The gross realized return for a bond is its end-of-period total value minus its beginning- of-period value divided by its beginning-of-period value. The end-of-period total value will include both ending bond price & any coupons paid during the period.
The net realized return for a bond is its gross realized return minus per period financing costs. Cost of financing would arise from borrowing cash to purchase the bond.
When a bondholder receives coupon payments, the investor runs the risk that these cash flows will be reinvested at a rate that is lower than the expected rate. This is known as reinvestment risk.
The market price of a bond may differ from the computed price of a bond using spot rates or forward rates. Any difference between bond market price and bond price according to the term structure of interest rates is known as the spread of a bond. A bond’s spread is a relative measure of value which helps investors identify whether investments are trading cheap or rich relative to the yield curve (i.e., the term structure of rates).
The yield to maturity, or YTM, of a fixed-income security is equivalent to its internal rate of return. The YTM is the discount rate that equates the present value of all cash flows associated with the instrument to its price.
For a security that pays a series of known annual cash flows, the computation of yield uses the following relationship:
CALCULATING THE PRICE OF AN ANNUITY
An annuity is a series of periodic payments that are received at a future date.
PV of Annuity = P [ 1-(1+r)-n ]/r
CALCULATING THE PRICE OF PERPETUITY
The perpetuity formula is straightforward and does not require an iterative process:
RELATIONSHIP BETWEEN SPOT RATES & YTM
When pricing a bond, YTM or spot rates can be used. The YTM will be a blend of the spot rates for the bond.
RELATIONSHIP BETWEEN YTM, COUPON RATE & PRICE
If two bonds are identical in all respects except their coupon, the bond with the smaller coupon will be more sensitive to interest rate changes. All else being equal:
Bonds with similar maturities, but different coupon rates, can have different yield to maturities.
Return decomposition for a bond breaks down bond P&L into component parts. This decomposition of P&L helps bond investors understand how their investments are making or losing money. A bond’s profitability or loss is generated through price appreciation and explicit cash flows. Bond total price appreciation can be broken down into three component parts for price effect analysis: carry-roll-down, rate changes, and spread change.
Powered by BetterDocs
Create a new account
Number of items in cart: 0
Enter the destination URL
Or link to existing content