It has come to my attention recently that even the so called finance professionals have difficulty understanding just what yield to maturity YTM means in regards to a coupon paying bond.

The difficulty stems from the cash flow of the bonds coupon payments. These cash payments are taxed and either reinvested or used as income for living expenses in the case of a retiree. The yield to maturity calculation assumes all coupon payments are reinvested at the YTM rate. This means if you have a bond yielding 10% till maturity that you will need to reinvest those interest payments at a rate of 10% (even higher if you consider the taxes on the interest) in order for the YTM calculation to come to fruition.

When dealing with premium, discount, or interest only (IO) bonds, the errors in the yield to maturity, YTM, calculation are magnified. For premium and IO bonds, the exaggeration comes from reinvesting larger coupon payments at a high rate while amortizing principal losses over the life of the bond. Bonds purchased at a premium result in principal losses of the amount of the purchase price over par (the premium) if held to maturity (as in the calculated yield to maturity). Discount bonds lessen the impact of yield to maturity errors due to a smaller coupon payments to reinvest.

In summary it is important to understand just what is implied by these and other calculations so investors can understand the numbers shown to us by our financial advisors so may determine the suitability of these types of investments.

Posted by: --gpowell