Invest money

The term YTM stands for yield to maturity. YTM represents the total return (profit) that you will get when you purchase a bond. It is something that a bond investor should understand in detail. Let us consider some special cases. Imagine a zero coupon bond that is due in exactly one year and is offered at par. An investor would buy the bond for $1000 and get back $1000. In this case, his effective rate of return is 0%. So this bond has a YTM of 0%. Even in today’s low interest rate environment we can do better. Now imagine that there is a zero coupon bond offered at 50. The investor would pay $500 dollars and get back $1000 in one year. He/she would double her money and would have a 100% rate of return. In this case, the YTM on the bond is 100%. Unfortunately, there are no quality bonds out there that offer such a high rate of return. Now, imagine that we are offered a zero coupon bond maturing in one year at a price of 98. In addition, we could buy a one year CD which is paying a 2% rate of return. Assume that the CD pays interest only once a year which means that the CD will only pay interest at maturity. Which should we buy? Well, if I buy the bond at 98 I put up $980 and get back $1000. If instead I were to put that money in the CD I would get back $980 + 0.02($980) = $980(1+0.02) = $999.60. In this case, CD had a lower rate of return. However, there exists a rate for the CD such that the total return on the CD and on the bond are the same. That rate is the YTM for the bond.

Here is another way to think about YTM. Finance people like to talk about present value of money. That is, if I have a payment coming to me in three years of $500 dollars that payment is not worth $500 today. That is, I have to discount the payment by some interest rate to make up for the delay in payment. Let me call that interest rate i. Now, I am considering buying a bond and for each payment I get from the bond, I discount that payment using the interest rate i. When I discount the payment by the appropriate interest rate, I get the present value of the payment. There is an interest such that the price of the bond is equals the present value of all the payments including the final redemption. That interest rate (i) is the YTM of the bond.

Now, you may be wondering why you care about the YTM of the bond. Imagine that your broker calls you and offers you two bonds for sale. The first bond has a 5% coupon rate and is offered at 100 and the second bond has a 4% coupon rate and it is offered at 95. How do you decide which bond to buy? One of the things I would do is to compute (or ask the broker) the YTM for both bonds. All other things being equal, I would tend to pick the bond with the higher YTM because that bond will give me the greatest return.

To Learn more How to Calculate YTM visit Bobs Stock Group’s Files