Bond Yields and Measurements - Essay Example

Bond yields and measurements Name Institution Introduction Every investor in any given capacity or business form needs to know that the capital he or she has invested in a business is paying off. In finance, there are very many varied forms of investment. A potential investor takes a pick of the various investment vehicles that are present in the market. The most influencing factor that narrows down the choice of investment that an investor makes is the yield that an investment vehicle brings. The higher that yield is, the more viable the investment opportunity seems to this investor. This paper seeks to investigate the relationship between the bond yields and the interest rates. It seeks to investigate how the yields realized on a bond changes when interest rates change. The paper will also look into the various ways in which bonds are rated and the assumptions that bond yields bring about. This will be done through an investigation into the various types of bond yields and ways of measuring the bond yields. Numerical examples will be offered where necessary. It will be found in this paper that the price of bond and the yield that bonds bring about is directly related to the interest rates. When the interest rates are high, the yield is lower and vice versa. Bonds Before embarking into a more detailed discussion of this concept, it is important to have an illumination into the definition of the investment vehicle itself. Duffee (1998) defines bonds as an IOU (i owe you). According to Duffee (1998), when one purchases a bond, he or she loans money to either the government or a corporate identity. The government, or the corporate identity for that matter takes the initiative of committing to repay these bonds at a fixed price and at a rate of return predetermined in a certain future date. There are many types and forms of bond depending on locality and structure of the government or the corporate identity. Bonds are known using a variety of names such as bills, debt securities or even debt notes depending on the maturity periods. Basically, bonds mature in a period of over 10 years. The key factor to note in this case is that these bonds have a legal binding to be paid of fully in terms of the principal amount as well as the interest rate at a given time in the future. Why issue bonds? Bonds are issued by government agencies or corporate bodies as a way of raising additional resources for development of projects or other investment activities. Sometimes, companies may not find the need to raise capital using additional shares. Floating more shares in the capital markets to raise capital may lead to the dilution of the already existing shares and this makes it hard for companies to generate the desired profitability (Ejsing et al 2012). Issuing bonds however is a more secure and faster process of raising additional capital to engage in business activities. Government entities do not operate like corporate bodies. They do not have the advantage of raising money through floating of shares in the market because they do not operate like corporate entities. However, following the anecdotes of monetary and fiscal policies, when the government needs to partake a particular project, it becomes important for it to raise money from its citizens in form of debts. These debts are called bonds. To cushion the citizens against the risk of inflation and fluctuation in the pricing of the same in the future, they give them a predetermined interest rate on these bonds. Upon maturity (expiry of the time agreed), the holder of the bond reserves the right to call on the bonds and reclaim his money as well as the interest paid on this bond. The interest rates paid on a certain type of bond is a variant of the price of the bond and the duration the bond takes to mature. The higher the amount invested, the higher the rates paid on the bond. The longer the period of bond investment, the higher the rates paid on the bond too. The opposite also applies. Measurements of bond yields There are several measures that are used to measure that yields of the various bonds in the market. these measurements have been described in the following paragraphs. Current yield Before defining this measure, it would be important to define the coupon rate. A coupon rate is a feature that shows the interest rate that the bond held will pay to the investors every year. The current yield is a measure of the bond yield that shows how the coupon (annual) interest is related to the market price. Mathematically, this is shown as follows: Current yield = Annual coupon interest/ price of the bond In this form of bond yield measurement, the time value of money is given little notice (Plummer, 2002). As an example, assume that a certain company, for instance Microsoft issues a ten-year bond. The interest payable on this bond is 7% and the market price is 112. To figure out the current yield of this bond, the following steps are followed. 1. Find the annual coupon interest on the dollar = 0.07 * 100 = $7 2. Calculate the current yield using the formula above. Current yield = $7/112 = 0.0625 = 6.25% When the bond sells at a discount, the current yield is higher. For instance, assume that in the above case, a 5% discount has been offered on this bond. The new yield becomes; Discount = 0.05*112 = 5.6 New price of bond = 112-5.6 = 106.4 Current yield then become $7/106.4 = 0.06578 = 6.58%. This shows that a discount of 5% on this bond leads to a yield that is 0.33% more than without a discount. Yield to maturity This is among the most commonly utilized methods of calculating the yield of a bond. It shows the interest rates that equates the present value of the cash flows to the initial investment. This could be calculated on both a semiannual as well as an annual bond. To get the yield of the bond using this measure, it would be vital to first get the price of the bond. The formula for getting the yield of the bond using a zero-bound coupon is as follows . To get the price of the semiannual bond, the following formula is used. P = Where: P = bond price, C = semiannual coupon interest, M = maturity value and n = period The yield to maturity takes into consideration the income of the coupon in current time as well as the capital gain or loss that the investor stands to have following his holding onto it (Fabozzi 2009). The time value of money is also taken into consideration in this case. Yield to call Another measurement of bond yield that measures the yield of a certain type of bond up to a certain point upon which it can be ‘called’ (Durand & Winn 1947). In other words, an investor holds onto a type of a bond for a certain period of time and reserves the right to call on the price of the bond at a certain pre-agreed call price. The pricing of the bond is dependent upon the call schedule. It shows the date when the call price was scheduled and set. This measurement assumes that the bondholder will call the bond at a certain time in the future. The call price is then fixed in the call schedule. Mathematically, this form of yield measurement can be calculated in the following way; P = Where M* = call price, n* = periods until call date. When calculating the yield to call on a bond-equivalent basis for a semiannual bond, you double the interest rate. Internal Rate of Return for a bond/portfolio of bonds yield Yield for a portfolio is found through the determination of the various cash flows for the portfolio. Then the interest rate is determined. This interest rate should be the rate that equates the present value of the cash flows to the value of the bond portfolio in the market. This shows that the Internal Rate of Return for a bond/portfolio of bonds yield tackles more than just the averaging of the yield to maturity of the portfolio as discussed above. Floating-Rate Securities yield measures To measure the yield spread of floating rate securities, one needs to tack how the coupon rate changes. This rate for a floating - rate security keeps on shifting along the basis of the coupon calculations (Berge, 2008). The calculation shows an interest rate, referred to as a reference rate and a quoted margin of the rate. Cash flows are not determined in this case because the future value for this reference rate is not yet known. The implication is that the maturity yield cannot be determined using this measurement method. To determine these yields, several measures are used which include simple margin, adjusted simple margin discount margin as well as the adjusted total margin. Discount margin measure shows the average margin over reference rate that a certain bond can be expected to earn during the life of the bond. Yield to put In this case, the investor forces the issuer of the bond, be it government or the corporate identity to buy back the bond at a specific price. Just like in the callable case, the putable bond can also have a put schedule that shows in all specifics when the bond can be put, the put price that would be maintained (Rao et al 1989). In definition of this concept, the yield to put is the interest rate that makes the PV of the various cash flows to the assumed date of put. It also shows the put price on that specific date as the put schedule highlights. Yield to worst In this case, the investor tends to try to avert a scenario whereby he might lose his or her investment following fluctuations in the interest rates in the market and the rates payable by a certain bond. When the rate that a bond offers is lower than the prevailing inflation rates in the market at the maturity date, the investor stands to lose an equivalent of the difference in the interest rates. To prevent this, and as precautionary activity mainly among risk averse investors, the investor calculates the yields to every possible call dates, every possible put date and the yield to maturity date (Trainor, 2010). Conclusion The above discourse has shown how various bond yields are measured and how these yields affect the interest rates of the various bonds. The relationship between the interest rates and the yield of the bonds have been observed to be directly proportional to the yield of the bond. The higher the rate of interest payable on the bond, the higher the returns that that particular bond has. For an investor, the bonds that pays the highest levels of return over the shortest period of time is more favorable. The investors want to realize returns on their investment as soon as possible. Through this format, the paper has looked into various measures that are used by the bond issuers to calculate the yields that these bonds have. There are several measurements discussed in this case. These are yield to maturity, yield to call, yield to worst, Floating-Rate Securities yield measures, yield to put and Internal Rate of Return for a bond/portfolio of bonds yield. Each of these measures have differing degrees of yields and are attractive to various groups of investors rallying from the risk averse to the risk takers. The discussion in this case has shown that bonds are truly safe instruments to invest upon. 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(2010). ‘Performance measurement of high yield bond mutual funds’. Management Research Review. 33(6):609 – 616. Read More