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, andC = 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).