Additionally, an investor may not be able to reinvest the entirety of the coupon payment. Investors usually have to pay taxes on the coupon in the year they’re paid. They may also use the coupon payments to pay for something else, like supporting their lifestyle.
Furthermore, YTM doesn’t factor in the potential for a debtor to default, which means an investor will not get future coupon payments, and their principal is forfeited. Likewise, the bond could be called before maturity if the contract has a clause that allows the issuer to do so.
How to use yield to maturity in investment decisions
Yield to maturity can be useful for investors trying to decide between multiple investment options. Calculating the YTM on each can give you an idea of what they’re getting for their money.
All else equal, an investment with a later maturity date should produce a higher yield to maturity. That’s because a bond maturing sooner is less exposed to interest rate risk. The higher the yield to maturity, the less susceptible a bond is to interest rate risk.
There are other risks, besides interest rate risk, that can increase yield to maturity: the risk of default or the risk of a bond getting called before maturity. Either can have an impact on yield to maturity, pushing the market to demand a higher yield for bonds with higher risk.
Many brokerages will automatically calculate yield to maturity for you, which makes it easy to compare potential investments. If you can determine that a premium is worth the risk, you may have found a great fixed-income investment for your portfolio that can pay consistently and appreciate in value.
