Yield to maturity: Encyclopedia II - Yield to maturity - Example

Yield to maturity - Example

Consider a 30-year zero coupon bond with a face value of $100. If the bond is priced at a yield-to-maturity of 10%, it will cost you $5.73 today. Over the coming 30 years, the price will advance to $100, and your annualized return will be 10%.

But what happens in the meantime? Suppose that over the first 10 years of your holding period, interest rates decline, and the yield-to-maturity on your bond falls to 7%. With 20 years remaining to maturity, the price of the bond will be $25.84. Even though the yield-to-maturity for the remaining life of the bond is just 7%, and the yield-to-maturity you bargained for when you bought the bond was only 10%, the return you have earned over the first 10 years is 16.26%.

Over the remaining 20 years of the bond, you will not earn 16.26% annually, but 7% annually. If you do the math, you will find that over the entire 30 year holding period, you will have made 10% annually.

Adapted from the Wikipedia article "Example", under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki