Bond Yield Measures - Essay Example

Title: Student’s Name: Course: Course Code + Name: Instructor’s Name: Bond yield measures inform investors of the rate of return on bonds under different assumptions. When investors invest they expect a certain return on their bonds this is referred as the required yield. In the financial sector the term required yield refers to the yield that is provided by plain vanilla bonds that are currently in the market that have the same quality and maturity in terms of credit (Melicher and Norton, 2013). The aspect leads us to the main subject of the essay that is the calculation of the essay. The first measure is the current yield, the term refers to the annual return on the dollar with respect to the amount that has been paid for the bond and it is not dependent on its maturity. When an investor purchases a bond at par the stated interest rate is the current yield. The current yield is greater when the bond is selling at its discount while on the other hand the current yield is equal to the coupon rate when the bond is selling at par value. When an investor buys a bond between the coupon payments and one calculates the yield they should use the dirty price instead of the market place in the equation below. The dirty price refers to the price that one pays for the bond but often the price that is used is the one quoted in the U.S.A markets. The formula is Adjusted Current Yield = {Annual coupon/Market price}*100 + {100-market price/ Years to maturity} ( Damodaran, 2012). The second measure is calculating the yield to maturity. The yield to maturity refers to the amount that the investor will get if they decide to hold the bonds until it reaches its specified maturity. In its calculation, one major factor that has to be taken into consideration is that the price of a bond is equal to the present value of its future cash flows (Damodaran, 2012). The yield to maturity allows the investors to compare the securities that they have on hand with those of bonds. The comprehension of how the yields tend to change with a change in the market price is beneficial to the investors. The reason for the statement is founded on the fact that it helps them to anticipate the changes in their various portfolios providing them with an opportunity to make sound decisions. Additionally, the yield to maturity does aid the investors in answering difficult questions on which investment option to take when they decide to invest their finances (Melicher and Norton, 2013). An example is whether a ten-year bond that has a higher yield is preferable to a five-year bond that has a high coupon. The yield to maturity has three potential avenues from which the investors can get a return on their bonds. They are coupon payments, capital gains, and reinvestment returns. When calculating the yield to maturity from the manual perspective, it often focuses on the trial and error method; a method is time-consuming and exhausting. To speed up the process, they introduced the financial calculator and a software program to make it easier for the investors in them calculating their returns (Melicher and Norton, 2013). Other important aspects that have to be considered when analyzing the bonds within the yield to maturity measures are: when the bond is selling at a discount, it satisfies the following conditions the coupon rate is less than the coupon yield which is less than the yield to maturity. The second aspect when the bond is selling at a premium, the coupon rate is greater than the current yield which is also greater than the yield to maturity. The last aspect is that when the bond is selling at par value, the coupon rate is equal to the current yield which is equal to the yield to maturity (Melicher and Norton, 2013). As the price of a bond increases the yield decreases the relationship is measured by the price value of a basis point. The PVBP does measure the degree at which the bond price will change when there is a 0.01% change in the interest rates. The negative relationship is as a result of the bond price being higher when it pays the coupon that is greater than the market interest rates. The formula for calculating the bond to maturity c (1+r)-1 +c (1+r)-2……c (1+r)-Y+ B (1+r)-Y=P. In this case, c refers to annual coupon payment; Y refers to the numbers of maturity refers to par value, and finally, P refers to the purchase price. The third refers to the yield to call. Yield to call this refers to the interest rate that the investors often get when they decide to hold the bond until its call date. It does make sure that the present value of the bond should be equivalent to the present value that is equal to the entire price of the bond. The call protection refers to the period until the first call. Its calculations have three components which are the length of time to the call date, the coupon rate and finally the market price. The formula used is Bond price =Cash flow + [1- {1/ (1+ interest rate) n} / interest rate] + [call value+1/ (1+interest rate) n] (Damodaran, 2012). In Europe, they have multiple callable bonds that often have multiple dates when calculating yield to call it can be calculated for all of them. The yield to call has validity when the yield is called before its maturity date. The fourth measure refers to the yield to put. The Yield to put refers to the interest rate that the investors have to get when they tend to hold their bonds until the stipulated put date. The yield to put uses the same formula to that of the yield to call. The only difference is that the bond put price is used instead of the bond call value. The other difference is that the time until put date is used instead of the time until call date (Acharya, Amihud, and Bharath,2013).The lowest measure that is used to calculate bond yield is the yield to worst. It is used by investors who are more inclined towards the conservative nature. The yields do not take into account the bonds that are unredeemable, those that are sold before the call or put date. Interest rates have a significant impact on the measures of the bonds. The interest rates often result in the fluctuations of the returns that the investors get from investing in bonds. When the interest rates increase the prices of bonds tends to reduce and when the interest rates are decreasing the bonds increase in value. The calculation of interest rates on the bonds is quite complex hence the use of the discount rate makes the process easy. The discounted rate takes into consideration the market prices for the bonds with similar risk and maturity. When that interest rate alters, it tends to change the bond prices in varying ways. The longer the maturity of the bonds the greater the price volatility.The reason for this statement is that the bonds long term maturity value and the payments that are being paid all are the future cash flows. As the interest rates increase, the long-term bonds are discounted hence resulting in the prices of the bonds falling significantly in the market (Nielsen, 2016). Coupon rates refer to the annual interest payments that are often paid to the person who gives out the bond and it does affect the volatility price of the bond. As the rate of the coupon increases the bond holder has the potential of getting more cash as the interest payment does increase before it even matures when it is compared to a lower coupon bond. In other words, as the interest rates increase, the future cash flows tend to be discounted at a rate that is higher. The lower coupon bond tends to, therefore, have more cash inflows in the distant future. The maturity bond value does indicate a larger portion of the total cash flow in the future than the present value of the bonds (Nielsen, 2016). When the above factors are combined, they tend to result in the production of bonds with high-risk levels on the volatility of the price. The bonds that are often referred to as being extremely risky are those that have lower coupons coupled with maturity rates that take longer. The bond that does define the pre-existing value for the bond is the long-term zero coupon bond. Investors who are more conservative that is they tend to avoid high levels of risk should, therefore, focus on investing in bonds that have shorter maturity periods of less than five years. Additionally, they should abstain from investing in the zero coupon bonds especially those with long term aspects attached to them (The Relationship between Bonds and Interest Rates- Wells Fargo Funds, 2016). In conclusion, bonds are securities that investors invest in with an expectation of getting higher returns. The comprehension of the measures employed in the calculation of the bonds and the how the interest rates affect the bonds are vital to the investor as stipulated in the essay. References Acharya, V. V., Amihud, Y., & Bharath, S. T. (2013). Liquidity risk of corporate bond returns conditional approach. Journal of Financial Economics, 110(2), 358-386. Damodaran, A. (2012). Investment Valuation: Tools and techniques for determining the value of any asset (Vol. 666). John Wiley & Sons. Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance: markets, investments, and financial management. Wiley Global Education. Nielsen, B. (2016). Understanding Interest Rates, Inflation And The Bond Market | Investopedia. Investopedia. Retrieved 28 August 2016, from http://www.investopedia.com/articles/bonds/09/bond-market-interest-rates.asp The Relationship Between Bonds and Interest Rates- Wells Fargo Funds. (2016). Wellsfargofunds.com. Retrieved 28 August 2016, from https://www.wellsfargofunds.com/ind/investing-basics-and-planning/bonds-and-interest-rates.html Read More