What Are Yield-to-Maturity and Yield-to-Call?
Yield-to-maturity and yield-to-call are two ways of measuring a bond’s yield. Other ways of measuring return are coupon yield, current yield, and the 30-day SEC yield. It’s a good idea to look up and understand each of these terms.
A much more accurate measure of return, although still far from perfect, is the yield-to-maturity. It’s a considerably more complicated deal than figuring out current yield. Yield-to-maturity factors in not only the coupon rate and the price you paid for the bond, but also how far you have to go to get your principal back, and how much that principal will be.
Yield-to-maturity calculations make a big assumption that may or may not prove true: They assume that as you collect your interest payments every six months, you reinvest them at the same interest rate you’re getting on the bond.
Thanks to the miracle of modern technology, you can punch a few numbers into your financial calculator, or you can go to any number of online calculators, like the calculator on Moneychimp (a great financial website that features all sorts of cool calculators).
After you find a yield-to-maturity calculator, you’ll be asked to put in the par (face) value of the bond (almost always $1,000), the price you are considering paying for the bond, the number of years to maturity, and the coupon rate. Then you simply punch the calculate icon.
If, for example, you were to purchase a $1,000 par bond for $980, and that bond was paying 5 percent, and it matured in ten years, the yield-to-maturity would be 5.262 percent.
The current yield for such a bond would be 5.10 percent. The yield-to-maturity on a discounted bond (a bond selling for below par) is always higher than the current yield. Why? Because when you eventually get your principal back at maturity, you’ll be, in essence, making a profit.
You paid only $980, but you’ll see a check for $1,000. That extra $20 adds to your yield-to-maturity. The reverse is true of bonds purchased at a premium (a price higher than par value). In those cases, the yield-to-maturity is lower than the current yield.
Unscrupulous bond brokers have been known to tout current yield, and only current yield, when selling especially premium-priced bonds. The current yield may look great, but you take a hit when the bond matures by collecting less in principal than you paid for the bond. Your yield-to-maturity, which matters more than current yield, may, in fact, stink.
If you buy a callable bond, the company or municipality that issues your bond can ask for it back, at a specific price, long before the bond matures. Premium bonds, because they carry higher-than-average coupon yields, are often called.
What that means is that your yield-to-maturity is pretty much a moot point. What you’re likely to see in the way of yield is yield-to-call. This amount is figured out the same way that you figure out yield-to-maturity (use Moneychimp if you don’t have a financial calculator), but the end result — your actual return — may be considerably lower.
Keep in mind that bonds are generally called when market interest rates have fallen. In that case, not only is your yield on the bond you’re holding diminished, but your opportunity to invest your money in anything paying as high an interest rate has passed.
From a bondholder’s perspective, calls are not pretty, which is why callable bonds must pay higher rates of interest to find any buyers. (From the issuing company’s or municipality’s perspective, callable bonds are just peachy; after the call, the company or municipality can, if it wishes, issue a new bond that pays a lower interest rate.)
Certain hungry bond brokers may forget to mention yield-to-call and instead quote you only current yield or yield-to-maturity numbers. In such cases, you may pay the broker a big cut to get the bond, hold it for a short period, and then have to render it to the bond issuer, actually earning yourself a negative total return.
Ouch. Fortunately, regulatory authorities have gotten somewhat tougher, and such forgetfulness on the part of brokers is less common, but it still happens.