The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• The price of a bond is the present value of the bond’s cash flows, the discount rate being equal to the yield offered on comparable bonds. For an option-free bond, the cash flows are the coupon payments and the maturity value.

• The higher (lower) the required yield, the lower (higher) is the price of a bond. Therefore, a bond’s price changes in the opposite direction from the change in the required yield.

• When the coupon rate is equal to the required yield, the bond will sell at its par value. When the coupon rate is less (greater) than the required yield, the bond will sell for less (more) than its par value and is said to be selling at a discount (premium).

• The conventional yield measures commonly used by bond market participants are the current yield, yield to maturity, and yield to call.

• The three potential sources of dollar return from investing in a bond—coupon interest, interest-on-interest, and capital gain (or loss); none of the three conventional yield measures deals satisfactorily with all these sources.

• Although the yield to maturity considers all three sources, it is deficient in assuming that all coupon interest can be reinvested at the yield to maturity.

• Reinvestment risk is the risk that the coupon payments will be reinvested at a rate less than the yield to maturity.

• The yield to call assumes that the coupon interest can be reinvested at the yield to call.

• The total return measure is more meaningful than either yield to maturity ...