8.8 Effects of Different Bond Components on Profit
The total return of a bond consists of three components:
- Coupon Interest
- Interest-on-Interest
- Price Change: Capital Gain / (Loss)
The effect of interest rates movements may have a different result on these components.
Example
- 10-Year Treasury Note, 6% Coupon, purchased @ 6% YTM.
- One-year holding period.
- What if rates over the year…
a. Moved down by 100 b.p.3 ?
b. Remained unchanged?
c. Moved up by 100 b.p.?
Let’s some assumptions to arrive at a reinvestment rate. First, we will assume that the six-moth, one-year, and ten-year yields are the same. We will also assume that mid-year yields are the averages of the beginning and ending yields. Note that, in practice, this is unrealistic as short-term rates are generally less than long term rates.
| -100 b.p. | Unchanged | +100 b.p. | |
|---|---|---|---|
| Purchase Price | $1,000.00 | $1,000.00 | $1,000.00 |
| Price in One Year | $1,071.77 | $1,000.00 | $934.05 |
| Capital Gain/(Loss) | $71.77 | $0.00 | ($65.95) |
| Coupon Income | $60.00 | $60.00 | $60.00 |
| Interest-on-Interest4 | $0.825 | $0.90 | $0.975 |
| Total Earnings (Sum) | $132.595 | $60.90 | ($4.975) |
| One-Year Holding Period Return | 132.60 / 1,000 = 13.595% | 60.9 / 1,000 = 6.09% | (4.975) / 1,000 = (0.005%) |
Questions
- What is meant by “Total Return?”
- Which of the three components of return has provided the greatest portion of total profit/(loss) or return?
