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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
You can think of the yield to maturity as an "average" of the spot rates, or you can visualize
it as a flat yield curve at some constant interest rate. This single interest rate makes the
present value of the future cash flows equal to the bond's market price.
It is important to note in the valuation process that the yield to maturity is an after-the-fact
calculation. Investors value each cash flow by discounting them at the appropriate spot rate.
The sum of these values is the bond's market price. From this price we derive the yield to
Realized Compound Yield:
A modest complication occurs when comparing a bond that pays semiannual interest with
some competing investment that pays interest on a different lime schedule. If bonds are
being compared to other securities, you can best reduce the likelihood that you compare
apples with oranges by computing the effective annual rate for all of them.
We do this via equation:
Effective annual rate = (1+ r/x)x -1
r= yield to maturity
x = number of payments per year
Current Yield:
A bond's yield to maturity measures the total return the bondholder receives if the bond is
kept for its entire life. The current yield, only measures the return associated with the bond's
interest payments. Capital gains or losses are not included in the current yield.
Current yield is an important statistic for someone primarily concerned with the spendable
income their investments generate. The fact that the long-run rate of return (the yield to ma-
turity) may be higher is not as important. A zero coupon bond has a current yield of zero. It
would be an inappropriate investment for a retired person who needed routine interest
checks for living expenses.
A bond whose market price is less than its par value is selling at a discount. If the market
price is more than the par value, the bond sells at a premium. Note that for bonds selling at a
discount, the yield to maturity will always be greater than the current yield because of the
capital gain an investor receives when the bond matures at par value. Similarly, for bonds
selling at a premium, the yield to maturity will be less than the current yield.
The reason a coupon-paying bond sells for a discount is that its package of cash flows is
worth less than that offered by the average competing investment.
Accrued Interest:
Bondholders earn interest each calendar day they hold a bond, unlike the situation with
common stock, where the dividend is an all-or-nothing feature. Despite this aspect, firms
generally only mail interest payment checks twice each year. Someone might buy a bond
today and receive a check for six months' interest two weeks later -- a substantial return in
14 days. The situation does not work this way, however, for the story is incomplete.