Question

A) Explain why the total return from holding a bond to maturity will be between the yield to maturity and the reinvestment rate.

B) For a long-term high-yield coupon bond, do you think that the total return from holding a bond to maturity will be closer to the yield to maturity or the reinvestment rate?

C) What are the limitations of using duration as a measure of a bond’s price sensitivity to interest rate changes?

D) Does convexity of a bond have investment implications? Carefully reason out your answer.

Answer 1

1.) Yield to maturity is the total return anticipated on a bond if the bond is held until it matures. The YTM is below(above) the coupon rate if the current market value is above(below) the par value. Calculation of YTM assumes that all coupons payments are reinvested at the same rate as the bond's current yield, then the total return would be the same as the YTM.

2.) For a long term high yield coupon bond the total return from holding a bond to maturity will be closer to the YTM, Calculation of YTM assumes that all coupon payments are reinvested at the same rate as bond's current yield.

3.) Duration has limitations when used as a measure of interest rate sensitivity. While duration calculates a linear relationship between price and yield changes in bonds, in reality, the relationship between the changes in price and yield is convex. The larger the change in the interest rates, the larger the error in estimating the price change of a bond.

4.) Convexity measures how the bond's duration and by the result, its price will change depending on how much interest rate change.

Taken together both duration and convexity show how a bond or portfolio can be expected to perform when the interest rate changes. This helps the investors take major investment decisions and help them understand the price of owning fixed income securities under different interest rate scenarios. In general, the higher a bond's coupon rate, the lower its convexity, or market risk.