BaseballRedhawks
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From CFAI book, page 149.
Can someone please help in explaining the below text? When interest rates rise, bond value falls. Which is bond for bondholders/fixed income. However, in this case, it seems like rising interest rates is good, because you get to reinvest income at a higher rate. Thanks for your help guys!
Total Return for Various Yields:
Suppose that a life insurance compnay sells a 5 year Guaranteed investment contract (GIC) that guarantes an interest rate of 7.5 percent per year on a BEY basis (3.75% every 6 months). Also suppose that the payment the policyholder makes is $9,624,899. You can plug this data in the calculator and get a future value that the life insurance company guarantees the policyholder 5 years from now = $13,934,413.
Assume the manager buys $9,642,899 face value of a bond selling at par with a 7.5% YTM that matures in 5 years. The portfolio will not be assured of realizing a total return at least equal to the target yield of 7.5%, because to realize 7.5%, the coupon interest paymentsm ust be reinvested at a minimum rate of 3.75% every 6 months. Thati s, the accumulated vlaue will depend on the reinvestment rate.
Suppose immediately after investing in the bond, yields in the mkt change and then stay at the new level for the remainder of the 5 years.
Answer: If market yields rise, an accumulated value (total return) higher than the target value (target yield will be achieved. This result follows because the coupon interest payments can be reinvested at a higher rate than the initial YTM. This result constrats with what happens when the yield declines. The accum value (total return) is then less than the target value (target yield). Therefore, investing in a coupon bond with a YTD equal to the target yield and a maturity equal to the investment horizon does not assure that the target value will be achieved.
Can someone please help in explaining the below text? When interest rates rise, bond value falls. Which is bond for bondholders/fixed income. However, in this case, it seems like rising interest rates is good, because you get to reinvest income at a higher rate. Thanks for your help guys!
Total Return for Various Yields:
Suppose that a life insurance compnay sells a 5 year Guaranteed investment contract (GIC) that guarantes an interest rate of 7.5 percent per year on a BEY basis (3.75% every 6 months). Also suppose that the payment the policyholder makes is $9,624,899. You can plug this data in the calculator and get a future value that the life insurance company guarantees the policyholder 5 years from now = $13,934,413.
Assume the manager buys $9,642,899 face value of a bond selling at par with a 7.5% YTM that matures in 5 years. The portfolio will not be assured of realizing a total return at least equal to the target yield of 7.5%, because to realize 7.5%, the coupon interest paymentsm ust be reinvested at a minimum rate of 3.75% every 6 months. Thati s, the accumulated vlaue will depend on the reinvestment rate.
Suppose immediately after investing in the bond, yields in the mkt change and then stay at the new level for the remainder of the 5 years.
Answer: If market yields rise, an accumulated value (total return) higher than the target value (target yield will be achieved. This result follows because the coupon interest payments can be reinvested at a higher rate than the initial YTM. This result constrats with what happens when the yield declines. The accum value (total return) is then less than the target value (target yield). Therefore, investing in a coupon bond with a YTD equal to the target yield and a maturity equal to the investment horizon does not assure that the target value will be achieved.