Return Computations
Dr HK Pradhan
Professor of Finance & Economics
XLRI Jamshedpur
Concepts
▪ Current yield is the ratio of its annual coupon to its closing
price.
▪ Yield to Maturity is the yield that equates the purchase price
of the bond to the present value of its future cash flows. It is
the most widely used measure of a bond's rate of return.
▪ Annualized Yield is the rate obtained by multiplying the
simple Semi-annual periodic discount rate by two.
▪ Average Rate to Maturity (ATRM) is the simple annual coupon
+ amortization income
▪ Yield to Call, YTC, is the rate obtained by assuming the bond
is called on the first call date. Like the yield to maturity, the
YTC is found by solving for the rate that equates the present
value of the bond’s cash flows to the call date(s) to its
market price.
Concepts of Yield
▪ The yield to maturity YTM) of a 18-year , 6% coupon bond selling for Rs
700.89, with a per value of Rs 1000
30 30 30 1030
700.89 = + + ..... +
(1 + 0.0475)1 (1 + 0.0475) 2 (1 + 0.0475) 35 (1 + 0.0475) 36
▪ Semi-Annual YTM = 4.75%
▪ Annualized Yield= 4.75 x 2 = 9.50%
n
R A
▪ Effective Annual Yield = 1 + −1
n
(1 + 0.095 / 2) 2 − 1 = 9.73 %
▪ Current yield = 60/700.89 = 0.0856 or 8.56%
▪ Current yield compares with the funding cost of a bond
Average rate to maturity (ARTM)
▪ Consider a bond with maturity 20-year, 7% annual
coupon bond, with a face value of 1,000, annual
coupon payments, and currently priced at 901.82.
▪ Average rate to maturity (ATRM):
70 + [(1000 − 901.82) / 20]
ARTM = = .078776
(1000 + 901.82) / 2
Return on Bond
▪ Starting point of bond return is the YTM or internal
rate of return on futures cash flows
Ct M
P = t =1
n
+
(1 + y ) (1+ y )n
t
▪ Return depends on periodic cashflows(coupon),
periodic reinvestment of cashflows (discount rate),
and realization of the par
▪ The relationship between price and the yield to
maturity of the bond has a non-linear relation
Issues
▪ Return as (yield to maturity) YTM of a bond
▪ Component of return (coupon income, reinvestment
income & amortization value)
▪ What happens if you sell the bond before maturity?
▪ Can you calculate the expected return of a bond if you
hold until a future date?
▪ How does the holding period return compares between
a par, premium and discount bond?
▪ How would you calculate the yield of a bond portfolio?
Amortization effect
The price of the bond selling at either discount or
premium will return to par as the bond moves closer to
the maturity
Let us understand the components of
return
▪ Coupon, Reinvestment of Coupon +Capital gain)loss)
Coupon + Reinvestment Income = (1 + r )n − 1
C
r
Total Coupon = nC
(1 + r )n − 1
Interest on interest = C − nC
r
Capital gain(loss) = Pt − P0
Example: 15 year 7% bond, par value 1000, Price 769.40,
YTM 10%
Coupon Interest + Interest on Interest =
(1 + 0.05)30 − 1
35 = 2325.36
0.05
Coupon Income = 35 x 30 = 1050.00
Interest on Interest = 2325.36 - 30(35) = 1275. 36
Capital Gain = 1000- 769.40 = 230.60
Total Return = 1050 + 1275. 36 + 230.60 = 2555.96
Horizon return
▪ Bonds slowly tend to par when matures(discount
bonds rise & premium bonds fall in value)
▪ For short term investment horizon, the dominant
source of return is the price movement
▪ For longer term, reinvestment coupon & price
movement become important
▪ When interest rate falls, change in capital gains
slows down a bit as the bond tends towards maturity
– since the price will be closer to par & the worry
is that coupons are reinvested at lower and lower
rates
– Thus when interest rates falls(rises) two year
horizon return will be below(above) the one-year
horizon return(so then 3-year ..4-year..)
An investor has a 3 years investment horizon and has
the following options:
Bond Coupon Maturity YTM
T Bills 0 364D 8.00%
G-Sec 7% 3 8.75%
G-Sec 6.5% 20 9.00%
PFC 11% 7 9.95%
Horizon Return
▪ Coupon is not always the same as yield
▪ Yield is not always same as return
▪ Return depends on coupon, reinvestment rate
and capital gain/loss
– For short term investment horizon, the dominant
source of return is the price movement
– For longer term, reinvestment incomes also
becomes important
Yield of a Portfolio
Example of three bonds:
Bond Coupon Maturity Par Price Yield to
Rate (%) (Years) Value Maturity (%)
A 7.0 5 10,000,000 9,209,000 9.0
B 10.5 7 20,000,000 20,000,000 10.5
C 6.0 3 30,000,000 28,050,000 8.5
▪ The yield for a portfolio of bonds is found by solving for the
yield that makes the present value of the portfolio's cash flow
equal to the market value of the portfolio
▪ You should not calculate this as the weighted average of the
individual yield of the portfolio?
Compute the yield of the portfolio cash flows:
A B C D E
1 Period A B C Portfolio
2 1 350000 1050000 900000 2300000
3 2 350000 1050000 900000 2300000
4 3 350000 1050000 900000 2300000
5 4 350000 1050000 900000 2300000
6 5 350000 1050000 900000 2300000
7 6 350000 1050000 30900000 32300000
8 7 350000 1050000 1400000
9 8 350000 1050000 1400000
10 9 350000 1050000 1400000
11 10 10350000 1050000 11400000
12 11 1050000 1050000
13 12 1050000 1050000
14 13 1050000 1050000
15 14 21050000 21050000
16
At 4.77% semiannual yield(or 9.54% annual) the market value of the
portfolio of Rs 57,259,000 is equal to the present value of cash flows as
shown in column E.
Yield of a Portfolio
▪ Look at the features of bonds
▪ Map cash flows each bond
▪ Use term structure for predicting floating
cash flows
▪ Freeze contractual cash flows(calls/puts)
▪ Use risk adjusted cash flows for risky bonds
▪ Compute IRR of portfolio
▪ For holding period yield, do horizon analysis
using term structure(derive forward rates)
▪ Examine sensitivities of yield changes on the
portfolio value(and return)
Investment Horizon Is the Key
