May I ask you a question?
Does anyone understand the difference between bond yields and bond returns. For me this is not 100 % clear. If the bond’s yield increases, then this means that the bond return decreases. Does anyone understand the reasoning behind this?
If it’s not possible to explain, no problem.
This is impossible to explain… Bill Gross has been trying to figure it out for years with no luck.
It’s a bit confusing, since “yield” is defined in different ways for bonds. I believe the most common definition of “yield” is the coupon payment. However, it could also mean the expected return if held to maturity, as a percentage of current market value. The bond “return” is the same as the second definition, although “return” might be better calculated after the trade has expired.
Bond yield (as meant by yield to maturity, which is the most common meaning for “yield” without an adjective) is the return you get if you pay the current price, all coupons come in as expected, principal gets repaid at par when expected, and all coupons are reinvested at the same YTM when they are paid. In this case, yield = return.
Break any of these assumptions, and your return will be different from the yield.
The most common problem is not being able to reinvest coupons at the same yield because yields change in the interim. Usually the difference is pretty small unless yields are high or have changed a lot. A zero coupon bond solves this issue, but is not always available.
The other thing that happens is that investors don’t necessarily hold to maturity. In this case you get coupon interest, reinvestmnt income, and capital gain/loss on the bond price. That return will probably not equal the yield unless things offset each othe just right.
Defaults or late payments also make a bond’s actual return different, for obvious reasons.
You can also buy premium bonds to get some extra yield by exploiting some market ineffeciencies, while at the same time decreasing the violatility of your fixed income portfolio. In this case, you are assuming some ‘par risk’ (don’t know the correct term) if the bond is callable – that is, it gets called before you make back the premium to par you paid for it.