Yield, Total Return, and Reinvestment Risk

1. Internal rate of return

2. Yields to maturity
3. Other Yields
Current yield
Cash flow yield
Yield for a portfolio

4. Decompose total dollar returns

5. Reinvestment risk
6. Compute total return for a bond
BUS424 (Ch 3)

Internal Rate of Return

The yield on an investment can be found as:

CF1
CF2
CF3
CFn
P

...
2
3
1 y (1 y )
(1 y )
(1 y ) n

The yield calculated from this relationship is the internal

rate of return. the return to make the above
equation hold.
What is the actual meaning of y:
(1)
(2)
Example: see page 36.
BUS424 (Ch 3)

Yield to Maturity of A Bond

The yield on an investment can be found as:
P

C
C
C
CM

...

1 y (1 y ) 2 (1 y )3
(1 y ) n

What is meant by y:

BUS424 (Ch 3)

The coupons of corporate bonds are typically

semiannually paid, doubling the periodic
interest rate or discount rate (y) gives the
annual yield to maturity.
But this is simple annual interest rate.
What does YTM really mean?

BUS424 (Ch 3)

Annualizing Yields
Also known as effective annual yield (EAY)
EAY=(1+periodic interest rate)m-1
Examples:
(1) The periodic interest rate is 4%, interest semi-annually paid, what is EAY?
(2) The periodic interest rate is 2%, interest quarterly paid, what is EAY?
(3) If APR is 8%, interest semi-annually paid, what is EAY?
(4) If APR is 8%, interest quarterly paid, what is EAY?

BUS424 (Ch 3)

Current Yield
Current yield = annual dollar coupon
interest/price
Only consider coupon payment

BUS424 (Ch 3)

Yield to Call
Call price: the price at which the bond may
be called
Yield to call:
Fixed call price
Call schedule
P

C
C
C
CM*

...

1 y (1 y ) 2 (1 y )3
(1 y ) n

BUS424 (Ch 3)

Assumptions for Yield to Call

1. Cash flows can be reinvested at the yield to call
until the assumed call date
2. The investor will hold the bond to the assumed call
date
3. The issuer will call the bond on that date

Also note: callable bonds could be traded above the

call price
BUS424 (Ch 3)

Bond price and call

This is a deviation from the yield to call, while it
helps to understand the pricing of callable bonds
Example on page 375:
Consider a callable bond with a 10-year 13% coupon
rate that is callable in 1 year at a call price of 104.
Suppose the yields on 10-year and 1-year bonds are
6% and 5%. Investors expect the bond would be
called in 1 year. What is the price of the bond?
Assume the bond pays coupons semiannually.
BUS424 (Ch 3)

Cash Flow Yield

For amortizing securities
Cash flow in each period includes
- coupon interest
- scheduled principal repayment
- unscheduled prepayments
Calculated as internal rate of return for a cash
flow
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Yield for a Portfolio

There are multi-bonds, their yields to maturity
are known or are calculable.
What is the yield to maturity of the portfolio?
Example on page 43.

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Yield Spread for Floating Rate Securities

Floating rate = reference rate + quoted margin
Calculate the discount margin by assuming the
reference is constant over the life of a bond.
Page 44-45

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What do we know here?

Maturity: 6 years
Coupon rate: reference rate + 80bp
Initial reference rate: 10%
Price of the bond: 99.3098
Question: what is the yield spread of the
bond?
yield spread = yield reference rate
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Total Returns
1. If the bond is sold before maturity
2. If the bond is sold at maturity

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1. If Bonds are Sold Before Maturity

3-year investment horizon
purchasing a 20-year 8% coupon bond for $828.40.
YTM is 10%
Reinvestment rate = 6%
YTM at the end of investment horizon is 7%
Total return for this bond?

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Step 1
Compute the total coupon payment + interest
on interest

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Steps 2 and 3
Determine the resale value of the bond

Adding the amounts in steps (1) and (2)

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Steps 4 and 5
Obtain semi-annual total return

Calculate annual return

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Reinvestment Risk
Future reinvestment rates will be less
than the YTM at the time the bond is
purchased.
Coupon

payments
Length of maturity of the bond is shorter
than the holding period

Is there any reinvestment risk

associated with zero-coupon bonds?
BUS424 (Ch 3)

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A Simple Example Bond Held until Maturity

15-year 7% bond, semi-annually paid, par $1000, price
$769.40. YTM = 10%. The bond is held until maturity,
reinvestment return = YTM=10%. Answer the following
questions.
(1) What is the total dollar return of the bond
(2) Evaluate the return from each source
(3) What is the reinvestment return?
(4) What is the reinvestment risk?

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Decomposing Dollar Returns

Assumption: reinvestment return=YTM
Three sources
Periodic coupon interest payments made by the issuer
-- nC
Capital gain
-- M-P
Interest on interest (reinvestment income, subject to
reinvestment risk)
-- C[((1+r)n-1)/r]-nC
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Additions
Multiple reinvestment rate: see the example on page
53.
What is the implication of total return in practice?
horizon return/horizon analysis
How to reconcile the analysis we have done so far
with the simple formula:
ret=(Ps-Pb+C)/Pb?
BUS424 (Ch 3)

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Exercise

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