The Different Methods of Bond Yield Analysis in the Market - Assignment Example

Name: Student number: Name of Lecturer: Subject: THE DIFFERENT METHODS OF BOND YIELD ANALYSIS IN THE MARKET Realization of a yield in the bond market means that the maturity stage has been realized and that the expected returns on the bond have been paid (Ariel, 2010). Security debts in the financial markets are most commonly caused by those bonds with high yields. The time frame by which a bond stays in the market will determine the level of interest rate that it will be charged. For instance, if the bond takes a shorter time then the interest rate most probably will be lower than when it stays for a longer period of time. (Vasikcek, 2003) argues that the realized yields on bonds are expressed as a percentage on the return got from the investment. Investors who therefore want or wish to invest in this market are advised to equip themselves with the proper knowledge of the market and the risks involved. There are different ways of measuring bond yield, some of which include; yield to put, yield to maturity, current yield, yield to cost, yield to call, cash flow yield, yield to worst and yield to portfolio. The bonds that yield high returns in the market are those debt securities that last for a longer period of time and are charged a lower interest rate. According to (Vasicek, 2003), the investors that give out high yield bonds in majority of cases do so in order to increase their capital to enable them expand their businesses and also for the purposes of improved cash flow in their companies. Mathematically, the general formula for bond yield is as follows; P= Where CFt = cash flow for the year t P = price of that investment N = number of years The above mentioned types of bond market yields can further be discussed below; 1) Yield to maturity This can be defined as that total amount the investment has earned at the end of the period it was invested that the investor expects to get (Chambers and Carleton, 2001). Another definition according to (Ariel, 2007) is the rate of interest that can be used to equate the investments present value to that of the initial cost of investment. This should not however confuse one with stock yield as bond yields are paid according to the investment value making it more complicated that the stock yield. This yield that is gotten from the bond reflects the capital gain or loss and also the investment return at the end of the period the bond was invested. It is represented mathematically as; P= Where C- interest on the coupon P- Price of bond N- Time period M- Maturity value Consider the following example; The table below shows Mr. Bens debt obligation to be paid as follows Number of years Cash flow in $ 1 250 2 150 3 200 4 350 If the interest rate per year is 5%, what is the yield to maturity? Solution 250/ (1+0.05)1 + 150/ (1+0.05)2 +200/ (1+0.05)3 + 350/ (1+0.05)4 = 238.1 + 136.05 + 172.77 + 287.95 = $ 834.87 2) Current yield We can calculate current yield by expressing the annual yield income as the total percentage of the bond return of the investment as per the prices of the market. The investor therefore in this case will earn the bond percentage rate of investment calculated annually. The market price in this case is calculated based on the par value of $100 annually as it often relates to the rates of interest. Current yield is calculated by dividing the annual rate of interest of the coupon by the bond prices, i.e; Current yield = annual rate of interest of the coupon / bond prices (Protte, 1990), explains that interest rate is only important factor that is used in the calculation of the current yield. Assume that the bond price is $ 300 and the annual rate of interest of the coupon is 30%. The yield calculation would be; = 30 / 300 =0.1% 3) Yield to put In this case, the person holding the bond has the right to force the person issuing the bond to state the specific prices of the bond. This condition is also being said that the bond is putable. In this case therefore the interest rate of the present inflow value can be overlooked until the put date after which it is added to that put price of the said date (Randall and Tavella, 2000). Yield to put can be calculated as Y = Where M* is the price of the put and n* is the time period Example Given that the maturity rate of bond is 20 years, the interest rate of the coupon is 10%, per value of the bond is $2000 and the first call is in the 10th year. Calculate the value in the first call. Solution Y= = 2000(1/ (1+0.2)10) = $323.011 4) Yield to call This is the total return on investment that an investor expects to get at the end of maturity period of the bond or until the time the bond is called. Calculation of the call price is possible in this case as the investor or the bond owner is in a position to call off the bond at a particular time. Call price in this situation means the price by which the bond is called. Calculation formula of the yield to call is similar to that of the yield to call. 5) Yield to portfolio In calculating the portfolio yield we find that rate of interest that equates the current value of the cash flow and the floated market value after finding the total cash flow. 6) Cash flow yield The repayment principle and the rate of interest in this case both form the cash flow in the market. The repayment principle is the original money that the investor invested on the bond at the beginning of the investment period while the interest rate represents that cumulated rate of interest at that particular time that the bond is called. 7) Yield to worst Yield to worst refers to the lowest return on investment that an investor can get at the end of investment period or at the time the bond is called off. The investor thus gets the lowest interest on the yield. Associated risks in the bond market Default risk This is the situation whereby the bond borrower is unable to repay the principle cash and the cumulated interest in time thus exposing the investor to unplanned costs. This may be due to inflation in the security markets of countries due to economic instability performances. The instabilities may cause the interest rate to either shift upwards or downwards and therefore causing a condition known as interest rate risk. (Rogers, 2003) says that the rate of interest in the bond market is inversely related to the price of the bond. Time, as a factor, also contributes to the changes in the rate of interest thus affecting the prices of the bond. In this situation, bonds that last for a longer time period are considered to be more risky that those with a shorter time span. Real interest risk Change in the real interest rate in the market and also inflationary risks are some of these risks that face the investors in the bond market. “These risks are brought about by economic factors of demand and supply of the bonds in the market” (Rogers, 2003).when there is a change on the rate of interest from 25% to 15% due to government policies like tax or other factors, then the investor with a low bond rate of 10% will suffer since the demand for its bond will be low thus attracting fewer buyers in the market. According to (Kidwell et al., 2010) these risks occur since the changes in the interest rates are not easily predicted. Various types of issuers of the bond These are the people in the market, who in majority of cases are those who issue out the bonds. For instance, Municipal government in Australia is an example of such organization that deals with issuing of bonds. There are various risks and rewards that each and every sector or players issuing bond are subjected to in the market. Within the markets, this is further classified into sectors which give common characteristics like financial sectors, industrial sectors and the interest rates which expose the investors to different risks. Inclusion of Options The bond issuer and the bond holder have no written proof of the transactions therefore making it difficult for any legal action to be taken in case of default. This forms part of the risks that is faced by the investor. The perceptions of the security of the bonds also affect the yield return and the investors should consider evaluating the option of investing in bonds and other security markets. Calculation of the changes in yield It is usually calculated in percentages, that is; Absolute change in yield = (1st yield – new yield) x 100 The change in percentage can also be calculated in natural logarithm as follows; Percentage change in the yield = 100 x log (new yield/ 1st yield) References Ariel, Z. (2010), Methods of Pricing Convertible Bonds Dissertation. Milton, Qld: John Wiley & Sons Australia. Chambers, D.R. and W. Carleton, (2001), ”A Generalized Approach to Duration”, Research in Finance, Vol. 7, 2000, 163-181, JAI Press Inc. Jamshidian, F. (2000): “Bond, Futures and Option Evaluation in the Quadratic Interest Rate Model,” working paper Fuji International Kidwell, D.S., Brimble, M., Basu, A., Lenten, L., Thomson, D., Blackwell, D.W., Whidbee, D., & Peterson, R. (2011). Financial markets, Institutions and money (2nd ed.). Milton, Qld: John Wiley & Sons Australia. Protter, P. (1990): Stochastic Interception and Deferential Equations. New York: Springer- Rogers, C. (2003): “Which Model for the Term Structure of Interest Rates Should One Use‘?’’ In Marhernnticcd Finance, ed. M. Davis, D. Duffie, W. Fleming, and S. Shreve. New York: Springer- Verlag, 93-1 16. Tavella, D.and Randall, C. (2000), Pricing Financial Instruments: The PDE Method. Wiley Vasicek, D. (2003): “An Equilibrium Characterization of the Term Structure,” J. Financial Ecori., 5, 177- 188 Verlag Read More