You've heard that bonds are a solid investment choice for the risk adverse, but when you started investigating bonds you came up against unfamiliar terms like "yield to maturity" and "required return." Bonds provide long- and short-term investment opportunities for investors who favor relatively safe holdings with reasonable returns. Bond investors analyze bond prices and interest rates to determine the best times to buy and sell.
Knowing the difference between yield to maturity and the required return on a bond, as well as the correlation between the two, can help you to gain a deeper understanding of bond investments.
A bond's yield to maturity measures how much it will earn over its life, while the required rate of return refers to the interest rate necessary to get investors interested in the bond.
How Bond Interest Rates Work
Companies and government entities set different bond interest rates at different times. Bond interest rates are set by the market, by a consensus of buyers and sellers. Because of this, bond investors need to analyze the long-term value of bond investments based on their total payout and their value in relation to interest rates offered in the future.
Yield to Maturity
Yield to maturity is a measure of what a bond investment will earn over its life. Expressed as a percentage, yield to maturity sheds light on the annual real rate of return offered by bonds with specific interest rates compared with other bonds on the market. Since yield to maturity requires extensive permutations, online yield calculators can be the best way to make quick calculations.
Required Rate of Return
The required rate of return on a bond is the interest rate that a bond issuer must offer in order to get investors interested. Required returns are predominantly set by market forces and determined by the price at which issuers and investors agree. Established companies with longstanding reputations and local governments may be able to get away with paying slightly lower interest rates than the market rate. Likewise, unknown companies may find it necessary to pay higher than the market rate to get investors to bite.
How They're Correlated
Since yield to maturity is highly influenced by a bond's specific interest rate, the required return on bonds at any given time will greatly affect the yield to maturity of bonds issued at that time. If market interest rates rise in the future, current bonds' yield to maturity will be lower than those offered in the future; the reverse holds true as well.