Question 1

Step 1: Calculate the numerator (Average Annual Return)

Accepted Answer

The numerator represents the total annual return, which includes the $60 coupon plus the annualized capital gain you will make by buying the bond at $920 and holding it until it matures at $1,000.

Question 2

Step 2: Calculate the denominator (Average Capital Invested)

Accepted Answer

The denominator represents the average amount of capital you have tied up in the investment over its lifetime. It is the midpoint between what you paid ($920) and what you will receive at the end ($1,000).

Question 3

Why do bond prices fall when interest rates rise?

Accepted Answer

This is the fundamental law of fixed income, driven by the concept of opportunity cost. If you own a bond that pays a fixed 4% interest rate, and the Federal Reserve raises rates so that brand new bonds are now being issued at 6%, your 4% bond is no longer attractive to anyone. No rational investor will pay full price for your 4% bond when they can buy a new one paying 6%. To sell your bond, you are mathematically forced to drop its price. You must discount the price exactly enough so that the new buyer's total return (the 4% interest plus the capital gain from buying it cheaply) equals the new 6% market rate.

Question 4

What is the difference between yield and return?

Accepted Answer

Yield is a forward-looking, annualized mathematical expectation based on holding the asset under specific conditions (usually until maturity). It assumes all payments are made on time and reinvested at the same rate. "Total Return," however, is a backward-looking historical fact. It calculates exactly how much money you actually made over a specific period, factoring in the actual price you sold the bond for, the actual interest you collected, and the actual rates at which you reinvested that interest. A bond might have a 5% Yield to Maturity on the day you buy it, but if you sell it a year later during a massive interest rate spike, your Total Return for that year could be -10%.

Question 5

How does reinvestment risk affect Yield to Maturity?

Accepted Answer

Yield to Maturity is a mathematical formula that inherently assumes every single interest payment you receive will be reinvested into the market at the exact same rate as the YTM. If your bond has a 7% YTM, the math assumes you are earning 7% on your coupons as well. If market interest rates fall to 3% while you hold the bond, your new coupons can only be reinvested at 3%. Because your interest is earning less interest than the formula projected, your actual realized return at the end of the bond's life will be noticeably lower than the original 7% YTM. This is why zero-coupon bonds are the only bonds with zero reinvestment risk.

Question 6

What happens if I sell a bond before its maturity date?

Accepted Answer

If you sell a bond prior to maturity, you are entirely at the mercy of the secondary market and current interest rates. You forfeit the guarantee of receiving the par value. If interest rates have fallen since you bought the bond, your bond's fixed higher payments are highly valuable, and you will sell it at a premium, realizing a capital gain. If interest rates have risen, you will be forced to sell it at a discount, realizing a capital loss. Selling before maturity transforms a predictable fixed-income investment into a volatile trading asset.

Question 7

Why would anyone buy a bond with a negative yield?

Accepted Answer

During the 2010s, negative-yielding bonds existed in Europe and Japan. Investors bought them for three primary reasons. First, institutional mandates frequently require pension funds and banks to hold a certain percentage of sovereign government debt for regulatory safety, regardless of the yield. Second, during periods of severe deflation, cash under the mattress loses value; a bond with a -0.5% yield might actually preserve purchasing power better than holding cash if deflation is at -2.0%. Finally, traders bought them hoping rates would go more negative, which would push the price of the bond even higher, allowing them to sell it for a quick capital gain before maturity.

Question 8

How often do bonds pay interest?

Accepted Answer

The vast majority of corporate and government bonds in the United States pay interest semi-annually, meaning you receive exactly half of your annual coupon payment every six months. For example, a $1,000 bond with a 6% coupon pays $60 a year, distributed as two $30 payments. However, Mortgage-Backed Securities (MBS) and many international bonds pay interest monthly. Zero-coupon bonds pay no interest at all during their lifetime, delivering the entire return as a lump sum at maturity.

Question 9

What is accrued interest and how does it affect the price I pay?

Accepted Answer

Because bonds usually pay interest every six months, a buyer and seller must account for the time between payments. If you buy a bond exactly three months after its last payment, the seller held the bond for three months and rightfully earned half of the upcoming interest payment. When you execute the trade, you must pay the seller the agreed-upon market price of the bond (the Clean Price) plus the exact dollar amount of the interest they earned over those three months (the Accrued Interest). The total amount you pay out of pocket is called the Dirty Price. When the next official coupon date arrives, you will receive the full six-month interest check, effectively reimbursing you for the accrued interest you paid the seller.

Bond Yield Calculator

Command Palette