Redemption Yield/Risk Free Rate of Return

Redemption Yield/Risk Free Rate of Return: is sometimes called “yield to maturity”. It is a concept most often applied to fixed income securities, like bonds, but also has applications to equity (stock) investing. The redemption yield has three components:

1. the running (or interest yield) on a bond;
2. interest-on-interest that would be earned if successive interest payments were reinvested; and
3. the annual rate of capital gain or loss that would be made if a bond were held until maturity and repaid at its issue (or “par”) value.

Redemption Yield = Running yield + Interest-on-interest + Gain/loss on maturity

The concept of a “Risk Free Rate of Return” is important for calculating the intrinsic value of a business (as we’ll see later). US Treasuries (bonds backed by the full faith of the US government) are considered to be as close to “risk-free” as one can get. If the US government can’t make payments on their debt, we all have bigger problems to worry about than our portfolio!

Bonds (treasuries) are not risk free, in fact the value of a bond in the secondary trading market will move inversely proportional to prevailing interest rates. When interest rates rise your bonds lose value and vise-versa. However, if you hold them to maturity, you are guaranteed you coupon interest rate and return of your initial capital-leaving only inflation as your enemy.