Chapter 11: bonds yield and return calculation

After completing this reading, you should be able to:

● Distinguish between gross, and net realized returns and calculate the realized return for a bond over a
holding period, including reinvestments.
● Define and interpret the spread of a bond and explain how to derive a spread from a bond price and a term
structure of rates.
● Define, interpret, and apply a bond’s yield-to-maturity (YTM) to bond pricing.
● Compute a bond’s YTM, given a bond structure and price.
● Calculate the price of an annuity and perpetuity.
● Explain the relationship between spot rates and YTM.
● Define the coupon effect and explain the relationship between the coupon rate, YTM, and bond prices.
● Explain the decomposition of P&L for a bond into separate factors, including carry roll-down, rate change,
and spread change effects.
● Describe the common assumptions made about interest rates when calculating carry roll-down, and calculate
carry roll-down under these

Gross vs. Net Realized Returns

The gross realized return on investment has two
components: Any increase in the price of the asset plus
income received while holding the investment. When
dealing with bonds,
Example: A Bond’s Gross Realized Return over Six Months
What is the gross realized return for a bond that is currently
selling for $1,060 if it was purchased exactly six-months ago for
$1,000 and paid a $20 coupon today?

When calculating the gross realized return for multiple periods, it’s essential to consider whether coupons received
are reinvested. If the coupons are reinvested, they will earn some interest at a given rate.

Example: Gross Realized Return over One Year With Reinvested Coupons
A bond purchased exactly six months ago for $1,000 paid a $20 coupon today. Suppose the coupon is reinvested at
an annual rate of 4.4% for the next six months
and that the bond is worth $1,080 after one
year. What is the realized return on the bond
over the one-year period?

Example: Example: Gross Realized Return over One Year With Reivested Coupons and Financing Costs
An investor purchased a bond exactly six months ago at $980 (per $1,000 nominal value). The purchase was entirely
financed at an annual rate of 2%. Today, the bond is worth $995.
Given that the bond paid a coupon of $20 today, determine the net realized return

Bond Spread
The spread of a bond is the difference between its market price and the price computed according to spot rates or
forward rates – the term structure of interest rates.
As a relative measure, a bond’s spread helps us determine whether the bond is trading cheap or rich relative to the
yield curve. We incorporate spread in the bond price formula as follows:

Recall that given a 2-year bond with a face value of P, paying annual
coupons each of amount C, its price is given by:

To incorporate the spread s, we assume that the bond is trading at a

premium or discount to this computed price.
can find the bond’s spread using the following formula:

Yield to Maturity
Yield to maturity (YTM) of fixed income security is the total return
anticipated if we hold the security until it matures. Yield to maturity is
considered a long-term bond yield, but we express it as an annual
rate. In other words, it’s the security’s internal rate of return as long as
the investor holds it up to maturity. To compute a bond’s yield to maturity, we use the following formula:
Where:

P = price of the bond

Ct=annual cash flow in year t
N = time to maturity in years
y = annual yield (YTM to maturity)
F = face value

Example: Yield to Maturity Suppose a two-year bond with a coupon of 5% sells for USD 106. What is the yield to
maturity expressed with semi-annual compoundiSng?
We can solve this by trial and error, to get y=1.93%

When cash flows are received multiple times every year, we can slightly modify the above formula such that:

Where:
P = price of the bond
Ct=periodic cash flow in period t
n = N × m = number of periods (= years × number of periods per year)
F = face value
Provided all cash flows received are reinvested at the YTM; the yield to maturity is equal to the bond’s realized
return.

For zero-coupon bonds that are not accompanied by recurring

coupon payments, the yield to maturity is equal to the normal
rate of return of the bond. We use the formula below to
determine YTM for zero-coupon bond:

Exam tip: The yield to maturity assumes cash flows will be reinvested at the YTM and assumes that we hold the
bond until maturity.
Prices of Annuities and Perpetuities
An annuity is a series of annual payments of PMT until the final time T. The value of an ordinary annuity is given by:
Where:
r=discount rate
Perpetuity is a type of annuity whose cash flows continue for an infinite amount of

time. The present value of a perpetuity is given by:

Suppose we receive a semi-annual coupon at the rate of USD 3 per annum forever. Suppose further that the yield to

maturity is 6%. Then, the present value of the perpetuity is

The Relationship between Spot Rates and YTM

We can use both the spot rate and the yield to maturity to determine the fair market price of a bond. However, while
the yield to maturity is constant, the spot rate varies from one period to the next to reflect interest rate expectations
as time goes.

The spot rate is a more accurate measure of the fair market price when interest rates are believed to rise and fall
over the coming years.

Given a bond’s cash flows and the applicable spot rates, you can easily calculate the price of a bond. You can then
determine the bond’s YTM by equating the price to the present values of cash flows discounted at the YTM.

The Coupon Effect

The coupon effect describes the fact that reasonably priced bonds of the same maturity but different coupons have
different yields to maturity, which implies that yield is not a reliable measure of relative value. Even if fixed-income
security A has a higher yield than fixed security B, A is necessarily not a better investment.

It also follows that if two bonds have identical features save for the coupon, the bond with the smaller coupon is more
sensitive to interest rate changes. In other words, given a change in yield, the lower coupon bond will experience a
higher percentage change in price compared to the bond with larger coupons. The most sensitive bonds are
zero-coupon bonds, which do not make any coupon payments.
Exam tips:
● The lower the coupon rate, the higher the interest-rate risk. The greater the coupon rate, the lower the
interest rate risk.
● If coupon rate > YTM, the bond will sell for more than par value or at a premium.
● If the coupon rate < YTM, the bond will sell for less than par value, or at a discount.
● If coupon rate= YTM, the bond will sell for par value.
Over time, the price of premium bonds will gradually fall until they trade at par value at maturity. Similarly, the price of
discount bonds will gradually rise to par value as maturity gets closer. This phenomenon is known as “pulling to par.”

Components of a Bond’s P&L

We generate the bond’s profitability or loss through price appreciation and explicit cash flows. The total price
appreciates as follows:
There are three components of price appreciation:

1.Carry-roll-down component: The carry-roll-down component comprises of price changes that emanate from a
deviation of term structure from the original structure to an expected term structure, denoted as Re , as maturity
approaches. It does not account for spread changes

2.Rate changes component: The rate changes component accounts for price changes due to interest rate
movements from an expected term structure to the term structure that exists at time t+1.
This component also doesn’t account for spread changes.

3.Spread change component: As the words suggest, the spread change component accounts for price changes
emanating from changes in the bond’s spread from time t to t+1.

Common Assumptions in Carry Roll-Down Calculation

● Realized Forwards: One of the fundamental assumptions in carry roll-down calculation is that forward rates,
as projected today, will be realized when the future period arrives. In other words, if an investor were to
reinvest at each coupon period, they would do so at the forward rates initially quoted. It is important to note
that in practice, actual realized forwards may differ from the initial forwards, with some being higher and
others lower than initially projected.
● Unchanged Term Structure: This means that if the current yield curve is flat, upward-sloping, or
downward-sloping, it is assumed to retain this shape over the investment period. For instance, if the term
structure is flat at 4%, it is assumed to remain flat at 4% in the future. In the real-world, the term structure can
and often does change in response to new information, economic events, and central bank policies.
● Unchanged Yields: Lastly, it is often assumed that yields remain unchanged. This is especially relevant for
the calculation of a bond’s carry, where it is presumed that the yield at which the bond was purchased will
remain the same over the investment period. However, yields are subject to market dynamics, influenced by
changes in risk perceptions, economic growth prospects, and shifts in monetary policy, which can lead to
yield variations over time.
Example 1: Flat Term Structure at 4%
In a bond market with a flat term structure at a 4% rate with semi-annual compounding, an investor holding a
five-year bond paying a 4% coupon would expect the price to remain constant at $100 if forward rates are assumed
to remain constant. Therefore, over a six-month period, the investor would earn a coupon payment, representing a
2% return (half of the annual 4% for semi-annual payments), which equates to a $2.00 return from the coupon
payments alone.

Example 2: Five-Year Bond with a 5% Coupon

Consider a similar market with a flat term structure at 4%, but now the investor holds a five-year bond with a 5%
coupon. The bond’s initial price is $104.49 due to the higher coupon. Should the term structure stay flat at 4%, after
six months as the bond approaches 4.5 years to maturity, its value would decrease to $104.08 due to the anticipated
reduction in future high coupon payments. The decrease in value, or $0.41, represents a negative change that
affects the carry roll-down. The total carry roll-down would thus be $2.09, derived from the half-year coupon of $2.50
minus the price depreciation of $0.41.

This detailed explanation separates the carry roll-down into two components:
Cash-carry, which is the actual coupon received in cash, amounting to $2.50 for the six-month period.
Price-change component, representing a reduction in the bond’s value, recorded as -$0.41 over the same time
frame.