Yield to maturity is the total return that will be earned by someone who purchases a bond and holds it until its maturity date. The yield to maturity might also be referred to as yield, internal rate of return, or the market interest rate at the time that the bond was purchased by the investor. The yield to maturity is expressed as an annual percentage rate.
To illustrate, let's assume that a 5% $100,000 bond will mature in 5 years and will pay interest each June 1 and December 1. Hence the bond will pay interest of $2,500 every six months until it matures. If the current market interest rate for this type of bond is 6%, the bond's current market value will be less than $100,000. The market value of a 5% bond in a 6% bond market will be approximately $95,735. This is the present value of the $2,500 of interest that will be received every six months for 5 years plus the present value of the $100,000 that will be received at the end of 5 years. (All of the cash amounts are discounted by the market interest rate. However, the 6% annual market rate will be restated to be 3% per semiannual period and the 5 years will be restated to be 10 semiannnual periods.)
The investor's yield to maturity will be the market rate of 6% (even though the bond's stated rate is 5%) consisting of the following two components:
- the current yield of more than 5.2% because the investor is receiving cash of $2,500 every six months ($5,000 per year) on an investment of only $95,735.
- a gain of $4,265 because the investor bought the bond for $95,735 but will receive cash of $100,000 at maturity.