With bonds, the terms "yield to maturity" and "required return" both refer to the money that investors make from owning a bond. But these concepts work in opposite directions. With yield to maturity, you're using the price of a bond to determine the investor's return; with required return, on the other hand, you use the return to set the price of the bond.
Bond Investing Basics
The cash flow generated by a typical bond depends on two things: the face value of the bond and its coupon rate. Say you own a 10-year bond with a face value of $1,000 and a coupon rate of 5 percent. Ten years after that bond was originally issued, it will "mature," meaning that you will receive the $1,000 face value. In the meantime, you will receive annual interest payments. Those payments are calculated by multiplying the face value by the coupon rate. In this case, it's 5 percent of $1,000, or $50 a year. These are known as coupon payments, because in the days before computers, a bond came with an attached set of coupons that you could redeem for each interest payment.
Prices and Yields
Bonds don't usually sell at face value because the return that investors get from the bond has to be competitive with the return produced by investments of similar quality and risk. If investors can get a 7 percent return for the same amount of risk, for example, they won't bother with a bond offering 5 percent.
Coupon rates can't be changed; once a bond is issued, the coupon rate is set in stone. But by changing the price of the bond, you can change the effective return on the bond, known as the yield. For a very basic example, imagine you have a one-year, $1,000 bond with a 5 percent coupon rate; at the end of one year, you get $1,050 — the $1,000 face value plus $50 in coupon interest.
- If you paid $1,000 for the bond, your yield is 5 percent — the same as the coupon rate.
- If you paid $990.57 for the bond, your yield is 6 percent — you get the same $1,050 back, but it now represents a 6 percent return on your initial investment.
- If you paid $1,009.62 for the bond, your yield falls to 4 percent.
Bond prices and yields move in opposite directions. When the price goes up, the yield goes down. When prices fall, yields rise.
Bonds that sell for face value are said to sell at par. Those that sell for less than face value sell at discount. Bonds that sell for more than face value are called premium bonds.
Yield to Maturity
Yield to maturity, or YTM, represents your overall return if you were to hold onto a bond until it matured — that is, if you didn't sell it. Holding the bond until maturity is important, because YTM takes into account not only the value of the coupon payments but also the difference between the price paid for the bond and the face value payment at maturity.
For example, say you bought a 10-year, $1,000 bond with a coupon rate of 5 percent, and you paid $822 for it. The $50 in coupon interest each year represents a 6.08 percent annual return on your money. But because you also get an "extra" $178 at maturity, it boosts your effective annual return to 7.61 percent. The YTM, therefore, is 7.61 percent.
In contrast to yield to maturity, required return starts with yield and works backward to determine the price. For example, say a corporation needs to raise capital, and it is preparing to issue 10-year, $1,000 bonds at a coupon rate of 5 percent. When it comes time to sell the bonds, however, similar investments are paying a 9 percent annual return. To make its bonds attractive to investors, the company will have to match that rate. So 9 percent is the required return on the bonds. If the company sells its $1,000 bonds for $743.50, investors will get that 9 percent return — a 9 percent yield to maturity, in other words.
You can use online yield-to-maturity calculators to find the YTM of a bond and also to determine the proper price for a bond based on its required return.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.