Yield Measures, Spot Rates, and Forward Rates Flashcards
yield measures
- based on certain assumptions, thereby limiting their use to gauge relative value accurately
- include current yield, yield to maturity, yield to call, yield to put, yield to worst, and cash flow yield, expressed as a percent return.
sources of return
- coupon interest payments
- capital gain or loss
- income from reinvestment of interim cash flows
Coupon Interest Payments
The main source of return on a bond is the periodic coupon interest payments, which are absent in case of zero-coupon instruments.
Capital Gain or Loss
- An investor can earn capital gain or loss, depending on the proceeds received while the bond matures, is called, or is sold. If the proceeds are more than the purchase price, a capital gain is generated, and vice versa.
- A capital gain is observed in bonds held to maturity, if the bond is purchased below its par value, and in callable bonds if the call price is more than the purchase price.
Reinvestment Income
- derived from the interest and principal payments that can be reinvested before final maturity.
- can make up a significant part of the total dollar return, and this is affected by reinvestment risk and interest rate risk
Current yield
- annual dollar coupon interest to a bond’s market price, calculated as annual dollar coupon interest/price.
- greater than coupon rate for a bond selling at discount, equal for bond selling at par, and less for bond selling at premium.
- only considers coupon interest and no other source of investor return
Yield to Maturity
- the most popular measure of yield and is the interest rate that makes the present value of a bond’s cash flows equal to its market price plus accrued interest.
- found through trial and error IRR calculation.
- usually annualized by doubling semiannual yield and is called bond-equivalent yield. (BOND)
a bond-equivalent yield (YTM)
- at par, coupon rate = current yield = yield to maturity;
- at discount, coupon rate < current yield < yield to maturity;
- at premium, coupon rate > current yield > yield to maturity.
The Bond-Equivalent Yield Convention
involves doubling the semiannual yield to obtain an annual yield. However, investors should make sure to use the bond-equivalent yield measure properly
Limitations of Yield-to-Maturity Measure
- considers not only coupon income but also any capital gain or loss and timing of cash flows. It also assumes that coupon payments can be reinvested at an interest rate equal to the yield to maturity.
- highlight the need to question their use in investment decisions.
total dollar return
An investor’s total return is the sum of coupon payments, capital gain/loss, and reinvestment income.
total future dollars
all the dollars an investor expects to receive including the recovery of the principal
Factors Affecting Reinvestment Risk
the maturity length (the longer maturity, the higher the risk)
and the coupon rate (the higher, the more dependent on reinvestment; Zero-coupon bonds have no reinvestment risk if held to maturity)
Comparing Semiannual-Pay and Annual-Pay Bonds
- A bond-equivalent yield is computed for non-U.S. bonds that pay interest annually.
- The bond-equivalent yield of an annual-pay bond is always less than the annual-pay bond’s yield to maturity.
- To compare the yield on a U.S. bond issue with that on an annual-pay non-U.S. bond, an adjustment using the bond-equivalent yield is required
Yield to Call
- Callable bonds have a yield to maturity and a yield to call
- assumes the bond will be called on a certain date at the price specified in the call schedule.
- Yield to first call is computed for bonds not currently callable
- yield to next call is computed for currently callable bonds.
- Yield to refunding is used when bonds are currently callable but prohibited from being called using certain funds for a certain period
- Bonds can be called with funds from other sources during the protected period.
- To calculate, find the interest rate that makes the expected cash flows equal the price plus accrued interest
- considers all potential returns from owning a bond, but it assumes unrealistic investor and issuer behavior.