Essays on Bond Yield Measures Inform Investors Of The Rate Of Return On Bonds Under Different Assumptions Assignment

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Bond Yield MeasuresA bond measure is a plan for the sale of bonds in order to acquire funds for various government projects such as infrastructure development, building of schools and hospitals, provision of public goods and services, research and development, transportation among other ventures. Bonds are of many types ranging from government bonds to zero coupon bonds, municipal bonds and corporate bonds but they all vary with their maturity date and the coupon payments. Zero coupon bonds do not have a maturity date attached to them and do not pay annual coupon payments to their holders.

Bonds have certain characteristics that define them such as maturity dates, face or par value, the yield and the coupon payments. Once a bond is issued and is trading in the bond market, all its future payouts are well determined and the only varying factor is its asking price. If you buy a bond at a lower price, the yield to maturity of investment increases extensively but can be confusing since people are not always consistent when they are talking about bond performance in the bond market.

There are three commonly quoted measures by the dealers and used by the investors. They are outlined below as follows; Current yieldIn obtaining the current yield, the annual coupon interest rate is divided by the market price of the bond (Dynkin, 2007). When an investor buys a bond at par, the yield is equal to the interest rate. The yield changes with changes in the price of the bond. This calculation only accounts for the coupon interest and no other sources of return that may influence an investor’s yield.

This method is straight forward because the bond price increases with declining market interest rates. The coupon rate on the bond is fixed and the only way to change a bond’s yield with changing interest rates is to change the price of the bond. The capital gain made by an investor if the bond is bought at a discount or the capital loss made by an investor if the bond is purchased at a premium are all held to the maturity of the bond and are not considered in this method.

The method also ignores the time value of money since the cash flows are computed until the maturity date of the bond. The current yield takes only into consideration the expected interest payments. It is a useful yield measure to those investors who are primarily concerned with earning proceeds from their portfolio. For those investors seeking a capital gain, it is not a good measure of return and it is a useless statistic for the zero coupon bonds which do not pay annual coupon payments to their holders (Diebold, 2003).

Current yield= Annual Interest ÷ Bond Price (Fabozzi, 1996)For example, a bond has a face value of $1,000, a coupon rate of 8% per year paid semi annually and has 3 years to maturity. The current value of the bond is $961.63.Coupon= coupon rate × face valueCoupon=8%×$1000=$80The current yield will be 80÷961.63×100= 8.32%

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