Bond Yield Measures - Assignment Example

DIFFЕRЕNT MЕАSURЕS ОF YIЕLD Name: Course Tutor’s Name: Date Introduction Measures of yield are different and varied. They take on different approaches with the aim of ensuring efficiency, tranquillity, reliability, accuracy, and accountability of the different investment strategies that investors opt for (Parameswaran, 2007). The manner in which investors analyze business and investment opportunities are influenced by a number of factors that include the different measures of yield employed (Smith, 2011). Treasury securities are vital aspects of yield measures that could be discussed based on their maturity characteristics and the actual manner in which bonds are spread. According to Fabozzi (2005), the yield on any given investment denotes the interest rate on that investment. The yield of a bond investment refers to the present value of the bond’s expected cash flow from the investments to the bond’s cost. P = ∑ CFt (1+y) t Yield to Call Calculation of the yield to call is a vital aspect of measuring yield. Since investment decisions should be done from an informed point of view, it is crucial to ensure that sustainability and improved constant growth is put in place. While the use of the yield to call calculator could be used to establish the level of efficiency and cost effectiveness of the measurement process, it is evident that such a process would be based on the assumption that a particular bond is called within the shortest possible time frame. Callable bonds could also be calculated with ease thus enabling one to understand the value of a given bond (Schwartz, 1989; Stafford, 2010). Estimation of expected investments on return all callable bonds is possible to undertake ones vital information that include the cost of bond, bond face value, number of years that it would take the bond to mature, years to call, and the call price. The calculation is done with the understanding that the yield to call is called on the best possible call date (Schwartz, 1989). Mathematically, the yield to call is arrived at using the financial formulate below: Yield to call = ((Annual Interest + ((call price – market price)/ the number of years need to call))) / ((call price + market price) / 2) For instance, when a bond whose face value is $1,000 is bought with a 7.5% coupon and at $ 900 and then it pays interest twice for single year and then ends up being called in duration of 7 years with a face value of 103%, the yield to call could be arrived using the above stated formula. Based on the above formula, the yield to call would be 9.8%. This applies to the bonds which are often likely to be called before the stated maturity date. As outline in the above calculation, all possible cash flows are often determined by critically conceptualising the different cash flows which occur whenever the issue that is called on the foremost call date is utilised. An increase in interest rates reduces the bond price while a reduction in the interest rate leads to an increase in the bond prices (Schwartz, 1989; Tuckman, 2011). Absolute Yield Spread This is a popular market mechanism of measuring spreads. Absolute yield spread plays a significant role in measuring the spread variation between two bonds (say bond 1 and bond 2) with reference to basis sections. The actual yield on bonds is of great essence in the measurement and derivation of the absolute yield spread (Guillermo, 2012; Smith, 2011). Mathematically, the absolute yield spread is arrived at as follows: AYS = Yield on Bond 1 - Yield on Bond 2 For instance, in the case of the International monetary Fund’s five year period bond with an estimated yield of 4.5 percentage with a relatively successful on-the-follow-up five year period on the government of 3.75 percent, the absolute yield spread could be arrived at in a very cost effective manner. AYS = Yield on Bond 1 - Yield on Bond 2 = (4.5 – 3.75) % = 0.75% On the other hand, the RYS on the same could be arrived as follows; = ((4.5 - 3.75) / 3.75) % = 20% Any significant increase on the yield would lead to a decrease in the AYS. The impact is similar to what would happen in the event that the interest rate is increased. The absolute yield spread on risky bonds is determined by the degree to which liquidity, inflation, and other economic factors impact on the demand and supply bond variables in the market (Parameswaran, 2007; Tuckman, 2011). The knowledge on the calculation of the absolute yield spread is crucial as it enable one to determine the most likely returns on investment and the yield spread variation between any two bonds. It also helps to effectively measure or estimate any realised spreads on bonds. An issue that is normally very complicated, tricky, and elusive to most people. Current Yield As a bond yield measure, Current Yield refers to a bond’s yearly return arrived at on the basis of its current cost and coupon payments and not the face value which is often similar to a product’s original worth. The annual yield could as well be incorporated in many other yield formulas thus being used to establish an investment’s returns on different bonds. To enhance its efficiency, cost effectiveness, and relevance, it is also important to streamline all investment strategies. Current Yield is mathematically arrived at by subdividing the overall annual cash flows by the market price. As referred to as either dividend yield or bond yield, the Current Yield is never an accurate replication of the true investment return from investment would realised from a business venture due to the constant change of both stock prices and business market factors (Guillermo, 2012). It therefore means that the specific yield on bond is highly influenced by the price of the bond at any particular moment (Stafford, 2010). The concept of Current Yield is highly influenced by the popular theoretical belief that a riskier investment would always attract higher premium on returns. According to Parameswaran (2007), the current yield barely regards the coupon benefit interest and no other sources for an investors return. For instance, in a normal business environment, an investment bond whose price is $95.75 with $5.10 as its yearly coupon implies that its current yield is 5.33 percent. In the even that it is a ten year bond that has nine years before its time elapses, one would get $5.10 though the actual return would be dependent on its actual price at the time it was sold. In case the interest rate during this period increased while the cost of the bond decreased to $87.34, it would eventually imply that the actual return on investment for that period would be -3.5 percent. Current Yield = C/Po Current yield = ((-3.31/95.75) $ % = -$3.5% Yield to Maturity Yield to Maturity (YTM) is a vital approach of informing investors of the rate of return on bonds based on the assumption that that the rate of return is held till the maturity date comes (Smith, 2011). The yield of maturity denotes the rate of return that is expected of a bond if this particular mechanism of indebtedness to the holders is maintained till the maturity date. According to Tuckman (2011), the yield to maturity is a long-term bond yield solution expressed as an annual rate or return on investment in bond issues. To achieve a realistic mathematical calculation of YTM, consideration of the market price, coupon interest, specific time to maturity, and the par value are of essence. The major assumption made here is that all coupons often reinvested at a similar rate in order to eliminate any form of biasness. In essence, though calculating YTM is a trial and error process, a bond yield table is a fundamental tool that helps to establish YTM. Under YTM, the yield to maturity ratio of maturity between two bond rations. Face value = $1000 Coupon rate = 10% Time remaining before maturity = 15 years Bond price = $862.35 A decrease in the coupon rate to say 7% would decrease the yield to maturity to 8.66% while an increase of the coupon rate to 15% would lead to a rise in the yield to maturity to 15.37% up from its initial 12% rate. Nominal Yield In finance and business investment, nominal yield is coupon rate attached to a bond. It is the par value that any given bond issuer to give the purchaser of the bond. Nominal yield of security bond does not always vary with the prevailing patterns in the market. Nominal yield therefore refers to any benefits accrued from a bond or from purchasing of a given bond security, whether at a higher price or at a lower price, the actual price yield is also affected (Stafford, 2010; Veronesi, 2010). In the event that an individual’s annual income is $55and the person has an annual income from a $1,000 bond, the person’s nominal yield becomes 5.5%. However, if $975 was paid for the bond in the business environment, then true yield would be 5.64%. On the other hand, 5.23% would be the true yield if an individual had paid $2,050. In the case of the use of nominal yield, it can be concluded that Conclusion Whether in corporate finance, derivatives, analysis of fixed income investments, equities investments, and equity investment strategies, it is apparent that yield measurement is a vital and very fundamental mechanism of enhancing transparency, accountability, and reliability of the investment in bonds and other related investment strategies. Veronesi (2010) elucidate that bond yield measures inform investors of the rate of return on bonds under different assumptions. The calculations have proved that the liquidity of the market highly determines on the rate of return on bond investments (Guillermo, 2012). This approach is crucial as it enable one to undertake comparison of the returns of different bonds. Use of appropriate discount rates is vital in the discounting of bonds References Fabozzi, F. J. (2005). Fixed Income Mathematics: Analytical & Statistical Techniques, 4th Ed., John Wiley. Guillermo L. D. (2012). Bonds, a Step by Step Analysis with Excel, Chapter 1: Pricing and Return, Kindle Edition. Parameswaran, S. (2007). Bond Valuation, Yield Measures And The Term Structure. McGraw-Hill Education: Securities Markets Series. Schwartz, A. J. (1989). Money in Historical Perspective. The University of Chicago Press, Chicago. Smith, D. J. (2011). Bond Math: The Theory behind the Formulas. John Wiley. Stafford, R. J. (2010). Bond Evaluation, Selection, and Management, 2nd Ed., John Wiley. Tuckman, B. (2011). Fixed Income Securities: Tools for Today's Markets, 3rd Ed., John Wiley. Veronesi, P. (2010). Fixed Income Securities: Valuation, Risk, and Risk Management. John Wiley. Read More