Measuring Portfolio Returns - Bond Yields
Any discussion of portfolio returns must also include the variety of ways that bond income may influence a portfolio's rate of return. While the stated (nominal) interest rate on a bond might appear to be the only measure of a bond yield, it is only accurate if you buy a bond at par and hold it until the bond matures. However, many investors buy a bond at a price above or below par, and many sell prior to maturity. The following measures are used to reflect these circumstances:
- Yield to maturity - This is the return based on the actual purchase price of the bond. It takes any premium or discount over par into account and uses the actual time to maturity for the number of compounding periods. If the bond was purchased at par, the yield to maturity will equal the stated coupon rate.
- Yield to call - This is a similar calculation, but it uses the call date for the number of compounding periods and incorporates any call premium into the future value.
- Current yield - This is simply the annual income divided by the market value of the bond. If the bond is trading at a premium, the current yield will be less than the nominal yield. If the bond is trading at a discount, the current yield will be greater than the nominal yield.
- Real interest rate - The investor receives this rate after inflation is taken into account. In essence, the nominal interest rate = the real interest rate plus an inflation premium. The inflation premium is typically higher for bonds with longer maturities.
Exam Tips and Tricks
Consider this sample question:
The method of evaluating investment returns that calculates the interest rate which discounts cash inflows and outflows to a present value of zero is called:
- inflation-adjusted return.
- internal rate of return.
- total return.
- net present value.
The correct answer is "b": "d" is incorrect because the method referred to incorporates the concept of net present value, but it is not a definition of that term.