Lesson Seven: Valuing a Bond: Understanding Yield to Maturity (YTM)

Lesson Seven: Valuing a Bond: Understanding Yield to Maturity (YTM)

By Michael Lamonaca 16 July 2025

For the disciplined investor building long-term wealth, understanding how to value all assets in your portfolio, including bonds, properly, is fundamental. This lesson focuses on Yield to Maturity (YTM), the most comprehensive measure of a bond’s return, and how it connects to the powerful concept of compounding interest.

The Foundation: Simple Bond Interest

Let’s start with the basics. When you own a bond, you receive regular interest payments, known as coupon payments. This is the ‘simple interest’ component. For example, if you hold a bond with a par value of $2,000 and it has a coupon rate of 4%, you will receive $40 every six months. This fixed, predictable payment is the straightforward return you get from the bond issuer.

Immediate Returns: What is Current Yield?

Bonds often change hands in the market after they are first issued. When an investor buys a bond in the market, they pay its current market price, which may differ from its original par value. This is where current yield becomes a useful, immediate snapshot of return.

Current yield tells you the annual passive income you receive from the bond relative to the actual price you paid for it. For instance, imagine you purchase a bond for $950 that provides an annual coupon payment of $50. Your current yield would be approximately 5.26% ($50 divided by $950). It’s a quick way to see your immediate return, but it doesn’t tell the whole story for long-term wealth.

The Full Picture: Unpacking Yield to Maturity (YTM)

While simple interest and current yield offer partial views, Yield to Maturity (YTM) gives you the complete picture of a bond’s expected return. YTM is the total annual return you can expect to earn from a bond if you hold it until its maturity date.

What makes YTM so powerful is that it accounts for everything:

• All your regular coupon payments: The interest income you receive over the bond’s life.
• Any capital gain or loss: If you bought the bond at a discount (below its par value) or a premium (above its par value), YTM factors in that difference. If you bought it cheaper, you’ll make an extra gain at maturity when it’s repaid at par. If you bought it more expensively, you’ll incur a small loss at maturity. YTM spreads this gain or loss over the remaining life of the bond, combining it with your coupon payments.

In essence, YTM provides the most accurate and comprehensive measure of a bond’s overall profitability, incorporating the effect of compounding. For the value investor, understanding YTM is critical for comparing different bond assets and making disciplined investing decisions that contribute to genuine financial freedom.