Using Yield to Maturity to Estimate Bond Holding-Period Returns

Summary

The document asks whether yield to maturity minus borrowing cost is a reasonable estimate of return for a leveraged bond position that will be sold before maturity. The proposed quote uses the bond’s starting YTM and a fixed annualized funding rate, with the funding cost described as potentially swapped from a short-term reference rate. The central concern is that ranking bonds by this spread may favor high-YTM securities and overlook lower-YTM bonds with larger coupons and prices that may be more stable.

The document offers no empirical results or alternative estimator; it frames the issue and seeks a simple, explainable measure rather than a complex predictive model. YTM reflects cash flows under a hold-to-maturity assumption, so it does not by itself capture the realized return from an earlier sale. That return also depends on the sale price, holding period, coupon income, and financing costs. The question therefore highlights a useful limitation of the proposed screen, but provides no evidence about how large the resulting errors might be or how to quantify them.

Key ideas

• YTM minus borrowing cost is proposed as a simple quote for a leveraged bond trade.
• YTM is a hold-to-maturity measure and may not represent return when the bond is sold early.
• Ranking bonds by YTM may miss lower-YTM bonds with high coupons or more stable prices.
• An early-sale return depends on the realized sale price, holding period, coupon income, and financing costs.
• The document raises the estimation problem but provides no empirical comparison of candidate measures.

Tags

# How accurate is YTM as a reference measure of non-holding-to-maturity return?


# How accurate is YTM as a reference measure of non-holding-to-maturity return?












We need to offer an estimated return of a non-hold-to-maturity strategy. Essentially, we borrow money from the market and buy a bond. Instead of holding the bond to mauturity and locking in a return equal to YTM, we will sell the bond before maturity. How should we provide an estimated return/quote for such strategy?

So far, we are using YTM - borrowing cost, where YTM is known at the time we start the trade, and the borrowing cost, for simplicity, is a fixed annulized rate (for example, if we borrow 100 to purchase the bond, the cost is 5 given a 5% borrowing cost per year. Usually we swap to such fixed rate from 3-month LIBOR using IRS).

My concern is if we use above measure, naturally we will look for bonds with higher YTM (for now, let's assume the borrowing cost is not related to YTM, bond ratings, hence possible lower cost from repo) and filter out bonds with lower YTM. However, since we are not holding the asset to maturity, is it possible that we might filter out some eligbile bonds with low YTM that offer high coupon and whose price won't change much in the future? In short, does YTM - borrowing cost serve as a reasonable estimate of holding-period return/quote for our clients?

(p.s., we tend to avoid rocket science predictive model if it's not siginificantly better than an easy measure like YTM. A ballpark measure that is relatively simple to explain and get is the best)

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.