Part 16. Understanding Fixed Income Risk & Return

Question 1

3 sources of returns from investing in a fixed rate bond:

Answer 1

1. Coupon and principal payments
2. Interest earned on coupon payments that are reinvested over investors holding period for the bond.
3. Any capital gain or loss if bond is sold prior to maturity.

Question 2

Given assumptions:

Answer 2

• bond makes all promised coupon and principal payments on time, no credit risk.
• assume interest rate earned on reinvested coupon payments is the same as YTM on bond.

1. investor who holds fixed rate bond to maturity will earn annualised rate of return equal to YTM of bond when purchased.
2. investor who sells bond prior to maturity will earn rate of return equal to YTM at purchase if YTM at sale has not changed since purchase.
3. if market YTM for bond, assumer reinvestment rate increases (decreases) after bon purchased but before first coupon date, a buy-and-hold investor realised return will be higher (lower) than YTM of bond when purchased.
4. if market YTM for bon, assumed reinvestment rate increases after bond is purchased but before 1st coupon date, bond investor will earn RoR lower than YTM at bond purchase if bond is held for short period.
5. if market YTM for bond, assumed reinvestment rate, decreases after bond is purchased but before first coupon date, bond investor will earn RoR lower than YTM at bond purchase if bond held for long period.

Question 3

Annualised holding period rate of return:

Answer 3

• This is calculated as compound annual return earned from the bond over the investors holding period.
• The compound rate of return based on purchase price of bond would provide an amount at time of sale or maturity of bond equal to sum of coupon payments, sale or maturity value and interest earned on reinvested coupons.