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4.2 Return from Investing in a Fixed-Income Bond

A fixed-rate bond has three sources of return:

  • Receipt of the promised coupon and principal payments on the scheduled dates
  • Reinvestment of coupon payments
  • Potential capital gains or losses on the sale of the bond prior to maturity A discount bond offers the investor a "deficient" coupon rate, or one below the market discount rate. The amortization of the discount in each period brings the return in line with the market discount rate as the bond's carrying value is "pulled to par." For a premium bond, the coupon rate exceeds the market discount rate and the amortization of the premium adjusts the return to match the market discount rate. Through amortization, the bond's carrying value reaches par value at maturity.

Factors Affecting Return

  • A horizon yield: the internal rate of return between the total return for the investment horizon and the purchase price of the bond
  • A carrying value: the purchase price plus (minus) the amortized amount of the discount (premium) if the bond is purchased at a price below (above) par value Calculation of the Sources of Return
  • There are two potential impacts on the return from the change in interest rates. The future value of reinvested coupon payments goes up because now coupons are reinvested at 11.40%. The value is 0.552613 (37.899724 – 37.347111) per 100 of par value. $37.347111 is the value of reinvested coupons if the yield-to-maturity (YTM) stays at 10.40%. But there is a capital loss of 3.888362 (89.668770 – 85.780408) per 100 of par value. $89.66877 is the sale value if interest rates stay at 10.4%.
  • The capital loss is greater than increase in interest from the reinvested coupon. The overall impact of an increased interest rate in this example would be negative (i.e., reduction from 10.4% realized return to 9.67% realized return).

Investment horizon and Interest Rate Risk The investment horizon is at the heart of understanding interest rate risk and return. Two investors holding the same bond (or bond portfolio) can have different exposures to interest rate risk if they have different investment horizons.

There are two offsetting types of interest rate risk 1. Coupon reinvestment risk: The future value of reinvested coupon payments (and in a portfolio, the principal on bonds that mature before the horizon date) increases when interest rates go up and decreases when rates go down. Coupon reinvestment risk matters more when the investor has a long-term horizon relative to the time-to-maturity of the bond. A buy-and-hold investor only has coupon reinvestment risk.

2. Market price risk: The sale price on a bond that matures after the horizon date (and thus needs to be sold) decreases when interest rates go up and increases when rates go down.

Lesson Wrap-Up

This lesson should leave you able to explain the return from investing in a fixed-income bond in a fixed-income context and connect it to the decisions made by issuers, investors, or analysts.

Review Prompts

  1. Explain return from investing in a fixed-income bond in your own words.
  2. State one exam-style risk, valuation, or market implication of the return from investing in a fixed-income bond.