Yield to Maturity, Yield to Call
Posted On March 12, 2017
Yield to maturity (YTM) reflects the rate of return on a bond at any given time (assuming it is held until its maturity date). It takes into account not only the bond’s interest rate, principal, time to maturity, and purchase price, but also the value of its interest payments as you receive them over the life of the bond. Yield to maturity includes the additional interest you could earn by reinvesting all of the bond’s interest payments at the yield it was earning when you bought it.
If you buy a bond at a discount to its face value, its yield to maturity will be higher than its current yield. Why? Because in addition to receiving interest, you would be able to redeem the bond for more than you paid for it. The reverse is true if you buy a bond at a premium (more than its face value). Its value at maturity would be less than you paid for it, which would affect your yield.
Example: Â If you paid $960 for a $1,000 bond and held it to maturity, you would receive the full $1,000 principal. The $40 difference between the purchase price and the face value is profit, and is included in the calculation of the bond’s yield to maturity. Conversely, if you bought the bond at a $40 premium, meaning you paid $1,040 for it, that premium would reduce the bond’s yield because the bond would be redeemed for $40 less than the purchase price.
Why is yield to maturity important?
Yield to maturity lets you accurately compare bonds with different maturities and coupon rates. It’s particularly helpful when you are comparing older bonds being sold in the secondary market that are priced at a discount or at a premium rather than face value. It’s also especially important when looking at a zero-coupon bond, which typically sells at a deep discount to its face value but makes no periodic interest payments. Because you receive all of a zero’s return at maturity, when its principal is repaid, any yield quoted for a zero-coupon bond is always a yield to maturity.
Note: Â The value of zero coupon bonds is subject to market fluctuation. Because these bonds do not pay interest until maturity, their prices tend to be more volatile than bonds that pay interest regularly. Interest income is subject to ordinary income tax each year, even though the investor does not receive any income payments.
Yield to call
When it comes to helping you estimate your return on a callable bond (one whose issuer can choose to repay the principal before maturity), yield to maturity has a flaw. If the bond is called, the interest payments will come to an end. That reduces its overall yield to the investor. Therefore, for a callable bond, you also need to know what the yield would be if the bond were called at the earliest date allowed by the bond agreement. That figure is known as its yield to call; the calculation is the same as with yield to maturity, except that the first call date is substituted for the maturity date.
A bond issuer will generally call a bond only if it’s profitable for the issuer to do so. For example, if interest rates fall below a bond’s coupon rate, the issuer is likely to recall the bond and borrow money at the newer, lower rate, much as you might refinance your mortgage if interest rates drop. The less time until the first date the bond can be called, and the lower that current interest rates are when compared to the coupon rate, the more important the yield-to-call figure becomes.
Why is yield to call important?
If you rely on the income from a callable bond–for example, if it helps pay living expenses–yield to call is especially significant. If the bond is called at a time when interest rates are lower than when you purchased it, that reinvested principal might not provide the same amount of ongoing income. Why? Because you would likely have difficulty getting the same return when you reinvest unless you took on more risk.
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|Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2017.