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Concept
Yield to maturity
Summary
The yield to maturity (YTM), book yield or redemption yield of a bond or other fixed-interest security, such as gilts, is an estimate of the total rate of return anticipated to be earned by an investor who buys a bond at a given market price, holds it to maturity, and receives all interest payments and the capital redemption on schedule. It is the (theoretical) internal rate of return (IRR, overall interest rate): the discount rate at which the present value of all future cash flows from the bond (coupons and principal) is equal to the current price of the bond. The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but more often market convention is followed. In a number of major markets (such as gilts) the convention is to quote annualized yields with semi-annual compounding (see compound interest); thus, for example, an annual effective yield of 10.25% would be quoted as 10.00%, because 1.05 × 1.05 = 1.1025 and 2 × 5 = 10.
The YTM calculation formulates certain stability conditions of the security, its owner, and the market going forward:
The owner holds the security to maturity.
The issuer makes all interest and principal payments on time and in full.
The owner reinvests all interest payments rather than spending them, to gain the benefit of compounded returns.
The market provides consistent reinvestment opportunity at the YTM rate throughout the future, with no cost to transact.
The YTM calculation accounts for the effect of the current market price on the yield going forward, but omits the possible effects of contingent events. Hence it is not an expected, or risk-adjusted rate. The YTM will be realized only if the above assumptions are met, and factors such as default risk or reinvestment risk do not occur. The total return realized at maturity is likely to differ from the YTM calculated at the time of purchase, perhaps considerably.
In practice, the rates that will actually be earned on reinvested interest payments are a critical component of a bond's investment return.
Official source
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