How Changes in Interest Rates Would Affect Bond Prices - Assignment Example

Dеsсribе the different mеаsurеs of yields using рrасtiсаl worked numеriсаl ехаmрlеs аnd ехрlаin hоw сhаngеs in intеrеst rаtеs wоuld аffесt bоnd рriсеs. Your name:   Course name:         Professors’ name: Date: Introduction The price of bond may go up and down in response to two factors: change in credit quality and interest rates. Investors in bond market tend to worry about the safety of their investment. Many Australians who have invested in bonds do not comprehend how a change in the interest rate will have an effect on the bond price. Since early 1980s, interest rates have been widely used to determine return on bond investments. The paper will use practical worked numerical examples to explain how changes in interest rates would affect bond prices (Amihud, 2002). Yield to Maturity (YTM) Yield to Maturity (YTM) (also known as redemption yield) is the most widely used measure of a bond’s price. YTM of a bond can be described as the rate of return of a bond that an investor would receive if he or she bought a bond at the current market price, assuming the investor will hold onto his or her bond till it matures, and that all coupon and principal payments will be made on schedule (Ripley, 1997). Contrary to a common belief that is often cited in financial literature that bond yield to maturity will not depend on a reinvestment of dividends (Houweling, Mentink and Vorst, 2005). Rather, YTM is simply the discount rate at which the sums of all future cash flows from the bond (principal and coupons) are equal to the price of the bond (Temal, 2001). This measure of bond yield is often given in terms of APR (annual percentage rate). Bonds yield have been seen to have different characteristics (Ripley, 1997), there are some variants of Yield to Maturity (YTM): Yield to call: the bond can be re-bought or repurchased by the issuer of the bond before it reaches maturity. Yield to put: same as yield to call, but it will depend with the person with the bond who has an option of selling bond back to the issuer of the bond at a fixed price on specified time or date. Yield to worst: when a bond is puttable, exchangeable, callable, or has other features, the yield to worst is the lowest yield of yield to call, yield to maturity, yield to put and others. During calculations, the yield to maturity (YTM) is illustrated by the following equation:  Where: B0 = the bond price, YTM = the yield to maturity on the bond, F = the face value of the bond, t = the number of years remaining until maturity, and C = the annual coupon payment. Therefore, an investor will use the above formula in order to calculate the percentage rate (r) an investor will make in the bond’s cash flows that is equal to the current selling price of the bond (Houweling, Mentink and Vorst, 2005). For example, let’s assume an investor own a Company X bond with a 1,000 AUD par value and a 5 per cent coupon that matures in 3 yrs. If the current market price of the bond is 980 AUD, using the above formula, YMT is found to be 2.87 per cent (Ripley, 1997). Because the coupon payment is semiannual, this is the yield to maturity (YTM) for 6 months. To annualize this rate for reinvestment of the interest payments, the below formula will be used:   Yield to Maturity (YTM) gives an opportunity to an investor to compare a bond’s price with other securities. When an investor understand how bond’s yields vary with market prices (that as yields rise, bond price fall; and as yields fall, bond prices rise). Also, YTM will help an investor to anticipate the effects of market changes on their portfolios (Ripley, 1997). Furthermore, Yield to Maturity (YTM) will help an investor to decide on whether to invest in a 5 year bond with ha high coupon or a 10 year bond with a high yield (Houweling, Mentink and Vorst, 2005). Current Yield There are many ways in which bonds yields can be calculated, the most widely used measure that is used by investors is the current yield. Current yield can be defined as the measurement of a bond over a 1 year period, and is usually expressed as a percentage of the current market values of a bond and can be determined by the following formula:  Current yield measures looks at the current price of a bond yield instead of its face value of the bond and represent the return of value a person investing in a bond would expect if an investor held his or her bond for a year. As illustrated in the following example: An investor has purchased a bond with a market value of 2000 AUD which has earned 2 payments of 100 AUD in a year. The same bond has a current yield of 10%. The current market price of the bond may not be necessary the amount the investor with the bond paid for since the bond price on the market may fluctuate (Temal, 2001). Therefore, return in investment on bonds should take into account the amount of the original investment on bonds and current market value. In the example illustrated above, if an investor paid 2200 AUD for the bond which has 200 AUD dividends and the market value for that bond is 2000 AUD, then the net return on the bond will be 0 AUD. The current yield for the bond will be reflected by the interest rate earned on the bond investment in 12 months, but not the profit of the investment (Temal, 2001). Therefore, in order for the investor to see a positive return on his or her investment, he or she will have to hold the bond for the investment until the bond earned additional dividends. Although current yield is seen as an important performance measure on investment, it does not factor in all the other factors that may affect the bond yield. Capital or income gains taxes and these may have an effect into the net return on the bond (Temal, 2001). Therefore, an investor who may purchase bond on the secondary market may be more concerned with the price of the bond and the yield to maturity than the current yield of the bond. Two key features of convertible are its yield to maturity and current yield. The difference between the two bond measures is that the current yield will indicate the bond yield of the bond based on its current value. While yield to maturity is the compounded interest rate that equate on the principal payments that may be received in the future on the investment relative to the present cost. For example, take an investor 2.125% convertible note due in 2014. The bond was recently priced at 95.893 AUD, it pays interest rate after every six months and the bond matures on September 15, 2014. When using the current yield formula; the annual interest (payout) will be used to divide the price paid on the bond (Ripley, 1997). In this case, the annual coupon will be 2.125% and this will be equated to the interest payment of 21.35 annually. The market price will be 958.93 AUD. When 21.25 AUD is divided by 95.93 AUD it will give use 2.2%. When using yield to maturity (YTM) formula. The formula will take into account all aspect of the bond investment: capital gains or losses, coupon, and the discounted future value of the money. Using the yield to maturity (YTM) formula the value of “r” can be calculated as: P = C/(1+r)y + C/(1+r)y + C/(1+r)y +…. + B/(1+r)y  Where: B = par value r = yield to maturity y = number of years to maturity P = purchase price C = annual coupon payment ($)    In this case, when solve for “r”, equals approximately 3.6% 958.93 = 21.25/ (1+r) + 21.25/ (1 + r) 2 + 21.25/ (1 + r) 3 + 1000/ (1 + r) 3 Yield to Call (YTC) YTC is a measure of the yield of a bond if an investor has to hold the bond until its call date. In other words, yield to call is the yield on callable bond, on the assumption that an investor holding onto the bond will call on the bond on the earliest possible date. In a normal scenario, there may be more than one call date, in which case there will be more than one yield to call number, such as yield to first call, yield to second call, yield to third call, and so forth (Park and Reinganum, 1986). If an investor bought a callable bond, the municipality or organization that issue the bond can ask for it back after the bond has been issued; long before the bond matures (Ripley, 1997). Bonds, such as premium bonds are often called before they reach maturity because they carry higher-than-average coupon yields (Temal, 2001). What this means is that an investor’s yield-to-maturity may be at moot point. What an investor is likely to seen in the way of yield is yield-to-call (Park and Reinganum, 1986). In normal scenario, bonds are usually called when the interest rates is down. In that case, not only the bond’s yield and investor is holding diminishes, but investor’s opportunity to invest his or her funds in anything paying as high as interest rate will pass (Park and Reinganum, 1986). In order for an investor to understand yield to call, he should understand the price of a bond is equal to the current value of its future cash flows, as illustrated by the following formula:  Where: t= time period C = coupon payment n = number of periods P = price of the bond F = principal at maturity. r = required rate of return on this investment. When using this formula, an investor makes assumption that the bond may be called at earliest possible time rather than the bond being held to maturity (Ripley, 1997). For example, a Company bond with a 1,000 AUD that matures in 36 months. Assume this bond can be called (or callable) in 24 months at 105% of par. The above formula will be used to calculate yield to call. In the example, the investor will pretend the bond matures in 2 years rather than 3 years, and calculate the bond’s yield accordingly. If the bond is selling for 980 AUD in the current market, the yield to call is calculated to be 4.23%. Conclusion In conclusion the relationship between yields to maturity, current yield, yield to call and coupon rate that a person investing in bond need to consider is that: (1). if a bond is being sold below par, the bond yield to maturity is seen to be greater than its current yield, which will be seen to be more than the coupon rate: (2). If a bond is sold at a premium price, the bond’s coupon rate will be greater than its current yield, and this will be more than the bond’s yield to maturity: (3). if a bond is sold at par, the bond’s yield to maturity is seen to be equal to both the coupon rate and current yield. References Amihud, Yakov, 2002, Illiquidity and stock returns: cross-section and time-series effects, Journal of Financial Markets 5, 31-56. Houweling, Patrick, Mentink, Albert, and Vorst Ton, 2005, Comparing possible proxies of corporate bond liquidity, Journal of Banking & Finance 29, 1331-1358 Park, S.-Y. and M. Reinganum, 1986, “The Puzzling Price Behavior of Treasury Bills that Mature at the End of Calendar Months,” Journal of Financial Economics, 16, 267-283. Ripley, William, 1997, Railroads: Finance & Organization. New York: Longmans, Green, & Co.. pp. 106–107. Temal, J. Wesalo, 2001, The Fundamentals of Municipal Bonds: The Bond Market Association. John Wiley and Sons, Inc.. p. 49 O'Hara, Neil, 2012, The Fundamentals of Municipal Bonds. Hoboken, NJ: John Wiley & Sons, Read More