Yields

One of the key advantages bonds have over stocks is that they offer relatively predictable returns. However, precisely calculating these potential returns in advance can be difficult.

Two measures of bond returns (yields) are current yield and yield to maturity (YTM).

When you buy a bond, the return consists of the following three elements:

  • the promised interest payment
  • interest on interest (the compounding effect of reinvesting the periodic interest payments)
  • capital gain or loss on redemption or disposal of the bond

YTM takes account of all three sources of return and is therefore a more accurate measure than current yield, which only takes account of he interest payments.

Yield to maturity

Yield to maturity is a measure of the rate of return yielded by a bond that is held to maturity. In simple terms, it takes into account all the cash flows produced by the bond over its life. These include the bond's coupons, the value of the reinvestment of those coupons (compounding) and the payout when the bond reaches maturity. The YTM rate is calculated by equating these future cash flows in present value terms with the current market price of the bond.