Coupon payment
F = Face value of the bond
P = Price of the bond
n = Number of years until maturity
For an example on calculating Yield to Maturity, let’s look at this bond from Toyota:
Using the screenshot above,
C = $3.05 (3.05% on $100 Face value)
F = $100 (Par value of the bond)
P = $92.153
N = 4.75 (this would depend on what day you look at this bond quote of course, this screenshot was taken on March 14th, 2023 – So the bond has 1,734 days until maturity, or ~4.75 years).
Plug that into the Yield to Maturity equation and you get a YTM of 4.89% – just as shown above
Example of Current Yield vs YTM
Note that the bond’s current yield is 3.31%.
However, the bond’s yield to maturity is much higher, 4.898% – What’s the difference?
The bond’s current yield is based solely on the coupon payment from the bond. This is the interest payment that the investor collects every 6 months.
The bond’s yield to maturity is based on the coupon payment from the bond, PLUS the gain the investor would receive when the bond is redeemed at par, or $100 in this case. Notice the price of the bond is below $100 ($92.153)
If you buy this bond today for $92.153, you will be paid $100 when the bond matures – a nice ~8.5% gain before considering any interest payments from the bond. Add that gain to the 3.31% interest payments and you will end up with a total return that is an annualized 4.898%.
As you can see, yield to maturity calculated the total return the bond investor would have received as long as they held the bond until maturity – This is the important distinction between yield to maturity and current yield.
Example With A Purchase Above Par Value
What if you purchase a bond at a premium, or at a price above its par value?
Consider this bond from NextEra Energy:
Notice now that the bond’s current yield is 4.998%. That means if you invest $100 into this bond, you will receive $4.998 per year until the bond matures.
But now, the YTM is lower than the current yield. This is because the price of the bond is $101.034, a premium to its $100 face value. An investor who purchases this bond today pays $101.34, but only receives $100 when the bond matures. That is a loss of ~1% on the investor’s initial principal.
This reduces the investor’s total return, and therefore the yield to maturity, from holding the bond.
For Bond and Debt Funds
We showed examples above about calculating Yield to Maturity for an individual bond. But much more applicable for ordinary investors is calculating the YTM for a bond fund.
You can do this the hard way, and get a listing of all individual holdings of a bond fund. But, most bond funds will tell you the calculation right on their website.
For example, let’s look at the yield to maturity for TLT – A long term treasury bond ETF:
Of course, the TLT ETF will never officially mature. So this figure is a little less useful when investing in a bond fund.
However, it is very useful for a certain type of bond fund like a Defined Maturity Bond Fund.
YTM for Preferred Shares
The same concept can apply to preferred shares as well. Since these are shares that offer both dividends and can be called at a certain price, you are able to calculate a yield to maturity for these investments in a very similar fashion.
For most preferred shares, your face value will be $25, and the maturity date will be a date that the preferred shares are eligible to be called.
Learn From the Best
In his book, Interpretation of Financial Statements, Ben Graham defines this as:
“Yield to maturity (of a bond) takes into account the eventual gain or loss of principal value to be realized through repayment at maturity.”