Yield to Maturity
What is the annualized total return
a bond bought
and held to maturity? The obvious answer is its quoted
(YTM) at the time of purchase. But that answer is
for the special case of a zero-coupon bond. Even a new issue bond
bought and redeemed at par will not return the quoted YTM, except in
YTM is a measure that only approximates
the true return.
Nevertheless it is useful because it is a quick way of making rough
of the returns on bonds of different coupons and maturities.
vs Total Return
There are similarities between YTM and
TR. Both are the annualized compound rate of return
purchase to sale. Both assume that all payouts (interest or
are reinvested. Both take into account the gain or loss due to
difference between the purchase and redemption price. However TR
is strictly a measure of past performance. It is often misleading
as a prediction of future performance unless one factors in the
rate history over the period for which the TR is quoted.
YTM, on the other hand, is a projection
of future performance.
Since future interest rates are unknown, YTM must assume a reinvestment
rate, and it assumes the YTM rate
itself. Thus YTM is an implicit
that can only be evaluated by the method of successive
approximations. Many hand calculators can perform this operation.
In practice it is virtually impossible
to reinvest the
interest payments at exactly the YTM rate. Usually the payments
in an account at a lower interest rate before being reinvested.
means that the YTM almost always overstates the true return. If
interest earnings are spent rather than reinvested, the return will be
even lower. It is also important to recognize that the interest
are normally trimmed by a tax bite, making it impossible to reinvest
full amount of each payment.
The reason that YTM applies exactly to a
zero coupon bond
is that there is no interest to be reinvested. The entire return
comes from the difference between the purchase price and the face value
of the bond. In ordinary bonds, this difference is treated as a
gain/loss and taxed when sold. However in a zero coupon bond,
gain is treated as interest income and taxed annually according to the
gain in accreted value. Since there are no interest payments to
and therefore none to spend, achieving the quoted YTM is automatic when
a zero coupon bond is held to maturity. Of course this ignores
annual income tax bite.
YTM is almost always quoted in terms of bond-equivalent
yield. This reflects the fact that bond interest payments are
made twice a year at half the coupon rate. The compounding of the
interest payments twice a year results in a
higher annualized return than would be the case for once-a-year
interest payments at the full coupon rate. Thus YTM expressed as
yield slightly understates the YTM when viewed as the annualized
rate of return.
In the absence of taxes, YTM would be an
of return if the yield curve were flat and interest rates remained
over the life of the bond. It becomes a poorer measure as the
curve steepens, or as the purchase price deviates further from par.