Chapter 1

Interest on Interest

The recent high level of bond yields and the uncertainty whether yields will be high in the years ahead emphasizes the importance of interest-on-interest, that is to say, the rate at which receipts from coupons can be reinvested in the future. An original investment compounds automatically at the purchase yield only until the funds are paid back in the form of coupons and finally of principal. However, some investors mistakenly expect that a bond purchased at a given yield will always produce that rate as a realized compound yield over the whole life of the bond. If future reinvestment rates during the life of the bond are less than the purchase yield, then the realized compound yield for the whole life of the bond ...

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