Question

What is yield to maturity and how is it determined in the market?

In week 4, we discussed interest rates and the current level at which rates reside. What impact do you think that the current interest rate level has had on bond prices and why do you believe this?

Answer 1

YTM refers to the percentage rate of return paid on a bond, note or other fixed income security if the investor buys and holds the security till its maturity date. Current Yield is the coupon rate divided by the Market Price and gives a fair approximation of the present yield.

If a bond's coupon rate is more than its YTM, then the bond is selling at a premium. If a bond's coupon rate is equal to its YTM, then the bond is selling at par. Formula for yield to maturity: Yield to maturity(YTM) = [(Face value/Bond price)1/Time period ]-1.

If a bond's coupon rate is more than its YTM, then the bond is selling at a premium. If a bond's coupon rate is equal to its YTM, then the bond is selling at par. Formula for yield to maturity: Yield to maturity(YTM) = [(Face value/Bond price)1/Time period ]-1.

If it isn't clear yet, the yield to maturity is important because it is that rate of return that a bond purchaser gets when they purchase a bond and if they hold the bond until maturity. And if that isn't important to someone, they aren't going to make a very good bond investor.

Well, normally the YTM is the yield you get if you hold the bond until maturity (In other words: It's the average of the forward rates). So investors generally prefer the higher YTM bond, of course IF THEY ARE COMPARABLE (Type, maturity, coupons..)

Bonds have an inverse relationship to interest rate. When interest rates rise, bond prices fall, and vice-versa. At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer examination, it makes good sense.

• Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall as there will be more investor demand that will drive up the price of the bond.
• Conversely, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond resulting in a decline in the price of the bond..
• Zero-coupon bonds provide a clear example of how this mechanism works in practice.

Zero-coupon bonds are issued at a discount to par value. Yields on zero-coupon bonds are a function of the purchase price, the par value, and the time remaining until maturity. However, zero-coupon bonds also lock in the bond’s yield, which may be attractive to some investors.