Question

The going yield-to-maturity on a 30 year US Treasury bond is about 1.4% (as of last Friday). Does this mean that an investor who buys this bond today will earn a rate of return of 1.4% % with certainty? Explain in detail

Answer 1

No this does not mean the return is guaranteed of 1.4%. Return is dependent on multiple factors-the time horizon, reinvestment rate, sale price. Total source of return is the coupons, interest earned from reinvesting coupons, capital gains yield.

Coupons are fixed. Hence, there is no source of uncertainty there.

But there is uncertainty from interest earned from reinvesting those coupons. This depends on the rate at which coupons are reinvested, which can be different from 1.4%. Hence, reinvestment income is dependent on the yield at which the coupons are reinvested, which can be different from 1.4%.

Also for capital gains yield there is uncertainty. If one assumes the time horizon of maturity, then the price one would receive is fixed i.e., the par of 1000. But if time horizon is less than maturity, price would dependent on the prevailing return, which could be different from 1.4%. Hence capital gains yield is dependent on the yield at the time at which the bond will be sold.