Introduction

Evaluating the potential return from a bond investment is a crucial aspect of making informed financial decisions. The expected return from a bond encompasses various components that contribute to the overall yield. Understanding these components is essential for investors to assess the attractiveness of a bond and compare it with alternative investment options. In this chapter, we delve into the key factors that contribute to the expected return of a bond, providing insights into how investors can analyze and evaluate their bond investments effectively.

Components of the Expected Return

• Coupon Interest Payment: The coupon interest payment is the regular interest paid by the issuer to the bondholder based on the bond’s coupon rate. It is typically expressed as a percentage of the bond’s face value and represents a fixed income stream over the bond’s life. For example, if a corporate bond with a face value of $1,000 has a coupon rate of 5%, the annual coupon payment would be $50 ($1,000 * 0.05).

• Capital Gain or Loss at Maturity: The capital gain or loss at maturity refers to the difference between the bond’s face value and its purchase price. If the bond is held to maturity, the investor will receive the face value, resulting in a capital gain or loss if the purchase price was different. For instance, if an investor bought a bond at a discount for $950 and receives the face value of $1,000 at maturity, the capital gain would be $50.

• Yield-to-Maturity (YTM): YTM is the total expected return an investor will receive if they hold the bond until maturity, accounting for both coupon payments and the capital gain or loss. It takes into consideration the time value of money, discounting future cash flows back to present value. YTM provides a measure of the annualized return an investor can expect. A higher YTM typically indicates a higher potential return.

• Call or Redemption Premium: If a bond is callable, the issuer has the option to redeem the bond before maturity. In such cases, the issuer might pay a call premium to bondholders if the bond is called. The call premium represents the difference between the call price and the face value of the bond. This component affects the potential return, especially if the bond is called before maturity.

• Reinvestment Risk: Reinvestment risk arises when coupon payments received from the bond cannot be reinvested at the same rate as the bond’s yield. This risk impacts the actual realized return, as investors might not be able to reinvest coupon payments at the original yield.