Yield to maturity contrasted with realised return
Question
What is the difference between a bond's yield and its rate of return?
Short answer
Yield is a promised, forward-looking rate; rate of return is what you actually earn over a holding period. Yield to maturity is the single discount rate equating the price to the promised cash flows, which you earn only if you hold to maturity, there is no default and coupons are reinvested at that yield. Rate of return is realised: coupons plus price change (and reinvestment income) divided by the purchase price, so it depends on how rates move while you hold the bond.
Adapted from Crack, Heard on the Street, Q3.4, p.33; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Duration and Convexity: Measuring and Managing Interest Rate Sensitivity
- Bond Prices, Discount Factors, and the Law of One Price
- Sample Spaces, Events, and the Probability Axioms
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