Fixed Income Investments - Assumptions Underlying Traditional Yield Curve Measures
The main underlying assumptions used concerning the traditional yield measures are:
1. The bond will be held to maturity.
2. Coupons can be reinvested at the yield to maturity
1. Current yield- Current yield only considers the coupon interest and no other sources for an investors return. It does not take into consideration the capital gain when a bond is purchased at a discount or the capital loss when the bond is purchased at a premium. Also, reinvestment income is not taken into consideration.
2. Yield to Maturity - Yield to maturity measures assume that the coupon payments will be reinvested at the coupon rate
3. Yield to Call - Yield to call assumes investor will hold the bond to the assumed call price and that the issuer will call the bond on that date which both are unrealistic. Also, the comparison of different yields to call with the YTM are meaningless because the cash flows stop once the issuer calls the bond.
4. Yield to Put - This assumes that coupon payments will be reinvested at the calculated yield and that the bonds will be put on the first date.
5. Yield to Worst - This measure does not identify the potential return over some time horizon and fails to take into account that the calculation for a YTW has different exposures to reinvestment risk.
6. Cash Flow Yield - Cash flow yield assumes that the coupons will be reinvested at the coupon rate and that the bond will be held to maturity. However, because cash flow yield tend to be used for MBSs or ABSs there is a risk that the bonds will be prepaid and the measure of cash flow yield will be thrown out the window.Importance of Reinvestment Income and Reinvestment Risk