Question-55: What do you mean by current yield?

Answer: Current yield is calculated based on the coupon on the bond. Below is the formula to calculate the current yield

Current yield = Actual amount received as coupon/ Bond Price

For example, if a bond is currently selling at price of $800 for $1000 par value. And coupon is 6%. Then you can calculate the current yield as below

= $60(annual coupon)/$800

= .075

= 7.5 %

The reason it is high then actual coupon. Because investor is buying the bond in less than its par value (on which coupon is declared). You are actually paying only $800 to buy this bond, but annually receiving coupon of 6%

Hence, you can see current yield is only considering the Coupon amount and not anything else, from which more return can be realized. Like re-investing this coupon and selling bond at more price then buy price. Which we will discuss in next questions.

Question-56: What is Yield-to-Maturity?

Answer: As name suggest, what would be investors yield, if he holds the bond till maturity. So it would include all the cashflows, which he would get as below

• All Coupon Payment
• At maturity par value

To calculate the YTM, trial and error procedure is used. Because, you have to try different interest rate until all your future cashflows (Above two) are equal to present value of a bond price.

Suppose you have 18 Year bond, having coupon 6% and current bond price is $800.

All Future cashflows would be

• $30 (36 times, assuming, investor is receiving coupon semiannually)
• $1000 at maturity.

So, All Future cashflows would be = $1000+ $1080 (Coupon $30*36) + (Re-investment of these coupon)

= $2080+*$1100(Assumption, that investor is making money by re-investing this coupon back)

=$3180

So, what is the interest rate by which all this future cashflow $3180 would be equal to the current bond price $800. That rate would be your YTM. However, to calculate this rate is not simple or straight forward. You need to use spreadsheet, software or sophisticated calculator. And Software would try different rates until the $3180 become equal to $800. Complexity comes because, you are receiving these coupons on different time period. However, in spreadsheet such formula’s already available and make is simple to calculate.

Hence, YTM or yield to maturity is the rate of return you get if you hold the bond till maturity. And also, YTM consider that, you are re-investing the coupon on the same interest rate back. Suppose your calculated YTM is 8%, then it is assumed in this YTM calculation that you are re-investing the coupon at 8.5% whenever you are receiving it. So, interest-on-interest is considered here. 

Hence, to get the YTM rate (Yield to maturity), investor has to

• Keep the bond till maturity.
• All the coupons he received needs to be re-invested on the same YTM rate.

Question-57: What is the re-investment risk?

Answer: As you can see in the above question. Investor has to re-invest the coupon received by holding the bond till maturity at the same rate as YTM (Yield to maturity). However, it is possible that investor may not find the avenues to get the same rate of return as YTM for future cashflows. And that is known as re-investment risk.

Question-58: What is the interest rate risk?

Answer: If interest rates increases in the market then bond price would reduce and investor would not hold the bond till maturity and sell it at lower price, because interest rates had increased. Which makes capital loss for the investor and that is known as interest rate risk. Because investor lose money because of interest rates.

Question-59: Can zero-coupon bond can have re-investment risk?

Answer: Re-investment risk is there if you are not able to re-invest the coupon at the same rate as YTM. However, zero-coupon bond does not have any coupon which investor has to re-invest. So there is no re-investment risk with zero-coupon bond.

Question-60: How do you related to high coupon bond with re-investment risk?

Answer: If there is high coupon on the bond then you would have to find the avenues accordingly to get the YTM rates by re-investing those received coupon. Hence, we can say that with higher coupon bond, reinvestment risk is high. It is difficult to find high return avenues.