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The way I understand it buying a simple term annuity from an insurance company is like depositing money in a account that earns fixed interest compounded for the duration of the annuity and taking out the annuity payment every month/year, etc.

Since a bond is an annuity then I would think that the same would apply. That buying a bond is like depositing my principal into an account, and removing the coupon payment every 6 months. Thus the yield to maturity which should be the interest earned on the principal should be fixed for the maturity of the bond. However it is not, and instead requires the investor to reinvest at the ytm.

Why does this explanation seem not to hold for bonds as it does for annuities?

  • For fixed rate bonds, the interest is guaranteed. So they are very much like an annuity. – D Stanley Jan 11 at 22:16
  • its just that For a bond inn order to earn the ytm you need to reinvest the coupons at the same rate, while for an annuity it doesn't seem like you have to – Skrrrrrtttt Jan 11 at 22:18
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    Don't confuse interest rate and yield. You certainly can reinvest annuity payments as well. From a cash-flow perspective they are the same. – D Stanley Jan 11 at 22:21
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    YTM does not assume reinvestment of the coupon payments, you're thinking effective yield. YTM effectively discounts the future coupon payments. Assuming a $1,000 bond that pays $100/year, effective yield will calculate something like 11% if you hold for 2 years, YTM sort of calculates it like it took your $1,000 two years to earn the second $100 payment, which is a much lower yield. When you blend all of the annual rates of return together then and consider the return of your capital in the future you come up with a YTM, but it certainly does not assume reinvestment of coupon payments. – quid Jan 11 at 23:12
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Annuity versus bond should really be more about considering your counterparty risk.

You really should be a lot more concerned about who or what issued the bond you are looking at, and what sort of protection you may have for your annuity. Insurance company annuities in the US are covered generally under an insurance guarantee pool, but still you wouldn't want to pile money in to an insurer unless you were reasonably sure it was being managed in a way that you'll be paid.

The thing is, you don't want to find yourself comparing yields and assuming everything is equally safe between

  • a 2% CD from a FDIC covered deposit bank
  • a 2.4% annuity from Firesale Insurer
  • a 6% bond from Enron

When you venture beyond FDIC covered deposits you actually do have to consider that the entity offering the yield needs to actually exist long enough to pay you. The yield is higher generally because you're now in the realm where you may not get paid back at all. Generally, the higher the yield the farther outside the guaranteed realm you are.

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