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B. Venkatesh

YOU may have noticed advertisements from consultants who offer you government bonds that pay interest as high as 11 per cent. Beware! The actual returns on such bonds will be substantially lower. Why?

Take a 10-year bond of Rs 100. Suppose the coupon rate is 11 per cent, but the current 10-year rate is 6 per cent. The government will offer you the bond at a price that will equal the current rate of 6 per cent. That means a substantially higher price than the bond's face value of Rs 100.

This rate of 6 per cent is called the yield-to-maturity (YTM). It refers to the rate at which the interest payments and redemption value are discounted to equal the current market price of the bond.

Suppose you pay Rs 102 for a two-year bond that pays Rs 5 as annual interest, and carries a redemption value of Rs 100. The YTM (4 per cent) will be the rate at which the discounted value of Rs 10 (annual interests) plus Rs 100 (redemption value) will equal the market price of Rs 102.

But the YTM is not the return on your investment. Why? The YTM assumes that the coupon payments are reinvested at the YTM rate.

That is, the Rs 5 you receive in the first year will have to be reinvested at 4 per cent for you to realise the YTM rate. But if the yields prevailing then are lower, you cannot reinvest at that rate. So, you will not earn the YTM rate.

The best way to measure your returns is to add the total cash inflows and divide it by the initial investment.

In the above case, your cash inflows are Rs 110, and your investment is Rs 102, so your holding-period return is 8 per cent.

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