How (and Why) to Calculate Yield to Maturity

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KEY POINTS

1. Yield to Maturity is the yield of the remaining payments due on a bond relative to its purchase price. Mathematically, the equation looks something like this:

((Sum of remaining coupon payments + par value)/ purchase price) – 1

2. The primary value of the yield to maturity is that it allows bond investors/traders to compare the income potential of bonds with radically different maturities, coupon rates, par values, and prices.

3. There is still some uncertainty regarding whether yield to maturity calculations should assume re-investment of each coupon rate at the yield to maturity rate of the bond. Most online calculators do not incorporate this possibility, though much of the recommended financial literature advocates doing so so that a true picture of a bond’s income potential can be obtained.

4. For bonds that are callable, the yield to maturity may be a bit misleading, as the bond could get called before all the coupon payments factored into the yield to maturity calculation are made. Some bond investors thus prefer to calculate what is known as the yield to call, which is the same calculation as the yield to maturity — but uses the next call date to determine maturity date. Conservative investors can then base decisions around what is known as yield to worst — the lower of the yield to call and yield to maturity.

Playing around with a yield to maturity calculator is a way for investors to better apply and understand the components that drive yield to maturity, and how they relate to each other.

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