Value a Bond
Yield to Maturity (YTM)
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Lesson 8 Objectives
Lesson Objective 1: Simple Interest from the Coupon Yield
Lesson Objective 2: Compounding of the Bond's Coupons
Lesson Objective 3: Bond Yield
Lesson Objective 4: Current Yield
Lesson Objective 5: Yield to Maturity
Lesson 8 Executive Summary
In this lesson the end goal is really to learn about yield to maturity, which is a function of compounding interest. However, to grasp this, the easiest thing is to first understand Simple Interest. Imagine that you have a 5% bond with a par value of $1,000. As an investor, you will receive $25 bi-annually in coupon payments. Simple interest can be understood easily since it’s that simple.
Oftentimes, bonds will not be held from the time it’s issued to the time of maturity by the same bond investor. Current yield is a reflection of bonds changing in price, and is a neat measure when bonds change hands. Since the coupon will be the same, your current yield will change. For instance, you pay $1,200 for a coupon of $50, and your yield is 4.2% (50/1,200).
In other words, Yield to maturity is a combination of the current yield and compound interest. Yield to maturity discloses the annual return you, as an investor, can expect to receive for your bond investment until the bond expires (matures). It combines the loss or gain the investor incurs if paying a different price than the par value for the bond with the coupon payment.
To gain expert knowledge in bonds I highly recommend the book titled The Bond Book, by Annette Thau. Be sure to check out the reviews on Amazon to see third party endorsements and concerns before simply taking my recommendation.