Saturday, November 25, 2017

Yield of a risky bond


When working with risky bonds, i.e. corporate bonds, what is usually defined as the yield of such a bond? Is it the yield calculated as if the bond was riskless, or is it calculated by properly taking into account the default risk in this case? And what about (risky and riskless) floating rate notes?



Answer




As John already mentioned the formula for calculating yield to maturity is independent of any risk-related numbers. Its just the connection between coupons, time and price.


In theory, default-risk can be seen as already incorporated in the yield. The yield spread between the bond and a comparable investment without default risk is a measure for the default risk premium.


For FRNs there is no way to compute a yield since coupon payments are unknown. You can only estimate the price/yield by forecasting the interest rates at the coupon dates. But the notion of yield is the same - one just estimates the coupons first.


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