Developing Foreign Bond Markets - Essay Example

Bond Yield Name: Instructors Name: Course title: Institution: Date: Introduction Bonds are debt investment tools, through which the investors gives out loans to corporate entities and governments. The former, borrow funding for specified duration and fixed interests. In developed countries such as US, Canada, Germany among others, the government utilize money obtained from bonds in financing various projects and public activities. Other notable borrowers except governments and corporate include municipalities, companies and states (Zhang, 2011).The indebted or the issuer issues these bonds at given interest rates that are payable at maturity data of bond principle or the loaned money. The main varieties of securities include bills and notes, corporate bonds, municipal bonds and treasury bills. The features of bonds are characteristics of bonds, credit quality and duration, which determines their interest rates. For instance, government bonds have maturity of up to thirty years, while treasury bills mature within 3 months. Further, corporate and municipal bonds features with a maturity of between three to ten years. Bonds are similar to loans, where holders are the creditors and issuers are the debtors. The price, which a bond is bought by an investor is known as issue price, and is approximate to the nominal amount (Homer, 2006). Most of the investors prefer to invest in bonds as compared to other areas, because bonds offers fixed income securities and are less affected by external market forces. For instance, if an investor purchased bonds with 15 years maturity period, at 6% interest rate and face value of $20,000. The investor will earn $ 1,200 in interest annually for 15 years. As the bond will, pay interests bi-annually, two payments will be received each valued at $600. At maturity period, the investor will receive the initial $ 20,000 amount (Yla, 2003). This paper critically analyzes the different methods used in measuring the yields of bonds, which informs the investors of the return of bonds under different assumptions. Bond yield Bond yield is percentage of returns or amount, which an investor anticipates to receive from bond issue, within specified duration. Black (2003) argues that calculating bond yields involves employing current data pertaining prevailing price of bond as opposed to price at moment of purchase. In determining present status of yield, one is also required to have clear understanding of prevailing annual coupon taht is associated with bonds. Calculation for bond yield assumes that, investor shall hold onto the bond for a period of not less than one year. Understanding how bonds yields function is one of the most important aspects for any investor (Yla, 2003). Through evaluation of factors, which are possible to influence the worth of bond issue, investors are able to determine the worthiness of purchasing particular bonds and holding onto them for one-year duration. If these projections indicate the fact that the bonds will produce a notable gains for the given period, investors may opt to purchase the issue (Homer, 2006). On the other hand, if there are indications that the bond prices will reduce in value in the first year, it translates to the fact that investors may not be able to sell the bonds at a break-even price that will result to lower profits. In a case like this, it is advisable for investors to look into other types of bonds or even opt for completely different for of investment opportunities. Zhang (2011) indicates that yields of bonds are return on bond expressed as annual percentages of face amount. However, its is worth noting that yields are more complicated, thus more useful as compared to coupon rates. There are many ways in which interests of measuring interest on bonds, although this depends on the type of investment made. A simple formula in calculating bond yields entails dividing annual coupon by price of bond. For example, if bonds had been priced at $ 100.00 with yearly coupon of $ 6.00, the bond yields shall be projected at 6%. However, this bond yield assumes that, there will be no any notable change in price and investors will hold to this bond for a minimum of one year (Batten, 2006). If changes in interest rates occur, there will be a shift in current prices of bond, making the bond yield to indicate capital loss. From the above example, if prices of bond feel by $ 10.00 to $90.00, the $ 10.00 loss is offset by coupon of $6.00. However, capital loss valued at 4.00 for annual period will remain (Stein, 2010). By similar token, any upward movement on prices of bonds, results to increased capital gain realized from investment. Beside the simple method of measuring yields bonds, there are other more complicated indicated below Yield to maturity This is the overall measure of return on bonds if they are held to maturity. YTM reflects all interest payments, available through maturity and principal to be repaid assuming that payment on coupons will be reinvested at current yield on bond (Stein, 2010). YTM is the most valuable form of measure because it reflects total income receivable. If an investor purchase bond at a given discount , yields to maturity shall reflect fact that at maturity the investor will receive additional income based on differences between price paid and principle returned. For instance, if one purchase bond worth $1000 for $800, the investor has an extra $ 200 as income upon maturity of the bond (Black, 2003).In actual sense, YTM is estimation of future returns, as rate at which payment of coupons can be reinvested if receiver is unknown. This enables investors to make a comparison of merits of various financial investments. YTM is mostly given in terms of APR (Annual Percentage Rate), although market conventions are followed , where yields are quoted semi-annually. To understand yield to maturity, one must understand that price of bonds are equal to present value of the future cash flow as indicated by the formulae below (Stein, 2010). Where P = price of the bond C =coupon payment n = number of periods F = maturity value r = Proposed rate of return on the investment t = period when payment is receivable (Bliss, and Panigirtzoglou, 2004). For instance, if a company has bond with a par value of $ 1000, and 5 percent coupon maturing in three years duration. If the firm is selling bond at $ 980, it is deductible that YTM value is 2.86%. Due to the fact that the coupons are paid semi-annually, this becomes YTM for a period of six months. In order to annualize the rate at the same time adjusting for reinvestment of the interest payments, the following formulae is used Effective Annual Yield= (1 + Period interest rate) Payments made per year -1 (Cox, 2006). = (1+0.0286)2-1 =5.81% (Black, 2003). It is worth noting that callable bonds ought to receive special considerations when calculating YTM. This is due to the fact that call provision limits potentiality of appreciation of price when interests fall, as it cannot go beyond the call price (Stein, 2010). Current Yield This is a financial term used in reference to bonds among other fixed interest securities like gilts. It therefore only refers to yield of bonds at current moment and does not reflect total returns over life of bond. Longstah (2005) indicates that current yield does not take account of the reinvestment risks, which is the uncertainty on rate that the future cash flow may be reinvested or fact that bond matures at par value, an important component of bond returns. The formula for the current yield is as follows Current yield= Annual Interest/ current Bond price (Cox, 2006). For instance, assuming that given bonds are trading 100% or 100 cents on dollar, and a firm pays coupons rate at 3.0 percent. In this given case the CY on bond will be CY= 3.0/100 =3% (Bliss, and Panigirtzoglou, 2004). However if the bonds are trading a that discount such as at 95 cents on dollar, although the coupon remains at 3%, the yields will be slightly larger as indicated below CY= 3.0/95 =3.15% (Yla, 2003). If the bond is trading at premium of the face value, may be at 110 cents of dollar, the coupon still remains at 3.0 percent but the current yields shall be lower Current yield = 3.0 / 110 =2.72% (Longstah, 2005) It is worth noting that for most of the bonds, stated coupon rates, usually remains the same, for example 3.0% for the above example. However, as level of interests changes in given durations, return, which investors require to hold to particular bond fluctuates. As a result, majority of the investors send bonds prices lower or higher until current yield on bond is equal to the other types of securities having comparable risk profiles (Zhou, 2001). Nominal yield Nominal yield, also referred to as coupon yield, is a coupon arte for fixed income securities that is fixed percentage of bonds par value. Unlike the other forms of yields such as current yield, nominal coupons do not vary with prevailing market prices of the securities. Cox, (2006) argues that nominal yield is the yearly income, which investors receive from bonds or fixed income security divided by par value of security. For instance, if an investor has $55 in the annual income on $1,000 bonds, nominal yield is 5.5 percent (Yla, 2003). However, if investor paid a sum of $ 975 for bond in market place, the actual yield is 5.63%. On the other hand, if investor paid $ 1,050, the actual yield is 5.22% (Zhang, 2011). Yield to Call YTC (Yield to call) is yield on callable bonds, based on assumptions that the bonds will be called on earliest possible time. Calculations of YTC is same to YTM in terms of calculations except the fact that ultimate cash flow is call price and only includes coupon payment before next call date. Bliss, and Panigirtzoglou (2004). argues that, calculations to yield to call highly coupon payment, reinvestment returns and capital gain. As a result of this, most investors considers the lower of yield to call as realistic indication of return, which investor will gain on the callable bond (Zhou, 2001). Realized Yield This is the actual amount of return earned on security investment in a given period. The period of time is usually the holding duration that may differ from expected yield upon maturity (Cox, 2006). Realized yield (RY) also entails return earned from there reinvestment dividends, interests among other forms of cash contributions. RY is obtained by taking income and the other gains on bond and dividing it by historical cost. For instance, suppose an investor procures a 10 years bond for 1000 US dollar, which issues coupons at 5% annually. Furthermore, if the investor sells the bond for 100 US dollar at end of first year, after payment on first coupon, then the RY coupon payment would be $50 (Longstah, 2005). Effects of changes in interest rates on bond prices As indicated above, interest rate is one of the fundamental aspects to consider prior to investing in the bond markets. This is due to fact that it presents both opportunities and risk for investor, especially in the current times, where low-interest-rate exists. For instance, the US bond yields have been on a decrease since the onset of the global financial rise. When the interest rates change, it results to rise or fall of bond prices (Black, 2003). For instance, if one buys an investment with fixed payment, and in a months time buy different investment that are promising higher rate, then the initial investment bought would not be worth the comparison and vice versa. Even if one invests in treasury bonds, where risks o default are zero, change in interest rates poses the risk of opportunity costs, especially in cases where interest rates goes up (Cox, 2006). Conclusion Although the bond markets appear more complex to many investors, it is generally driven by similar risk or return tradeoffs such as stock markets. Investors only need to master the few basic measurement and terms in unmasking well-known market dynamics, thus becoming more competent bond investors (Stein, 2010). References Batten, J. (2006). Developing Foreign Bond Markets: The Arirang Bond Experience in Korea .IIS Discussion Papers (138). Black, F. (2003).The pricing of options and corporate liabilities.Journal of Political Economy 81, 617-654. Bliss, R. and Panigirtzoglou, N. (2004). Option-Implied Risk Aversion Estimates. Journal of Finance 59, 407-446. Cox, J. (2006). Valuing Corporate Securities: Some Effects of Bond Indenture Provisions. Journal of Finance 31, 351-367. Homer, S. (2006).A History of Interest Rates. Harvard: Rutgers University Press Longstah F. (2005).Corporate Yield Spreads: Default Risk or Liquidity. New Evidence from the Credit Default Swap Market. Journal of Finance 60,2213-2253. Stein, P. (2010). Dim Sum Bonds' on the Menu for Foreign Investors .The Wall Street Journal. Yla, E. (2003).Final Surge in Bearer Bonds. New York: Cambridge University press Zhang, B.(2011). Explaining Credit Default Spreads with the Equity Volatility and Jump Risks of Individual Firms.BIS working paper. Zhou, C. (2001). An Analysis of Default Correlations and Multiple Defaults, Review of Financial Studies 14, 555-576. Read More