Accrued Interest

BOND RISKS >>

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

maturity.

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

Where;

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.

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