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What is the relationship between the YTM of a bond and the spot rates of Interest?

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posted Jul 10 by Ananya Saha

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Bonds are marketable and relatively liquid securities, and there are several different accounting methods for discounting their values to give investors a sense of their present worth. The most common of these is called yield to maturity, or YTM, which represents the expected rate of return on a bond if held to maturity. Spot rates are not specific to bonds; they are most often quotes for currencies or commodities but can be useful for calculating bond price for immediate settlement. The spot rate is quite similar to YTM with one major exception: it varies from period to period as future interest rate fluctuations are anticipated.

To appreciate the difference between YTM and spot rates, understand bond investing basics. Bond prices are purchased at "par value," or the dollar amount printed on the bond, such as $1,000. Each bond generates interest payments, also known as the "coupon." A bond's yield is the discount rate that represents the its cash flow to its present dollar value. However, bonds are time-sensitive instruments since the time until maturity is constantly shrinking, which means fewer future coupons as they age.

Without getting bogged down by technical details, it is important to know that a bond's yield moves inversely with its price. The YTM calculates the interest rate the investor would earn from investing every coupon payment from the bond at an average interest rate until maturity. Thus, bonds trading at below par value, or discount bonds, have a YTM higher than the actual coupon rate, and bonds trading above par value, or premium bonds, have a YTM lower than the coupon rate.

The spot rate is calculated by finding the discount rate that makes the present value of a zero-coupon bond equal to its price. These are based on future interest rate assumptions, so spot rates can use different interest rates for different years until maturity, whereas YTM uses an average rate throughout. In essence, this means spot rates use a more dynamic and more potentially accurate discount factor in a bond's present valuation.

answer Jul 11 by Tanmay
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