Various Measures of Yield - Essay Example

Different measures of yield Name Course Tutor Date Different measures of yield Introduction In finance, yield describes the returns from bonds, treasury bills or other forms of investment by an investor. Yield is more complex than the coupon rate when calculating them for different investments. When calculating or measuring yield for bonds, it is expressed in percentage form for the whole year of the face value (Arnold 2008). This makes it easy for investors and finance analysts to make evaluations on the performance of bonds using such information. This paper looks at the various ways of measuring yield for bonds as a form of investment by using some examples of such calculations. These examples will use numerical examples to explain different measures of yield. It also explains the effect that interest rates have on the bond price in the market. Measure on yield of bonds acts as an indication of the profitability of the investment because it is given in percentage. This measure entails comparing interest or dividends of an investment by the purchase cost, the face value of the bond. The analyst in this sector carries out calculations using different formula to calculate various forms of yield. The paper contains the practical examples for the calculations on the measures of yield so that the formulas are clear and easy to operate. It gives the amount in terms of money that an owner of an investment or security gets after a given duration of time. The returns do not include price variations in the securities market which include fixed income instruments. Such include bonds, bills or treasury notes among others. Calculation of yield can either be a ratio or percentage like the internal rate of return. There are three major measures of yield that investors use and they include the nominal yield, yield to maturity and current yield. The three measures apply different formulas and this paper seeks to explain their differences and methods. The three calculate the same type of investment which is the yield for bonds, though they are a little bit different from each other. However, they different measures arrive at the same result of the yield on bonds for an investor. The nominal yield is also known as the coupon yield and entails using the total number of coupons in a year. The coupons or interest is paid by the principal or face value of the specific bond. This means that it calculates the bond excluding all other outside factors. In case an investor purchases the bond and holds it to maturity then the method of calculating it is different. In such cases, it becomes the annual return that an investor receives for the bond. This measure indicates the percentage derived from dividing total annual interest by the face value of the specific security (Arnold 2008). This measure also indicates the annual dollar interest rates or the coupon to the market price of the bond. This measure only involves the interest rather than other factor affecting the yield of an investor. It also assumes the time value of money. Capital gain on a bond or capital loss that an investor realizes is also assumed under this method of measure. That means that it does not matter whether the bond gains or looses after its maturity because it ignores such considerations. The formula for this measure is Nominal yield= annual dollar coupon interest / nominal value. Or Nominal yield= total annual interest / nominal value of security. A numerical example for this measure using the formula for the bond is shown here: Apple fifteen year bond with a total interest rate of 10% and nominal value of 150. In this case the nominal yield would be calculated as 10/ 150= 0.6667= 0.6667%. The second measure is the current yield which entails the same payments over the market price of the bond. In this case, annual coupon rates are divided by market price of the bond so that it shows the yield at that particular time without considering time value. It measures the return of a particular bond given its current price which depends on the interest rates and it differs from the coupon rate (Megginson & Smart 2008). For instance, an investor might buy a $2000 par value bond paying 15% coupon ($150) per year for $500. The current yield in this case is the return on the interest payments on the basis of the $500 investment. This then would be 150/500= 0.3. Another example for this current yield is: Apple fifteen year bonds with an interest rate of 10% and market price of 150. In this case the current yield would be calculated as 10/ 150= 0.6667= 0.6667%. Therefore, it is different from the coupon rate.The formula for this measure is: current yield= total annual interest/ current market value of security. This measure is usually greater when bonds sell at a discount. However, in cases where the bond sells at par, the current yield is usually equal to the coupon rate. The current yield has a major drawback because it only uses the coupon rate and ignores all other factors. It does not consider anything else apart from the coupon rate, hence; making it disadvantageous in some cases. The third measure of yield is the yield to maturity. It is a special form of the internal rate of return (IRR). It is the internal rate of return on the cash flows of the bond, the buying price and the principal of maturity for the bond. This means that there is a relationship between the yield of bond and the current price. They have an inverse relationship. It acts as the interest rate that makes the current value of cash flows from the bond equal to the price of such an investment (Schofield & Bowler 2011). The approximate value is used as the average income per duration of time over the amount invested. This value is known as the average yield. Another procedure for the same yield is by finding the interest rate that makes the present value of the cash flow. The rate should be equal to the price of the bond and the result is given in four decimal points. This ratio indicates the probability of the overall return on an investment expected from buying securities (Megginson & Smart 2008). This ratio mostly indicates the probabilities of fixed-interest securities. The formula for this yield is more complex than the other measures of yield because it entails compounding such interest until the maturity date of the security. It gives the rate of return on the initial investment for the life of the security. The rate of return for the security is also calculated. Therefore, the formula for the yield of maturity is given as follows: Yield to maturity= total compounded rate of return/ initial purchase price. For instance, a purchase of $2500 par value bond for $500, the investor has $2000 extra income at maturity of the bond. However, the calculation would be different in cases where a bond is purchased at premium. This measure considers extra amount paid for the bond. For instance, in a case where cash flows consist of 20 payments of $2.5 for every six months. This means that the investor has to calculate the present values using semi-annual discounts. This results to a semi-annual yield to maturity of 2.9% How changes in interest rates would affect bond prices There is a relationship between interest rates in the bond market and bond prices. This means that a change in interest rates will automatically affect bond prices in the market. This is because interest rates affects investment, hence; investors have to rely on such rates when making decisions on purchasing bonds. There are other many factors that affect bond prices but this paper focuses on how interest rates will affect prices of bonds. They affect bond price both positively and negatively depending on its effect on bonds and the state of the interest rates at a specific time (Choudhry 2001). This means that if the interest rates rise or fall, then there will be an effect on the bond prices due to changes in the rates. Bond prices have an inverse relationship with interest rates because when they rise, bond prices fall and vice versa. For instance, a bond purchased at $20,000 for ten years with a 5% interest rate payable in every six months. Then the interest rates rise to 6%. This means that in case an investor is willing to sell the bond, then few people will be willing to buy it when it is paying below market rates by about 1% (6% - 5%). However, such an investor could sell the bond at a premium in case the interest rate went up instead of falling. The question of what happens to bond prices when interest rates rise is common among many investors and how they handle such an occurrence. There arte several factors that may cause an increase in interest rates like inflation. Investors prefer buying government bonds that have a higher interest than others. However, this does not include inflations when considering the effects of interest rates on bond prices. For instance, after 5 years the government bonds pay 10% instead of the previous 5%. It is unlikely that an investor will get the $5000 for 5% bond. A new investor will go for the higher interest bond that pays 10% and not the one that has 5 years remaining but with an interest of 5%. Conclusion When interest rates fall in the bond market then prices of bonds increase. The yield to maturity is mostly used in the case of deciding whether interest rates are favouring bond prices or not .This is because they consider the maturity of the bond in terms of the time of maturity for the bond. A fall in the interest rates in the securities market indicates a rise in the bond prices because then there is a higher demand for the bonds than before. Therefore, many investors are demanding for the bonds, hence; their prices increase. There is usually a rule for investors that when a bond has more time to maturity, it will be affected by interest rates in the market and vice versa. Therefore, a bond that matures in 5 years will be affected more by changes in the interest rates than one that expires in two years. Its value changes largely when interest rates change, whether they increase or fall. References Schofield, N. C & Bowler, T. (2011): Trading the fixed income, inflation and credit markets: a relative value guide: John Wiley & Sons. Choudhry, M. (2001): The bond and money markets: strategy, trading, analysis: Butterworth- Heinemann. Megginson, W. L & Smart, S. B. (2008): Introduction to corporate finance, abridged edition ( with SMART Moves Printed Access Card and Thomas ONE): Cengage Learning. Baker, H. K & Powell, G. (2009): Understanding financial management: A practical guide: John Wiley & Sons. Boyes, W & Melvin, M. (2012): Macroeconomics: Cengage Learning. Arnold, R. A. (2008): Economics: Cengage Learning. Brigham, E. F & Houston, J. F. (2008): Fundamentals of financial management, concise edition (book only): Cengage Learning. Read More