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

Limitations:
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

Related Articles
  1. Investing

    Understanding the Different Types of Bond Yields

    Any investor, private or institutional, should be aware of the diverse types and calculations of bond yields before an actual investment.
  2. Investing

    Explaining the Coupon Rate

    Coupon rate is the stated interest rate on a fixed income security.
  3. Investing

    Bond Yields: Current Yield And YTM

    A bond's current yield, also called "bond yield," is the interest it pays annually divided by the bond's price. A stock's current yield, also called "dividend yield," is the sum of its annual ...
  4. Investing

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  5. Investing

    Interest Rates, Inflation and the Bond Market

    Interest rates, bond prices and inflation all have an impact on one another.
  6. Managing Wealth

    How Bond Prices and Yields Work

    Understanding bond prices and yields can help any investor in any market.
Frequently Asked Questions
  1. What is the formula for calculating the current ratio?

    Find out how to calculate the current ratio and what that result can tell you about a potential investment.
  2. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based.
  3. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The concept of CAGR is relatively straightforward and requires only three primary inputs: an investments beginning value, ...
  4. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors with insight into how efficiently a company (or more specifically, ...
Trading Center