Yield to Maturity - Explained

Few things confuse investors as much as bond investing terminology. And within the universe of bond lingo, one of the key parameters for making investment decisions is the YTM or “Yield to Maturity” of the bond in question. 

The importance of YTM while making a bond investment decision can be best illustrated with an example. Say, you need to decide between making an investment in two available bonds today. Bond A has an annual coupon of 8.75 per cent and is due to mature in 2029. It is trading at Rs 106.08, versus its par (maturity) value of Rs 100. Bond B at a par value of Rs 100 with a 9.5 per cent coupon, and is due to mature in 2028. It is currently trading at Rs 108.42. Which one would you choose? Bond A at Rs 106.08 or Bond B at Rs 108.2? Confusing, isn’t it? Fortunately, YTM serves as a simple enough decision making tool.

Put in simple terms, the YTM on a bond is the total annualized return that you’ll earn from it if you buy it today and hold it until maturity, and if it pays all its coupons as per schedule and doesn’t default. The YTM calculator also estimates that cash flows arising from the coupon payments made by the bond will be reinvested at the same rate. 

For example – if you buy the Bond A for Rs 106.08, you’ll receive a coupon of Rs 8.75 per annum for the next 7 years, plus Rs 108.75 at maturity in the 8th year. With a simple IRR (Internal Rate of Return) calculation for these cash flows, you’ll arrive at an annualized “return” or YTM of 7.71 per cent. For Bond B, though you’ll be paying Rs 2.63 more for the bond today, you’ll be receiving a higher annual coupon of Rs 9.5, and the YTM works out to 7.92 per cent. Because Bond B has a higher YTM than Bond B, you should ideally choose it over the other if they have the same credit profile.

There’s a noteworthy point to make here, though. The above stated decision is a cut-and-dried one because both bonds in question carry similar credit rating profiles, and so it’s an automatic choice to select B and earn 0.21 per cent extra per annum. But what if the comparison was between bonds of differing credit profiles, for instance what if the choice was between the AAA rated B bond and a 2029 maturity, AA+ rated bond that was issued by Issuer C with a superior YTM of 8.7 per cent? Should you automatically choose the higher YTM bond in this case?

The answer to that question would be different, for different investors. If you feel that the marginally higher default or credit risk is worth taking in lieu of the additional return of 0.78 per cent, choose Issuer C. If absolute safety of principal and zero default risk is what you seek, stick with the lower YTM, Bond B. 

Combining YTM data with information related to the credit profile of the bond issuer can help you make sound fixed income investment decisions that are in line with your risk profile and investment objectives.