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Sources of Return in a Fixed-Income Security

receipt of the promised coupon and principal payments;
reinvestment of coupon payments;
capital gains or losses on the sale of the bond prior to maturity.

A discount bond offers a “deficient” coupon rate or a “below the market” discount rate. For a premium bond, the coupon rate exceeds the market discount rate. Through amortization, the carrying value of a bond reaches the par value at maturity.

Example: Sources of Return

An investor initially buys a 5-year, 8% annual coupon payment bond at the price of 85.00 per 100 of par value.

Case 1: Holding the Bond to Maturity The bond’s yield-to-maturity is 12.18%. As seen previously, the easiest way to find the value of r is to use the financial calculator: n=5; PV=-85; PMT=8; FV=100; CPT => I/Y = 12.18

The investor receives a series of 5 coupon payments of 8 (per 100 of par value) for a total of 40, plus the redemption of principal (100) at maturity.

Case 2: Selling a Bond Before Maturity

Let’s assume a second investor buys the 5-year, 8% bond but sells it after four years.

Reinvestment Risk Reinvestment risk is the chance that an investor will not be able to reinvest cash flows from an investment at a rate equal to the investment’s current rate of return (yield to maturity).

Market Risk (Price Risk) Bond market prices will decrease in value when the prevailing interest rates rise.

Question

Which of the following sources of bond return is most likely subject to interest rate risk assuming the bond is held until maturity?

Reinvestment of coupon payments.
Redemption of principal at maturity.
Original purchase price depending on the investment horizon. Solution The correct answer is A. The interest rate risk results mainly from changes in coupon reinvestment rates.