If you (or your company) are interested in investing in bonds, you must understand the relationship between yield to maturity and internal rate of return. Yield to maturity is a term that defines the expected rate of return on a bond if held to full maturity date. Internal rate of return represents the financial return an individual or company expects to receive from capital investments. This relationship shows potential growth that the individual or institutional investor might receive from increased investment in a particular security.
Yield to Maturity
The term "yield to maturity" (YTM) identifies the rate of return that you will earn if your long-term securities such as bonds are held to full maturity. YTM is a complex calculation that requires the use of bond yield tables and mathematical calculations. Investors seek a YTM greater than the stated coupon rate at a bond's purchase date. YTM measures the rate at which an investment brings financial growth to the investor. You should only invest in bonds that will bring a rate of return greater than the stated coupon rate of the bond.
Internal Rate of Return
"Internal rate of return" is a rate that's used as decision-making tool to determine the advisability of going forward with a particular long-term capital investment opportunity you are considering. IRR measures the financial return that you can expect to earn on capital investments. Your capital investment is considered a sound expenditure of your company's financial assets if the IRR is greater than the interest that could be earned on other types of investments available to your company. Positive IRR should create additional value in your company's overall financial standing.
If you are planning to invest in bonds, you should compare the present purchase value to what you expect the value to be at full maturity. The increase in value you expect to receive at full maturity will be used to repay your original investment, and provide you with a positive rate of return. If you sell your bonds before full maturity, the selling price may not provide the cash flow that you need in order to justify the investment. The bonds you invest in should yield an internal rate of return that is greater than other investment opportunities.
Yield to maturity uses the concept of the time value of money to quantify the value of financial investments. Time value of money means the dollars you have today are more valuable than dollars you expect to receive in the future. This is because you can use the dollars you have today to earn interest. Your ultimate goal is to create greatest possible profitability from your investments. YTM represents the relationship between the current value of an investment to the final value at full maturity. This relationship is also called the internal rate of return for the investment.
- Scott Olson/Getty Images News/Getty Images