Redemption Yield

Definition of Redemption Yield

Redemption yield, also known as yield to maturity (YTM), is the total return anticipated on a bond if the bond is held until it matures. The yield includes the interest payments received from the bond and the difference between the purchase price and the face value of the bond. Essentially, it is the internal rate of return (IRR) for an investor who buys the bond at its current market price and holds it until maturity.

The redemption yield is crucial for investors as it provides a comprehensive measure of the bond’s profitability, encompassing both income from interest payments and capital gains or losses due to price changes.

Examples of Redemption Yield

Example 1: Zero-Coupon Bond
- Imagine an investor purchases a zero-coupon bond with a face value of $1,000, maturing in 10 years, at a current market price of $614. The redemption yield will factor the discounted purchase price and the total time until maturity to provide the investor’s annual yield.
Example 2: Coupon Bond
- Another investor buys a 10-year bond with a face value of $1,000, a 5% annual coupon rate, and a current market price of $950. The redemption yield will consider both the periodic interest payments and the change in value as the bond reaches maturity.

Frequently Asked Questions (FAQs)

What is the difference between redemption yield and current yield?

Redemption Yield: Is the total return anticipated if the bond is held until maturity, including all interest payments and adjustments for the purchase price vs. the face value. Current Yield: Measures the bond’s annual interest income relative to its current market price, not considering the capital gains or losses when the bond matures.

How is the redemption yield calculated?

Redemption yield can be calculated through a complex formula that sets the present value of the bond’s future cash flows equal to its current price. Financial calculators and spreadsheets can simplify this calculation using built-in functions.

Why is redemption yield important for investors?

Redemption yield provides a clear picture of the bond’s potential profitability, encompassing both income from interest and any capital gains or losses at maturity. This holistic view can guide investment decisions.

Does redemption yield change over time?

Yes, the redemption yield may change with fluctuations in the bond’s market price and interest rates. When the market price of a bond decreases, the redemption yield increases and vice versa.

Gross Redemption Yield: Similar to redemption yield but before any deductions such as taxes.
Current Yield: The bond’s annual interest payment divided by its current market price.
Yield to Call (YTC): The interest rate anticipated on a callable bond if the bond is called before the maturity date.
Yield Curve: A graph depicting the yields of bonds of varying maturities, often used to infer interest rate changes and economic activity.

Online References

Suggested Books for Further Studies

“The Bond Book” by Annette Thau
- Offers comprehensive insights into the world of bonds, including details on redemption yield and other aspects of fixed-income investment.
“Investing in Bonds for Dummies” by Russell Wild
- A guide for beginner investors that covers the basics of bonds, including how to calculate and interpret the redemption yield.
“Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
- Provides an in-depth look at various fixed income securities and their valuation, including the principles behind the redemption yield.

Accounting Basics: “Redemption Yield” Fundamentals Quiz

### What does the redemption yield of a bond measure? - [ ] Only the coupon payments. - [ ] Only the current market price of the bond. - [x] The annual return if held till maturity including interest and price difference. - [ ] The penalty for early redemption. > **Explanation:** The redemption yield measures the annual return an investor can expect if they hold the bond until maturity, including coupon payments and the difference between the purchase price and the face value. ### Is redemption yield the same as current yield? - [ ] Yes, it is exactly the same. - [x] No, they measure different aspects of bond returns. - [ ] Yes, but only for zero-coupon bonds. - [ ] No, current yield includes capital gains. > **Explanation:** Redemption yield takes into account the total return if the bond is held to maturity, while the current yield only considers the annual interest payments relative to the current market price. ### Which type of bond often involves calculating redemption yield? - [ ] ETF - [x] Corporate Bond - [ ] Real Estate Investment Trust (REIT) - [ ] Common Stock > **Explanation:** Redemption yield is typically calculated for interest-bearing securities like corporate bonds to assess the total return to maturity. ### Why might an investor prioritize redemption yield over current yield? - [x] They want a comprehensive view of the bond's total return. - [ ] They only care about short-term returns. - [ ] They prefer focusing on coupon rates. - [ ] Redemption yield is always higher. > **Explanation:** An investor looking for a comprehensive view of the bond’s potential total return, including both interest payments and price adjustments at maturity, would prioritize redemption yield. ### Redemption yield incorporates which elements of bond returns? - [ ] Only the market price. - [ ] Only the periodic interest payments. - [x] Both interest payments and capital gains or losses. - [ ] Only capital gains. > **Explanation:** Redemption yield includes both periodic interest payments received and any capital gains or losses realized if the bond is held to maturity. ### If a bond's market price increases, what happens to its redemption yield? - [ ] It remains constant. - [ ] It increases. - [x] It decreases. - [ ] It only affects the current yield. > **Explanation:** When a bond's market price increases, its redemption yield decreases because the fixed interest payments are now being divided by a higher price. ### Which tool can simplify the calculation of redemption yield? - [x] Financial calculator - [ ] Standard calculator - [ ] Pen and paper - [ ] Bond certificate > **Explanation:** A financial calculator or spreadsheet software simplifies redemption yield calculation with built-in functions for present value and IRR calculations. ### What happens to the redemption yield if a bond is called early in a falling interest rate environment? - [ ] It stays the same. - [x] It typically gets affected as the yield to call may be lower than YTM. - [ ] It increases. - [ ] It switches to current yield. > **Explanation:** In a falling interest rate environment, if bonds are called early, it reduces the time an investor holds the bond, often resulting in a lower yield to call as opposed to the initially calculated YTM. ### What does a higher redemption yield indicate about a bond? - [x] It might be a riskier investment. - [ ] It is a safer investment. - [ ] It is a government bond. - [ ] It has a high credit rating. > **Explanation:** A higher redemption yield often indicates a higher risk associated with the bond, requiring a higher return to attract investors. ### Why is it essential to consider redemption yield before purchasing a bond? - [ ] To ignore market price movements. - [ ] To only consider short-term gains. - [x] To understand the true return on investment. - [ ] To avoid paying any taxes. > **Explanation:** Considering redemption yield is essential as it provides a true measure of return on investment by taking into account both interest payments and the potential capital gains or losses up to maturity.

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