When you buy a bond, an important part of your return is the interest rate that the bond pays. However, yield to maturity is a more accurate representation of the total return you'll get on your investment. Yield to maturity is a figure that incorporates both the bond's interest rate and its price.
Price & Yield to Maturity
Yield to maturity is the percentage of total return you can expect to receive when you buy a particular bond at a specific price. Yield to maturity includes both the interest payments you receive from a bond along with the capital gain you receive at maturity, if any. The lower the price you can pay for a particular bond, the higher your yield to maturity will be, all other factors being equal.
Let's take the case of a bond paying 6 percent interest with a maturity value, or par value, of $1,000, which is common for bonds. If you pay $1,000 for this bond, your yield to maturity will be exactly 6 percent, as you will receive the exact amount of money you originally paid for the bond. However, if you only pay $900 for the bond, your yield to maturity will be greater because, in addition to the 6 percent interest, you'll earn a capital gain of $100. If you paid more than $1,000 for the bond, your yield to maturity would be less than 6 percent, as you would get back less than you paid at maturity.
Selling a Bond Before Maturity
The yield to maturity at the time you buy a bond is only valid if you hold the bond until it matures. That's because your yield to maturity at the time you buy the bond is based on receiving the full maturity value of the bond, typically $1,000. If you sell a bond before it comes due, you'll receive whatever the current market value is for your bond, which may be more or less than you paid. As a result, your yield to maturity will vary.
Calculating Yield to Maturity
The formula for calculating yield to maturity is a bit complex for a beginning investor. But even professional bond buyers don't usually take pen to paper to calculate a bond's yield to maturity. That figure will be automatically computed for you by any reputable bond broker at the time you're ready to buy.
