Identification

• To understand what yield to maturity (YTM) means and how it works, you'll need to know about the basic features of bonds. The par (or face) value is the amount the issuer must bay to the bond's owner when it matures. The coupon rate is a fixed sum paid each year (usually semiannually) on the bond. The price you pay for a bond will almost always be different than the par value. If the bond is selling for more than the par value, it is at a premium. If it's selling for less than par value, it is at a discount. Calculating the YTM of a bond involves all of these concepts.
  
  

Features

• The first factor that goes into figuring YTM is the actual interest rate is on a bond. That's different from the coupon rate. If a $1,000 bond has a coupon rate of $100, it is 10 percent. However, if the bond is trading at a discounted price of $800, the interest rate is $100/$800, or 12.5 percent. The interest rate depends on both the coupon rate and the price you pay for the bond. This actual interest rate is called the yield of the bond.
  
  

Function

• The yield to maturity takes the difference between a bond's price and its par value into account. If, for example, you buy a $1,000 bond for $800 and hold it for several years until it matures you'll receive $1,000 when the bond is redeemed, plus the coupon rate during the time you owned the bond. As a result, you make more money than just the interest, so the return on your investment is higher. That net return, combining the difference between price and par value and interest, can be calculated as an average percentage rate from the time you buy the bond until it matures. That's your yield to maturity. It will be higher than the interest rate if the bond is bought at a discount, and lower if the bond is bought at a premium.
  
  

Time Frame

• The price of a bond that is years away from its maturity can vary a great deal from its par value. As the maturity date approaches, the bond's price will begin to get closer to thee face value. The time element plays a role in another way: The main reason why bond prices diverge from the par value is that prevailing interest rates change. For very short-term bonds (the kind traded by money market funds) interest rates rarely change significantly during the life of the bond and the YTM measure is rarely used.
  
  

Considerations

• When considering a bond investment, you should keep a couple of other factors in mind. A good quality bond that is selling at a discount due to interest rate fluctuations is likely to be an attractive option. But if that discounted price is due to perceived increases in risk, you need to be cautious. A high YTM is not going to be worth much if the issuer cannot pay the bond when it matures. Take the type of bond into account. Municipal bond interest is usually exempt from taxes (some United States bonds carry tax breaks as well). These may be a better investment than a corporate bond with a higher YTM because you don't pay taxes on the earnings.