Measures of Bond Yields and Yield to Maturity - Report Example

Name: Course: Instructor: Institution: Date: Bond yield is the income earned from a bond. If for any reason the bond pays periodic interest, then it equals the interest collected. On the other hand, when a bond is sold at a discount on the par value, then it equals the difference between the amount received on bond’s maturity date and the purchase price. Interestingly, the actual rate of return earned by the bondholder is not fully reflected by the coupon rate on a bond. It is however, dependent on the credit or default risk, reinvestment risk and the price risk. Bond yield is a critical concept that must be taken into consideration in bond investing. This is because, bond yield is a tool investors use to measure the return of one bond against another hence makes the investor to make informed decisions about which bond to buy. As described above, bond yield is the rate of return an investor gets on bond investment. However, a point to underline is that bond yield is not fixed as compared to the bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates. There are different bond yield measures that are used to determine the rate of return to the bond investments. Bond yield measures This is the annual return on dollar amount paid for a bond, despite of its maturity. If an investor buys a bond at par, the stated interest rate equals its current yield. Hence, the current yield on a par-value bond paying 5% is 5%. To obtain the current yield, the annual coupon interest is divided by the market price. When calculating the current yield, the coupon interest and no other source of return that will affect an investor’s yield should be taken into consideration. The time value of money is ignored. In addition, the capital gain realized by the investor as a result of purchasing a bond at a discount or the capital loss earned by the investor if a bond is purchased at a premium is held to maturity are also not taken into consideration. However, the current yield will be different as long as the market price of the bond is more or less than par. For instance, if an investor buys a $1,000 bond with a 6% stated interest rate after a rise in the current interest rate, the investor will pay fewer pars. Assuming the price is $900. The current yield would be 6.67% ($1000 X 0.06/$900). Yield to call These are calls that may be called prior to the stated maturity date. It is an indication of the total return an investor would receive if he/she was to buy and hold the security until the call date. The investor should be aware that yield to call is valid only if the bond is called prior to maturity. The important elements of yield to call are coupon rate, the length of time to the call rate and the market price of the bond. Generally, yield to call calculates they yield of a bond that would be earned if the bond were to be called at its call date as opposed to its maturity date. If the bond is trading below its face value or at a discount, then the yield to call is greater than the yield to maturity. On the other hand, a bond trading at a premium will have a yield less than the yield to maturity. As a result, a bond characterized by being called, then there is a possibility that a bond holder may receive unattractive or lower yield. Consider two 10-year bonds with an annual coupon rate where Bond X is priced at par and Bond Y is priced at a premium. Bond X: Issued On: 12/12/2012, Maturity Date: 12/12/2022, Face Value: $100, Price: $100, Coupon: 6% This is what Bond X’s yield to calls would be: Yield to Maturity 6% Call Date: 12/12/2013 Yield to Call 6% Call Date: 12/12/2015 Yield to Call 6% Call Date: 12/12/2017 Yield to Call 6% Call Date: 12/12/2019 Yield to Call 6% Bond X is priced at par or its face value equal to its price. The yield to calls is the same to the yield to maturity. Bond Y: Issued On: 12/12/2012, Maturity Date: 12/12/2022, Face Value: $100, Price: $110, Coupon: 6% Bond Y’s yield to calls would be: Yield to Maturity 4.54% Call Date: 12/12/2013 Yield to Call -3.66% Call Date: 12/12/2015 Yield to Call 2.42% Call Date: 12/12/2017 Yield to Call 3.63% Call Date: 12/12/2019 Yield to Call 4.15% As witnessed above, since Bond Y is priced at a premium therefore its yield to call is less than its yield to maturity. As opposed to Bond X which is characterized with a yield of 6%, Bond Y’s lowest yield is -3.66%. It is worth noting that if the price of Bond Y is increased-say from $110 to $150-then its yield to calls would have been even lower. In general, the higher a bond’s premium, the lower the yield to call will be and hence the less attractive the return will be. With regards to the call dates above, the issuer of the bond has a lot of flexibility since he has an option of calling the bond at any time. Decline in the interest rates is the main reason why the bond issuer may prefer calling the bond. The knowledge about the yield to call and yield to worst of a bond is important to give an investor for a successful return. Yield to maturity The yield to maturity is the internal rate of return earned by an investor on a bond if he holds the bond until the end of its lifetime. Yield to maturity is a long-term bond yield which is expressed as an annual rate and takes into account the current price of the bond, par value, coupon interest and the time to maturity. The yield to maturity is sometimes calculated in terms of Annual Percentage Rate, however more usually market convention is followed. The fact that yield-to-maturity includes all aspects of investments makes it the best measure of the return rate. The formula for calculating yield-to-maturity for a zero-coupon bond is given below: Consider of a 30 year zero-coupon bond with a face value of $100. If this bond is priced at an annual yield to maturity of 10%; the current cost will be $5.73 (100/(1.1)30). However, for the next 30 years, the price will increase to $100 and hence the annualized return will be 10%. Consider a situation where the interest rates decline for the first 10 years and the YTM on the bonds falls to 7%. The price of the bond will be 100/0.720 or $25.84 for the remaining twenty years. In addition, considering the fact that the YTM for the next 20 years just 7%; and the YTM bargained for during the purchasing periods of the bond was only 10%, the first 10 years will be characterized by 16.25%. This is attainable through evaluating (1+i) from the equation (1­+i)10=(25.842/5.731) which gives 1.1625. It is however not possible to solve for YTM in terms of price algebraically for bonds with coupons. How changes in interest rates affects bond prices The market price of a bond today is the sum of all future cash flows, discounted in value because they are not available today. The discount rate used in calculating the market price is the rate of interest prevailing in the market for bonds of the same risk and maturity. A change in the interest rate affects the price of all bonds, but to varying degrees. Bond prices are inversely related to interest rates. An increase in interest rates will result to a decline bond prices and a decline in interest rates will result to an increase in bond prices. It is worth noting that this is applicable to previously issued bonds trading on the open market. Bibliography Fabozzi, F. J. (1999). Duration, convexity, and other bond risk measures. New Hope, Pa: Frank J. Fabozzi Associates. Johnson, R. S. (2004). Bond evaluation, selection, and management. Malden, MA: Blackwell Pub. Madura, J. (2008). Financial markets and institutions. Mason Ohio: Thomson. Megginson, W. L., Smart, S. B., & Lucey, B. M. (2008). Introduction to Corporate finance. London: Cengage Learning EMEA. Parameswaran, S. K. (2007). Bond valuation, yield measures and the term structure. New Delhi: Tata McGraw-Hill. Read More