Bond Yield Measures - Assignment Example

Bond Yield Measures Student’s Name Institution Bond Yield Measures A 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; 1. Current yield In 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 value Coupon=8%×$1000=$80 The current yield will be 80÷961.63×100= 8.32% 2. The Bond Yield to Maturity on a Payment Date The return on any investment is the rate of interest that will make the present value of the cash flows from the investment be equal to the cost of the investment. The bond price volatility is the sensitivity of the bond’s price to the changes in the interest rates. The aim of this calculation is to find the interest rate that will make the present value of the cash flows equal to the price of the investment. In order to calculate the average yield the average income per period is calculated from an approximated value and then is divided by the average amount invested. The bond price and its yield are inversely related. When the price goes up, the yield goes down and vice versa. This method measures both current income and expected capital gain or losses unlike the current yield. There is no formula that can be used to calculate the actual yield to maturity on a bond (Campbell & Taksler, 2002). The calculation can be done on a trial and error basis which is tedious by hand and quite easy with the use of a computer Microsoft excel program. This is the internal rate of return of the bond. It measures the expected compound average annual return rate of the bond if purchased at current price and held to maturity. Formula= Coupon÷2 (PVIFA 8%÷2)2×3+ Face value (PVIF 8%÷2)2×3 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.The yield to maturity using the trial and error basis will be 9.50%.The yield to maturity is greater than the current yield of 8.32% which is in turn greater than the coupon rate of 8%. The Yield to Call on a Payment Date This applies to bonds that may be called back prior to the stated maturity date necessitating a yield measure to be commonly quoted by the dealer: the yield to call. This method gives the issuer the right to buy back the bond before maturity at a specified price. The call price will usually be set at par or a little above the face value. Bonds with call options will usually sell at a higher yield (lower price) than comparable non callable bonds (Place, 2000). In calculating the yield to call, the cash flows occurring if the issue is called on the first call date are utilized. The bond issuers offer a call premium to the investors to make the callable bonds more attractive. A call premium is an extra amount in excess of the par value of the bond in case the bond is called before the maturity date. The call premium declines if each call date passes without a call. If a bond is called before the maturity date, then the investor’s rate of return will be different from the promised yield to maturity and it is for this reason that we calculate the yield to call for the callable bonds. In concept, the yield to maturity is identical to the yield to call except that the assumption is based on the call date for the bond on the next day and a call premium is added to the face value of the bond. 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. The bond is called in one year with a call premium of 3% of the face value. The yield to call on the payment date will be 15.17%. The changes in the prevailing interest rates in the economy will affect bond prices adversely. The interest rate is the rental price of money expressed as an annual percentage of the amount borrowed. For the borrower, interest is the penalty paid for consuming income before it is earned. Interest for the lender is reward for postponing current consumption. An inverse relationship exists between the bond prices and the level of interest rates (Fabozzi, 1996). When interest levels rise, the bond prices in the market fall and when they decrease the bond prices in the market rise. This has an effect of raising yields of older bonds when interest rates increase and matching them with newer bonds with high coupons and lowering the yield of the older bonds when the interest rates decrease and matching them with newer bonds with lower coupons. The fundamental determinant of the rate of interest rates is the interaction of saving and investment. The higher the return on an investment, the more likely producers are to undertake a particular investment project. At higher interest rates, fewer business projects can earn the required rate of return. Therefore, the demand for capital will be lower. The lower the interest rates and the demand for capital will be higher and many business ventures will earn the required rate of return. When it comes to saving, many people prefer to consume goods currently than on the next day. At low levels of interest, most people will postpone very little consumption for saving and thus the supply of saving will be higher. With higher interest rates, most people will not postpone consumption for saving and thus the supply for saving will be lower (Zipf, 2002). In order to avoid fluctuations due to interest level changes, interest rates can be forecasted using the economic modeling. Economic modeling predicts interest rates by estimating the statistical relationship between economic variables and the level of interest rates. The key assumption being that the causality among variables is stable. There is also an interest rate risk that exists and consists of price risk and reinvestment risk. Price risk arises from the inverse relationship between bond prices and interest rates. Reinvestment risk is more complex and arises because interest rate changes cause fluctuations in investors’ realized yield. The rise in returns makes bond prices fall but coupon rate reinvestment increases and vice versa. The price risk and reinvestment risk offset each other to some extent. Therefore, a measure that accounts for both risks is needed. Duration matching is a method used to eliminate both the price and the reinvestment risk. References Campbell, J. Y., & Taksler, G. B. (2002). Equity volatility and corporate bond yields. Cambridge, MA.: National Bureau of Economic Research. Choudhry, M. (2010). An introduction to bond markets (4th ed.). Chichester, West Sussex: Wiley. Diebold, F. X., & Li, C. (2003). Forecasting the term structure of government bond yields. Cambridge, Mass.: National Bureau of Economic Research. Dynkin, L. (2007). Quantitative management of bond portfolios. Princeton: Princeton University Press. Fabozzi, F. J. (1996). Bond markets, analysis and strategies (3rd ed.). Upper Saddle River, NJ: Prentice Hall. Place, J. (2000). Basic bond analysis. London: Centre for Central Banking Studies, Bank of England. Zipf, R. (2002). How the bond market works (3rd ed.). New York: New York Institute of Finance. Read More