A fixed-income security, such as a bond, provides three different types of returns, and a yield measure used by the investor should consider all these three sources of return. These are: the coupon payment received, capital gains/losses, and reinvestment income. Let’s look at each of these sources of income in detail.
When an investor purchases a regular bond, the issuer of the bond makes coupon payments to the investor periodically based on the bond specifications. For example, a 5-year $100 par 8% semi-annual coupon paying bond will pay $4 coupon to the investor semi-annually for the next 5 years. At maturity the investor will receive the final coupon payment and the par value ($100) from the bond. Unlike a regular bond, a zero-coupon bond does not make coupon payments. Instead the investor purchases the zero-coupon bond at a deep discount and receives the par value at maturity, compensating him for the interest.
Bonds also provide capital gains or losses. While purchasing the bond, the price that an investor pays may be above par or below part. However, at maturity the bond always pays par value. So, if a bond has a par value of $100 and the investor purchased the bond for $95 (below par) and held it till maturity, he will have a capital gain of $5. Alternatively, if he purchased the bond at $102 and held it till maturity, then he will have a capital loss of $2. If the investor does not hold the bond till maturity, then the capital gain/loss will be calculated as the difference between the purchase price and the sale price. If a bond is called by the issuer, then the capital gain/loss will be calculated as the difference between the call price and the purchase price.
The periodic income (coupons) provided by the bond can be reinvested in other securities, and income from such reinvestment is called reinvestment income. When we talk about yield-to-maturity (YTM), it specifies the yield considering that all your interim cash flows continue to earn the same yield. However, it may not always be possible for the investor to be able to invest these interim funds at the same interest rate. On the other hand, since zero-coupon bonds don’t pay coupon, there is no reinvestment income. All the money remains invested in the zero-coupon bond till its maturity ensuring a fixed yield.