Different Measures of Yields - Coursework Example

Yield measures and return rates Name Institution Date Yield is an important concept in bond investment. It is a way used to measure the profit gained from a bond compared to the other bonds. It equips investors with the knowledge to make a sound decision on the bonds to invest in. Yield is the profit gained from bond investing. The return is not a constant. It changes according to price changes caused by fluctuating rates. It is measured in percentage in annual bases. Yield is more complex and therefore more important than the coupon rate.. This paper will look into different measures of yields and explain how changes in interest rates affect bond prices. There are various measures of yields, which include: Current yield It is the measure of the annual return of a bond in relation to the current price, regardless of its maturity. Its return is based on its annual coupon and current price as opposed to its face price. If one buys a bond at certain price, current yield is equal to interest rate. One can simply calculate the current yield by dividing the coupon rates with the current bond price. If the market prices is high or low than initial price, current yield varies. Current yield is the yield most investor focus on in determining the attractiveness of a certain bond because it gives a reasonable estimate of the income generated from a certain investment at a specific point in time (Berk et al, 2011) It focuses on coupon interest and does not account for capital gains or losses that the investor could realize, nor the effect of compounding resulting from interest reinvestment. For most bonds, the stated coupon rate usually remain the same. However, as level of interest rates change, the return investor needs to hold a certain bond will fluctuate. This will result to some investors raising or lowering the current yield of that bond until it is equal to bonds of similar profile. Yield to maturity An investor gets this return when he/she buys a bond and holds it until its maturity date and all the profit received reinvested using the same rate. It is expressed as an annual percentage rate. Unlike current yield, this measure of yield includes all interest and any gain realized or loss suffered by purchasing bond above par. It enables an investor to compare and contrast bonds with different maturities and coupons. It is the most valuable measure of yield as it reflects the total income an investor receives. It is a looking forward measure unlike current yield and is termed as a more accurate indicator of the return the investor will experience. (Bruce.E, 2011) When investors buy bonds at a discount, yield to maturity reflects that at maturity, the investor have an additional income because of the difference in the price and principle returned. In a $500 par value for $300, the investor have $200 extra in income at maturity date. Every bond consist of a par payment. This is the most widely used measure. When investors speak of yield, they mean the yield to maturity. Yield to call This is another type of profit gained from a bond. An investor buys, keeps the bonds to the day of its call. In this type of yield, the profit is gained when the bond is renounced prior to its maturity. It simply tells the investor the total return that could be received if bond are bought and withheld to the day of call. Yield to call only works when the bond is called before the day of call hits. It is calculated considering the market prices and the duration of time to the day of call. Moreover, yield to worst is used to ensure that the investor is searching for the most conservative scenario in evaluating bonds. (McGraw-Hill, 2011). Generally, bonds are redeemable over certain period and usually called at a premium. The call date is usually before the maturity date. Calculating the yield to call is important because it reveals what rate of return the investor will receive assuming that the bond is called out on the earliest date possible. The bond is usually purchased at the current market price. A bond is redeemable before it matures. In some cases, the prices change when a bond is in the hands of an investor and not the corporate. Here, corporates demands renews the terms of the bond by lowering the gain rates. Corporates then issues the bond again; this time at a low rate of gain. This is the only risk involved. In many cases, investors prefer yield to call rather than the maturity one as it is more realistic indicator of the return an investor receives. Investors calculate yield to call for the first call date and possible dates. They then compare all yields to call and maturity and rely on the lowest of them known as yield to worst. Most investors focus on the future interest rates. Investors need to ask themselves whether the interest rate will rise in future or not. If the interest rises, investors should go for the bonds that mature on a short period of holding. They should have a strategy to escape the declining value of a bond. This can be achieved by holding the bond until it matures. (McGraw-Hill, 2011). Many Investors, for them to buy new bonds, they do a market research to identify the prevailing market condition. Bond prices fluctuate change daily on daily basis depending on the market changing rates. It is clear that in rates and prices, one determines the other and vice versa. Interest rates have an inverse relationship with the bond price. If rates go high, current prices declines and vice versa. Noted that bond’s yield to maturity is directly opposite to its price, as bond’s price go high, its maturity gain goes down. Profit gain increases when bond’s price fall. Investors take a real risk in the bond business. They fear that changes in interest will counter the prices of bonds commonly termed, as interest risk. Sometimes in the market, the rates may go high which makes the bond sell at a loss compared to its original cost. In other scenarios, rates drops and the bonds make more profit compared to the initial price, which is an advantage to the investors. Bonds value change according to the finance situation of the seller. Changes in interest rate, general market and economic conditions. Stock value changes daily depending on the kind of activities, an organization engages in. The worth of a bond is affected by several factors: the sellers’ money situation, prevailing market status, current economic status and variation in rates. Variation in rates changes and their impact on the bond market can be unpredictable. High yield bonds investments have its own risks and sometimes the risk is not worth to the investors. The bottom line is that bond’s yield rise when the bond value declines. (Johnson, 2011) In conclusion, yield is measured using different methods. It is evident that investors ought to go current one over the maturity because it is more realistic and gives a prediction of possible profit gain.. It is also evident that when bond yields or the interest rate rise interprets that the value of bonds declines. This is the reason as to why rising bonds yields are generally termed as undesirable. References  Fabozzi, Frank. The Handbook of Fixed Income Securities. McGraw-Hill, 2005, p. 87. Berk, Jonathan; DeMarzo, Peter (2011), Corporate Finance (Second ed.), Boston, MA: Prentice Hall, pp. 966–969. Bruce Tuckman (2011). Fixed Income Securities: Tools for Today's Markets (third Ed.) Pietro Veronesi (2010). Fixed Income Securities: Valuation, Risk, and Risk Management R. Stafford Johnson (2010). Bond Evaluation, Selection, and Management (second Ed.) Brealey, Richard A.; Myers, Stewart C.; Allen, Franklin (2011), Principles of Corporate Finance (Tenth ed.), New York, NY: McGraw-Hill Irwin, pp. 50–53 Read More