Lesson: How to Value a Bond and Yield to Maturity

Lesson Objectives

1. Understanding Simple Interest
2. Understanding Compound Interest on Bonds
3. Understanding the Current Yield
4. Understanding Yield to Maturity (YTM)

Key Concepts

Simple Interest

• Simple Interest Calculation:

  • Total value of the coupons without reinvestment.
  • E.g., $25 per coupon for a total of $1,500 after 60 coupons.
  • Focuses on the cash collected from coupon payments only.

• Coupon Yield:

  • One year's worth of coupon payments ($50) divided by the bond's par value gives the coupon yield (e.g., $50 / $1,000 = 5%).

Current Yield

• Current Yield Calculation:

  • Coupon payment for one year divided by the price paid for the bond.
  • Example: If Jesse buys the bond for $1,200, his current yield is $50 / $1,200 = 4.2%.
  • Does not account for price changes at maturity (i.e., gains/losses between purchase price and par value).

• Example Variations:

  • Price bought at $1,200: Current yield = 4.2%
  • Price bought at $1,000: Current yield = 5%
  • Price bought at $800: Current yield = 6.3%

Compound Interest

• Compound Interest Calculation:

  • Assume reinvesting each coupon at the bond's coupon rate (5%).
  • After 30 years, compounds to a total of $3,400 as opposed to $1,500 with simple interest.

• Comparison:

  • Simple interest yields $1,500 total.
  • Compound interest yields $3,400 total with reinvestment.

Yield to Maturity (YTM)

• Importance of YTM:

  • Accounts for both compound interest and the difference between purchase price and par value at maturity.
  • Reflects the true yield of holding the bond to maturity.

• Example Calculations:

  • Bought at $1,200: YTM = 3.3%
  • Bought at $1,000: YTM = 5%
  • Bought at $800: YTM = 7.2%

• Understanding YTM:

  • Essential for evaluating the true return on a bond investment.
  • Reflects the real scenario of returns when held to maturity.

Conclusion

• Summary:

  • Grasp the distinctions between coupon yield, current yield, and YTM.
  • YTM provides the most accurate measure of bond return when considering all factors.

• Recommendations:

  • Re-watch the lesson or previous lessons if needed for clarity.
  • Use practical exercises and the bond calculator to reinforce learning.

End of Lesson

• Continue to Unit 3 for further learning.