Measures of Investment Returns Flashcards
Components of Total Return
Capital appreciation or depreciation
Dividends or interest
After Tax Return
Taxes can take away from return as well. It is important to consider how much is paid in taxes on investment gains when evaluating how much you have really earned. For example, if your investments yield a long-term capital gains of $1,000, then 15% of the long-term gains, or $150, is due to the IRS as Federal tax on the gains. Depending on the state you live in, there could be an additional amount due for state taxes as well.
After Tax Return = Total Return (1 - tax bracket)
Taxable Equivalent Yield
TEY = Tax Free Yield/(1 - Tax Bracket)
Yield to Maturity (YTM)
Yield to Maturity (YTM) is the compounded rate of return of a bond. YTM is usually defined as the discount rate that equates the present value of all of a bond’s future cash flows with its current market price (purchase price).
Yield to Call (YTC
Yield to Call (YTC) is calculated when the market interest rates decline and makes it profitable for a bond’s issuer to call the bond before it matures.
Bond Equivalent Yield (BEY)
Bond Equivalent Yield (BEY) is used to make pure-discount bond yield similar to regular semi-annual coupon-paying bond yields for comparison purposes.
Realized Compound Yield
Realized Compound Yield is the actual yield that an investor earned or will earn by reinvesting the cash flows.
After-tax Yield
.After-tax Yield is the tax equivalent yield that can be used to compare taxable yield with non-taxable yield.
Current Yield
Current Yield gives an idea of how a bond is doing currently.
Which of the following scenarios would lead to realization of YTM for a bond?
A. The bond is held to maturity; coupons are reinvested immediately at YTM; all payments are received on time.
B. The bond is called by the issuer due to a low interest rate environment.
C. The bond is held to maturity; coupons are reinvested immediately realized at a compound yield different than YTM; all payments are received on time.
D. The bond is a zero coupon bond and is held to maturity; par payment is received on time.
Correct Answer: A. and D.
Explanation: For YTM to be realized, the bond must be held to maturity, the issuer must make full payments of coupon and par on time, and the cash flows must be reinvested immediately at YTM. Pure-discount (zero coupon) bonds do not have cash flows to reinvest, so if held to maturity, the holder earns YTM.
Molly is trying to decide between purchasing a corporate bond paying 8%, a bond fund paying 30-day net annualized yield of 7.2%, and a municipal bond fund paying 5.5%. If Molly is in the 28% tax bracket, which option would translate into the biggest after-tax yield for her?
A. Bond Fund
B. Corporate Bond
C. Municipal Bond Fund
Correct Answer: B. Corporate Bond
Explanation: The tax equivalent yield for the municipal bond at Molly’s tax bracket is 7.638%. Although it is higher than the bond fund, it is not as high as the corporate bond. If Molly was basing her decision purely on how much yield she would receive, the corporate bond would be the best investment choice.
Consider a $10,000 bond paying a 3.5% annual coupon rate for 10 years. The bond’s present value is $8,140.32, if its cash flows are discounted at the YTM of 6% per year (or 3.0% per 6-month period). The bond’s yield-to-call is 9.373% at an annual rate. What will you consider to make the buy/sell decision for the bond?
A. Present value = $8,140.32
B. Yield to maturity = 6%
C. T = 10 years
D. Yield to call = 9.373%
Correct Answer: B. Yield to maturity = 6%
Explanation: After computing the two different yields, you must select the lower yield for investment decision-making purposes, because that return represents the minimum yield that the investor can expect to earn.
Which of the following statements concerning bond yields is incorrect?
A. Nominal yield is higher than current yield for a premium bond.
B. Yield to maturity is higher for a premium bond than for a discount bond.
C. If the realized compound yield is less than YTM, then the bondholder will earn less than the YTM.
D. Bond Equivalent Yield converts discount debt instrument yields to a yield similar to a semi-annual coupon paying bond.
Correct Answer: B. Yield to maturity is higher for a premium bond than for a discount bond.
Explanation: YTM does depend on whether the bond is selling at a premium or a discount. YTM is less for a premium bond because the premium is amortized over the remaining years to maturity, so less money is available for compounding. If a bond is selling at a premium, then the nominal yield is divided by a larger price to obtain the current yield, therefore the current yield would be lower. If the bondholder reinvests cash flows at a rate below YTM, there will be less interest to compound. Bond equivalent yield makes a pure discount bond’s yield equivalent to a coupon paying bond.
