Different Measures of Yield and How Changes in Interest Rates Affect Bond Prices - Assignment Example

Name: Student number: Name of Lecturer: Subject: Analysis of Bond Yield In many cases, high yield bonds are usually debt securities in financial markets with lower interest rates. The lower interest rates are determined according to the period of time it has stayed. The issuing entities of the high yield bond usually do this to raise more capital to expand businesses and also to improve the cash flow in the company (Jamshidian, 2000). When the bonds are left to maturity and the expected return on it realized, then it is said to have realize a yield. (Vasicek, 2003) adds that such yields can be defined as a percentage on the return on investment. Therefore, there are categories of yields types which markets currently offer. Such include: a. Current Yield There is a consensus that Current Yield is regarded as annual yield income expressed as a total percentage of overall cost of the bond or return on the investment expressed in market price (Chambers and Carleton, 2001). In current yield, the bond yield is usually calculated based on $100 par value. Giving a practical example of the above statement; Mr. Steve has a bond which has annual coupon rate of 15% and it costs $ 20,000. In order to calculate the current yield of the bond based on the rate and the amount above, 15/1000 = 15% But if you paid $ 24,000 = 15/240 = 6.25% And if the bond cost is $19,000 then = 15/190 = 7.5% Ariel, (2010) explains that calculations above or rather, estimating values of the current yield is vital in that it helps investors to compare other investments opportunities such as the trust income of common shares. On the other hand, current yield values have two disadvantages; firstly, when an investor hold a bond to maturity then the bond price has been locked as par. Secondly, the current yield only considers the interest rate of the coupon but such excludes time factor of the bond. b. Yield to Maturity The relationship of the bonds can be interpreted differently owing to the fact that they are repaid as par value of the investment. This is also the aspect that differentiates it from the stock yield of an investment. The yield on the bond reflects both the return on investment and the capital loss or gain on an investment by the end of the investment period. Yield to maturity thus is be defined as the return on the investment an investor expects by the end or at the maturity of an investment (Chambers and Carleton, 2001). An economical or mathematical interpretation of the above assertion is; P = Giving a worked example; Let’s take and an investor by the name Malike. He has a bond worth $ 19,000 and has a coupon interest rate of 10% annually. If the maturity period of the bond is 5 years, calculation of the yield to maturity will be; Solution 19,000/ (1+0.1)1 +19,000/ (1+0.1)2 + 19,000/ (1+0.1)3 + 19,000/ (1+0.1)4 + 19,000/ (1+0.1)5 17,272 + 15702 + 14275 +12977 + 11798 = 72,024 The yield to maturity can also be calculated using approximate yield to maturity method. Approximate yield to maturity is done by averaging the purchase price of a bond and its redemption price in the market. [(Interest income +annual price change) / (purchase price + 100)/2]* 100 c. Yield to call There are some cases whereby the issuer of the bond can decide to call his or her bond during the first date of call; the yield gotten from such kind of a bond is called a yield to call. The use of call date as the maturity date of the bond in the yield to call is what makes it different from the call to maturity yield. In most cases, investors calculate both yield, that is, yield to maturity and yield to call. The lowest value of the two will actually give the most promising investment return. One most important thing to note when calculating yield to call is that it is normally assumes the interest of coupons in any bond. Yield to call is calculated by the formula P = Interpreting the formula above, M* is the call price and n* is the period. Practical example; Let us take a consideration that there is a bond which is supposed to mature after 8years. The rate attracted by the coupon is 8%, the par value is $1000, and the first call is in the 4th year. Calculating the first call of the above bond, the figure will be; = = 1000[1/ (1+0.08)4] = 1000/0.735 The yield in this case is 1360.54 d. Yield to worst There are points where investors are not expecting good returns on their investments due to the market factors like inflation within the economy. The point where the investors get the worst return on the bond is what is called yield to worst Rogers, (2003). The anticipation always spoils the stock market compared to the bond market since bonds are more stable securities. e. Yield to put The issuer of the bond can quote or refuse to quote the bond prices in the market. However, holder can make the issuer quote some specific prices following the fixed schedules which are putable. Therefore in such cases, yield to put is normally expressed as a percentage rate and can therefore be defined as that rate in which the cash inflow of a bond can be overlooked until the put date is added to the put price of that bond. It uses similar formula as yield to call. Types of risk associated with bond a. Real interest risk Apart from inflationary risk which the investors are exposed to, they are also exposed to other risk like the change in the real interest rates in the market. These will be brought about by economic factors of demand and supply of the bonds in the market (Rogers, 2003). Supposed the interest rates changes from 10% to 8% due to government policies like tax or any other factors, it will be realized that the investor with a bond rate at 10% will suffer since the demand for its bond will be low thus attracting fewer buyers in the market. The risk comes as the effect of interest changes cannot be precisely predicted (Kidwell et al., 2010) b. Default risk. This arises in a situation where the bond borrower might not be in a position to pay the principal amount plus the interest rates in time exposing the investor to unplanned risk. Due to unstable economic performance of different countries, the security markets are affected by a lot of inflation. The interest rates keep on changing either upwards or down wards. These changes in the interest rates are what are called interest rate risk. Research studies (Rogers, 2003) discovers and approves that interest rates are inversely related to the bond price. That is to say, any increase in the interest rates will automatically lower the bond prices. On the other hand, any decrease in the interest rates will increase the bond prices. To clarify this point, take a point where one holds a bond worth $10,000 for the next 8 years at an interest rate of 9% and the coupon is paid half yearly. Due to inflation, the interest rate of the bond market increases to 11% after 5 years. If the person wants to sell the bond now before then the person who wants to buy your bond must be willing to forgo the 2% increase in price since the bonds are issued at fixed interest rates for a fixed period of time. But incase the market interest rates of bonds has reduced to 7% then it means the bonds held is fetching higher return compared to other bonds in the markets hence it will be regarded as cash cows which will translate to higher prices in the market. Time factor also affect the bond prices in relation to interest rates where long term bonds are more risky compared to short term bonds due to future uncertainty in economic changes. Types of Issuers of the bond In most cases, the market is classified according to the people who are issuing out bonds. For instance, in Australian, Municipal government is an example of an orgainsation issuing bonds. Each and every sector or players issuing bond are subjected to different risk and rewards in the market. Within the markets, this is further classified into sectors which give common characteristics like financial sectors, industrial sectors and the interest rates which expose the investors to different risks. Inherent Credit Worthiness of Issuer of the bond Circumstances may arise when the issuer of the bond is not in a position to pay the interest and the bond principal in time. This is a risk called credit risk or risk of default of payment. Inclusion of Options There is lack of contractual agreement between the bond issuer and the holder of the bond hence there is no way one can take action against the other which brings with it additional risks. The perception that the bond are very secure and there are no risk involve also affect the yield return and the investors should consider evaluating the option of investing in bonds and other security markets. References Ariel, Z. (2010), Methods of Pricing Convertible Bonds Dissertation. Milton, Qld: John Wiley & Sons Australia. Chambers, D.R. and W. Carleton, (2001), ”A Generalized Approach to Duration”, Research in Finance, Vol. 7, 2000, 163-181, JAI Press Inc. Jamshidian, F. (2000): “Bond, Futures and Option Evaluation in the Quadratic Interest Rate Model,” working paper Fuji International Kidwell, D.S., Brimble, M., Basu, A., Lenten, L., Thomson, D., Blackwell, D.W., Whidbee, D., & Peterson, R. (2011). Financial markets, Institutions and money (2nd ed.). Milton, Qld: John Wiley & Sons Australia. Rogers, C. (2003): “Which Model for the Term Structure of Interest Rates Should One Use‘?’’ In Marhernnticcd Finance, ed. M. Davis, D. Duffie, W. Fleming, and S. Shreve. New York: Springer- Verlag, 93-1 16. Vasicek, D. (2003): “An Equilibrium Characterization of the Term Structure,” J. Financial Ecori., 5, 177- 188 Read More