Aurora Borealis
1 July 1977 Financial Analysts Journal Volume 33, Issue 4

The Problem with Redemption Yields

  1. Stephen Schaefer

A coupon bond resembles a portfolio of pure discount bonds in that it makes payments at a number of future dates. In an efficient market, the price of a coupon bond should equal the price of the corresponding portfolio of pure discount bonds. Such a market discounts payments made by different bonds at the same point in time at the same spot rate—the rate of exchange between money today and money at a single date in the future—whereas it discounts payments made by the same bond at different points in time at different spot rates.

These properties of spot rates contrast sharply with the properties of the redemption yield—the single internal rate of return equating the discounted value of all future payments to a bond’s price. Redemption yield is a derived figure; we need to know the bond’s price before we compute it. The redemption yield, therefore, cannot help us estimate the bond’s value.

When comparing two or more bonds, it is far more useful to estimate the relevant sequence of spot rates than to calculate the bonds’ redemption yields.

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