Question

4.

A) Explain the total return, the current yield, and the capital gains yield for a bond and how each is determined.

B) What is price risk for a bond? What is reinvestment risk for a bond? What bonds would have the most price risk? What bonds would have the least price risk?

C)

How is default risk measured for a bond? What lets you know a bond is investment grade? What lets you know that a bond is speculative (junk)?

Answer 1

Q-4)

a) The total return is equal to the total income that is received from the investment in a fixed income security, current yield measures the income on the price of the bond whereas the capital gain shows the price gain from buying and selling the bond. The total return on a bond consist of coupon income, reinvestment income from coupon and capital gain or loss from the bond. The current yield on a bond is calculated as annual coupon being paid on the bond divided by current price of the bond. The capital gain yield is the difference between the price at which you purchase the bond and the price which you well the bond.

b) Price risk refers to the change in fall in the price of the bond because of the increase in interest rate and reinvestment risk refers to the risk that the in the event the interest rate falls in the market the cash inflow would increase and it would be reinvested at lower rates which would cause the investor fall in income. Long term bonds have higher price risk because interest rate can change and the price of the bond can vary significantly where as bonds which are of short-term maturity have higher reinvestment risk.

c) Default risk is the risk that the issuer of the bond will default on its obligation to pay back the debt. There are many ways in which the default risk is measured, the most prominent one is credit rating. Credit rating is a rating given by debt rating agencies to different companies based on different financial metrics. Lower the credit rating higher is the default probability and vice versa. Another measure is the spread on the bond in comparison to treasury bond. Treasury bonds are considered to be risk free, so higher the spread over the treasury bond higher is the probability of default. The Investment grade and speculative grade are based on credit rating. Any credit rating below BBB is said to be of speculative or junk grade where as BBB or higher are considered to be of investment grade. Although different rating agencies use different metrics to show the difference between speculative and investment grade bonds.