A bond pays two things: a regular coupon and the face value (typically £1,000) at maturity. But bonds trade at prices above or below face value depending on interest rates. A bond bought below face value has a built-in capital gain at maturity; one bought above face value has a capital loss. YTM incorporates both to give a complete picture of return.
The intuition
Suppose a bond has:
- Face value: £1,000
- Annual coupon: £50 (5% coupon rate)
- Years to maturity: 5
- Current price: £950 (trading below face value)
You receive £50/year in coupons, plus at maturity you receive £1,000 — a £50 capital gain on your £950 purchase. YTM captures both these returns in a single annualised percentage. In this case, YTM ≈ 6.4% — higher than the 5% coupon because you also earn a capital gain.
Price < Face Value → YTM > Coupon Rate (bonus capital gain)
Price = Face Value → YTM = Coupon Rate
Price > Face Value → YTM < Coupon Rate (capital loss at maturity)
YTM vs current yield
| Formula | What it ignores | |
|---|---|---|
| Current Yield | Coupon / Price | Capital gain/loss at maturity |
| Yield to Maturity | Solves: Price = Σ CF/(1+YTM)ᵗ | Nothing — it's complete |
The reinvestment assumption
YTM assumes you reinvest every coupon at the same YTM rate. In practice this rarely holds — interest rates change, and reinvestment rates differ. When rates fall after you buy a bond, you reinvest coupons at lower rates, and your actual return will be below YTM. This "reinvestment risk" is larger for bonds with higher coupons and longer maturities.
What this means for you
YTM is the correct metric for comparing bonds with different coupon rates and different prices. When bond fund managers talk about their fund's yield, they mean YTM. When the yield curve inverts (short-term yields higher than long-term), it means short-dated bonds have higher YTMs than long-dated ones — a historically reliable recession predictor, because it implies the market expects rates to fall in the future as the economy weakens.