Yield to Maturity: The Only Honest Number a Bond Has

Yield to maturity is honest because it cannot be flattered by picking a convenient slice of the result: it rolls into a single annual rate everything that happens to your money from purchase to redemption at par — the price you paid together with accrued coupon interest, all remaining coupons on the schedule, repayment of the face value on the maturity date, and the length of time your money is tied up. Any other "yield figure" for a bond describes only a fragment. The coupon rate is the issuer's obligation against the face value, not against the price you paid; current yield is the coupon divided by the price, with no regard for whether you will get back more or less than you paid. Bonds can only be compared with one another on yield to maturity, and that is the figure the screener shows in the bonds section.

What actually goes into the number

The calculation starts from the cash flows. On the way in there is an outflow: the price as a percentage of face value multiplied by the face value, plus the accrued coupon interest paid to the seller, plus the broker's commission. After that come the inflows: coupons on their calendar dates and the face value (or the remaining face value, if the bond amortises) on the maturity date. Yield to maturity is the discount rate at which the present value of the inflows equals your outflow. Two consequences follow from this, and readers most often miss them.

First: the number is tied to the specific price of a specific trade, not to the bond itself. Buy cheaper and the yield is higher, because the pull to par is added to the coupons; buy above par and part of each coupon goes towards offsetting the future loss on the price. Second: the number is tied to a date. Yesterday's yield to maturity on your bond is no longer yours — it describes whoever is buying today.

Where the honesty ends: the reinvestment assumption

That is why, for long-dated bonds with a large coupon, the gap between the calculated yield and the yield actually earned can be significant, while for short bonds and bonds with a small coupon it is barely noticeable: there is simply little to reinvest and little time to do it. If you do not plan to reinvest your coupons but spend them instead, look not at the effective yield but at the simple yield to maturity — it makes no reinvestment assumption, and that is precisely why it is lower. The difference between simple and effective yield accounts for a large share of the cases in which different brokers show different figures for the same bond; the remaining causes are covered in the article on how a bond's yield is calculated.

A put option cuts the calculation short

If a bond carries a put option (an offer), the time to maturity is no longer the term of your investment: the issuer may buy back the issue early or reset the coupon, and in that case yield to maturity is calculated on cash flows that will never happen. Here the figure to compare is the yield to put — the same calculation, but with the put date in place of the maturity date and the buyback price in place of the face value. This substitution is easy to overlook: a high yield to maturity on a bond with a put option often means only that the post-put coupon has been set as a formality, not that the market is paying more generously. More on this in the glossary entry on put options.

Yield before deductions and after

The yield-to-maturity calculation knows nothing about tax or inflation. The coupon and any positive difference between the sale or redemption price and the purchase price form the tax base — the composition of the base and the current rate are given in the reference note 13%. Inflation takes another slice: the nominal rate shows how many roubles you will end up with, not what they will be worth. The move from nominal yield to real yield is explained in the article on real yield. If you do not hold the bond to maturity, the honest result of your trade is described by the total return on the bond, not by yield to maturity: it brings in the market price at which you exit.

How to use this number

Step 1: make sure the bond has no put option and no amortisation; otherwise use the corresponding version of the calculation. Step 2: compare yield to maturity only with bonds of similar maturity and similar credit quality — otherwise you are comparing not yields but risk premiums. Step 3: check whether you can actually buy at the price from which the yield was calculated: in an illiquid issue an attractive figure is taken from the bid-ask spread rather than from a trade, and only the seller will get filled at it. The guide here is trading volume.

What yield to maturity does not measure

It does not measure the probability that the issuer will pay. A higher yield to maturity is not a bonus but the price of risk the market has assigned to the bond; with OFZ, collected in a separate section, this shows up in reverse — lower yields at a comparable maturity. Nor does it measure interest-rate risk before maturity: if rates rise, the price of your bond will fall, and you will only be able to exit early at a loss, even though the yield to maturity was locked in correctly at the time of purchase. Ways to limit this risk are covered in the article on hedging. Definitions of the other calculation methods are collected in the glossary.