What will be the rate of return in Example 11.5 if the manager forecasts that in two years the yield to maturity on 18-year maturity bonds will be 10% and that the reinvestment rate for coupons will be 8%?

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A 20-year maturity bond with a 10% coupon rate (paid annually) currently sells at a yield to maturity of 9%. A portfolio manager with a two-year horizon needs to forecast the total return on the bond over the coming two years. In two years, the bond will have an 18-year maturity. The analyst forecasts that two years from now, 18-year bonds will sell at yields to maturity of 8%, and that coupon payments can be reinvested in short-term securities over the coming two years at a rate of 7%. To calculate the two-year return on the bond, the analyst would perform the following calculations: 1. Current price = $100 x Annuity factor (9%, 20 years) + $1,000 x PV factor(9%, 20 years) = $1,091.29 2. Forecast price = $100 × Annuity factor(8%, 18 years) + $1,000 x PV factor(8%, 18 years) = $1,187.44 3. The future value of reinvested coupons will be ($100 x 1.07) + $100 = $207 4. The two-year return is $207 + ($1,187.44 - $1,091.29) $1,091.29 = 0.278, or 27.8% The annualized rate of return over the two-year period would then be (1.278)¹/2 - 1 = 0.13, or 13%. EXAMPLE 11.5 Horizon Analysis