Bonds and Interest Rates - Essay Example

Bonds and Interest Rates Relationship between Bonds and interest rates A bond is a debt instrument issued by companies or government bodies to borrow money for a fixed period of time. The interest rate, called the coupon rate is generally fixed close to the prevailing interest rates. Some bonds may offer variable coupon rates. Bonds issued by government bodies and financially strong companies would have lower coupon rates than weaker or lesser known companies. Bond price and interest rates have an inverse relationship.

When interest rates go up compared to the coupon rate, bond prices would fall in the market and when interest rates fall, bond prices would go up. 2. The calculations involved with pricing a bond and a stock a) A bond is priced by converting the future cash flows from the coupon rate and the maturity payment to their present value. The discount rate for calculating the present value is the investor’s required yield. The formula is shown below. An Excel worksheet has PV calculation as a built-in macro.

Bond Price = C / (1+r)) + C / (1+r) 2 …………… C / (1+r) n + M / (1+r) n Where, ‘C’ is the Coupon rate ‘n’ are the number of payments ‘r’ is investor’s required yield M is the maturity value of the bond b) The price of a stock is determined using the Dividend Discount Model where the future dividends to be paid out by the company are discounted to a present value. An assumption often made is that there would be a growth in the rate of payment of dividends as the company grows in the future.

The formula is shown below : Price of stock = Dividend per share / (Discount rate – Dividend growth rate) Where, Dividend per share is the actual payout by the company in the present year Discount rate is the investor’s required yield Dividend growth rate is the expected rate of increase in dividends. This is based either on the company’s own past history or from other companies in the same industry. 3. Analysis of Procter & Gamble stock and bond prices The company selected for analysis is Procter & Gamble.

The data on P&G stock price and dividends for the past 5 years is shown, together with the yield calculation. The year-end stock price is on Jan 2 or 3, immediately after the end of the year. For 2015, stock price on Nov 2, 2015 has been used. Analysis of P&G Stock Price Year Dividend Stock Price at year-end Yield Yield on US Treasury 2010 1.928 63.30 3.05%   2011 2.100 63.04 3.33%   2012 2.248 75.16 2.99%   2013 2.408 76.62 3.14%   2014 2.576 84.29 3.06%   2015 2.652 75.30 3.52% 2.27% Dividend 5-year Growth rate 6.

58%       2016 expected 2.827 80.30 3.52%   Note: Data from Yahoo! Finance, accessed on Nov 18, 2015 Investing in P&G stock would give a yield of 3.52 % which is higher than the yield of 2.27 % on a 10-year US Treasury Note. P&G has also issued Bonds with varying dates of maturity and coupon rates. Data on the four series of bonds with the highest yield to maturity are shown below. Yield to maturity on P&G Bonds Name Maturity Date Coupon Rate Market Price Yield to Maturity P&G 5.

55 % March 2037 5.55 % 120.8 4.08 % P&G 5.125 % Oct 2017 5.125 % 100.0 5.12 % P&G 4.875 % May 2027 4.875 % 127.9 2.11 % P&G 4.7 % Feb 2019 4.700 % 109.6 1.65 % Note: Data from Morningstar.com accessed Nov 18, 2015 The P&G 5.55 % and the P&G 5.125 % bonds give a yield higher than investing in the stock. Though the P&G 5.125% bond yield is the highest, the maturity date is October 2017 which is in two years. The P&G 5.55% bond matures in March 2037 and with long term interest rates expected to decline causing bond prices to go up, the 2037 bonds appear to be the best for investment.

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