Q. A “buy-and-hold” investor purchases a fixed-rate bond at a discount and holds the security until it matures. Which of the following sources of return is least likely to contribute to the investor’s total return over the investment horizon, assuming all payments are made as scheduled?
- Capital gain
- Principal payment
- Reinvestment of coupon payments
Solution
A is correct. (If the investor bought the bond at discount, how comes there’s no capital gain?)
Here Constant Yield Price Trajectory or Pull to Par effect comes into play. The bond purchased at discount will be equal to the par value as the maturity passes. The discount amount will get amortised over the life of the bond.