Different Measures of Bond Yield - Essay Example

Bond yield Insert Name Course, Class, Semester Institution Instructor Date Introduction There is different security that investors can invest in depending on their risk appetite. This means that investors have varied options where they can invest their funds in the securities markets. Among the many options, bonds are one of them. Bonds are long term securities issued by corporate bodies or the state. They are considered as low risk securities due to the fact that they have a fixed rate of return where interest payments are made. In addition, bonds have a fixed date when the principal amount is paid back to the investors often known as the maturity period. In the financial market, bonds are known as fixed income securities due to the fact that they have a cert6ain income which is due either half year or at the end of every year. Bonds are either issued at a discount at a premium or at their par or nominal value. It is at this issue price that the investor can now calculate their expected returns from their investment choice. In addition, bonds are mainly affected by their interest rates, and the maturity period. The maturity period is the period with which the issuer has to repay the full amount to the investor. This implies that if all payments will be made by the issuer on the maturity date, then there will be no further obligations due to be fulfilled (Veale, 1988). However, the longer the maturity period, the riskier the bond is considered to be and hence the higher the price. On the other hand, coupon rate or the interest rate is the rate by which the issuer of the bond pays the investor or the bond holder. Plainly, the coupon rate is the cost of finance incurred by the issuer. It is from the rate of interest payment where different types of bond come from. There are the zero coupon bonds where no interest payments are made, the only fact being that they are issued at a discount but redeemed at the nominal value. There are also the fluctuating interest rate bonds where the interest payments are affected by the prevailing economic conditions. On the other hand, there are fixed bonds which have a fixed rate of return, regardless the prevailing economic conditions (Fabozzi& Mann, 2005). Bond yield therefore implies the rate of return that the investor receives for investing in the particular bond. This particular rate of return is expressed as a percentage and usually calculated annually based on the investments initial cost. Bonds have four kinds of yield which includes the following; nominal yield or the coupon yield, current yield and the yield to maturity. From an analyst’s perspective, the yield of a bond is inversely related to the price of the bond. This implies that, if the price of the bond falls, the yield goes up (Johnson, 2004). On the other hand, in instances when the price of the bond increases, the yield will decrease. The basic calculation of yield is the formula that; yield = coupon rate/ the price of the bond. This generally implies that when the bond is purchased at par value, the yield of the bond will be equal to the interest rate of the bond. However, changes in the price of the bond will cause related changes in the yield. This paper seeks to evaluate the different measures of bond yield and the underlying assumptions therein. Nominal yield This is the coupon rate of a particular issue. This implies that a bond with a 10 percent coupon has a 10 percent nominal yield. This provides a very convenient way through which coupon characteristics of a bond are described (Choudhry, 2001). Current yield The current yield heavily relies on the market price of the bond. This particular measure of yield directly relates to the nominal values of the coupon cash flows received on an annual basis to the current or market price. This implies that this measure of yield does not take the timing of the respective cash flows into consideration. The current yield also does not incorporate other sources of return such as the capital gains or losses. This particular measure of yield is allied to income oriented investors. Yield to maturity The internal rate of return (IRR) is the yield to maturity. This bond yield measure takes into account the time value of money by including the cash flows derived and the capital gains that the investor will realize if they hold on to the particular bond till maturity. There is a relationship between the current yield, the coupon rate and the yield to maturity. This is due to the fact that, when the market price of the bond is at par, the coupon rate will be equal to the current yield which will be equal to the yield to maturity. On the other hand, when the market price is at a discount, the coupon rate will be less to the current yield which will also be less compared to the yield to maturity. When the market price is at a premium, the coupon rate will be greater to the current yield and the yield to maturity. The main assumption underlying the yield to maturity is broken down into two. The first being that the bond will be held to maturity and the second being that all the cash inflows received before maturity are reinvested at the yield to maturity rate reason being the fact that all cash flows are discounted at that rate (Crabbe & Fabozzi, 2002). This reinvestment assumption has implications to the actual return of the bond because there is an inverse relationship between the actual return of the bond and the coupon rate as well as the maturity period. This is evident from the fact that, a longer maturity of higher coupon bond will depict more relevance to the reinvestment assumption. This is due to the basic reason that, failure to reinvest the interim cash flows of a long term bond or one with a high coupon rate will increase the loss in value of such a bond. Yield to call This yield measure is applicable where the bond might be called prior to the intended maturity period. This exists because some bonds can be repaid before the maturity period. The calculation of the yield to call measure is the same as to the yield to maturity measure. The only difference is the fact that the cash flows utilized are those expected to occur before the first call. This is with the assumption that the bond will be redeemed after the first call. The basic assumption underlying the yield to call bond measure is that the interim cash flows will be reinvested at the yield to call rate and that the bond will be held to the first call date. Horizon yield The horizon yield measures the expected rate of return for a bond that is expected to be sold prior to its maturity period. The horizon yield is as such a total return measure which facilitates the projection of the performance of a bond over a certain time horizon or time frame. This aspect is hence beneficial to investors who will be aware of the performance of the bond over a planned time frame (Parameswaran, 2007). The major drawback of the horizon yield as a bond measure is the fact that, assumptions are made in regard to the reinvestment rate, future yield and the specified time horizon. However, the bond measures also enhance the evaluation of the bond performance under various interest rate scenarios thus assessing the sensitivity of the bond to the different interest rate changes. Bond price volatility There exists a relation between the bond price and the changes in the interest rates or yield (Fabozzi, 1999). This is due to the fact that, an increase in the required yield will lead to a subsequent decrease in the price of the bond. On the other hand, a decrease in the required yield will lead to an increase in the bond's price. The graphic illustration is as follows; The convex shape represents the relationship between bond price and the related yield. This bond price volatility is measured as a percentage change in the price of a bond. However, it is notable that the volatility of a bond is not only affected by price alone. There are other factors that affect the volatility as a bond and they include; the par value of the bond, the coupon rate of the bond, the maturity period of the bond and the prevailing interest rate of the bond. Generally, the following trend is evident; price is inversely related to the bond yield. The Price volatility of a bond is directly related to the maturity period of the particular bond. This is to mean that the longer the maturity the higher the price fluctuations in the price of the bond (Baker& Powell, 2005). However, it is worth noting that the price volatility increases with at a diminishing rate. A decrease in the yield of a bond will certainly raise the bond price but there is no symmetrical relationship if the increase in yield resulted due to similar lower prices. Conclusion It is evident that there are different measures of bond yield. These different measures of yield arise due to the fact that there are different investors in the market with different preferences. The different measures of bond yield are used by the portfolio managers to project that cash flow that may be derived in respect to a particular bond. It is quite apparent that investors have different risk appetites and hence different portfolios. Each of the bond yield measures is guided by a number of assumptions which at times turn out to be the drawbacks of the bond measures. It is this important that the portfolio manager clearly advices the bondholder on the measure of yield being used and the underlying assumptions. References Baker, H. K., & Powell, G. E. (2005). Understanding Financial Management: A Practical Guide. Oxford: Blackwell Pub. Choudhry, M. (2001). The bond and money markets: Strategy, trading, analysis. Boston: Butterworth-Heinemann. Crabbe, L. E., & Fabozzi, F. J. (2002). Corporate bond portfolio management. New York: J. Wiley & Sons. Fabozzi, F. J. (1999). Duration, convexity, and other bond risk measures. New Hope, Pa: Frank J. Fabozzi Associates. Fabozzi, F. J., & Mann, S. V. (2005). The handbook of fixed income securities: Chapter 5. New York: McGraw-Hill. Johnson, R. S. (2004). Bond evaluation, selection, and management. Malden, MA: Blackwell Pub. Parameswaran, S. K. (2007). Bond valuation, yield measures and the term structure. New Delhi: Tata McGraw-Hill. Veale, S. R. (1988). Bond yield analysis: A guide to predicting bond returns. New York, NY: New York Institute of Finance. Read More