Types of Bond Yield in the Securities Market - Example

Name Professor Course Date BОND YIЕLD MЕАSURЕS Bond yield measures inform investors of the rate of return on bonds under different assumptions Introduction This paper seeks to explain the various types of bond yield in the securities market. Bonds are a form of investment that are considered debts or loans. It also looks at the different measures of yield and analyzes some numerical examples. Changes in the Interest rates affect bond prices in the market which is analyzed in this paper. Different kind of bond yield A bond is a type of investment in the form of a debt. Bond yield is the interest expressed in percentage form that an investor receives from a bond. This means that a greater yield signifies more money for the investor of the bond. This arises from the payments one receives from the interests of the bond (Baaquie 2009). The higher the bond yield, the higher the risk of default to the investor. However, it does not necessarily imply that the higher the yield the better the investment. There are times when a high yield does not signify a good investment. There are different ways of calculating bond yield depending on the life of the bond. Investors consider three parts of a bond when calculating bond yield. This includes the coupon, the current price of the bond and the maturity of the yield. The three types of bond determine the amount of returns that an investor gets from the bond depending on the time that the bond is being sold. For instance, there are bonds with lower credit rating than others. Treasury and municipal bonds are examples of high-yield bonds with low credit rating. The bond yield fluctuates depending on the economic situation and other events that affect. Bonds come with various types of risks that associate with them. The investors face these risks and affect the prices of bonds and their ratings in the market. There are three important types of risks. They include the price risk, reinvestment risk and credit risk. This paper seeks to explain these risks in details and their effects on bond ratings in the market. This section also explains on how interest rates affect bond prices. Changes in the interest rates will definitely affect bond rates because the two factors relate with each other. Face value This is the value of a bond in terms of the principal or redemption value. The interest payments issued to an investor for a bond are expressed as a percentage of the bond’s face value. For instance, if a bond is sold before its maturity, its actual value could be greater or less than the face value. This depends on the interest rate to be paid and the risk of default that the bond has. Face value is the amount that an investor receives for a bond at its maturity date. It is also known as par value. This amount is payable to the investor on condition that the issuer does not default. Bonds to be sold in the secondary market fluctuate depending on the surrounding factors. For instance, the interest rates determine the price of bonds and the rate at which they are sold in the market. High interest rates mean that the bond will be sold at a discount or below the face value (Mobius 2012). There are cases when the interest rates are lower than the coupon rate. In that case, the bond sells at premium meaning that it is above the face value. A bond sold at its face value usually has a coupon rate. This rate is in such a manner that the bond measures an amount equal to the original issue value. The coupon rate can also be equal to its own value after redemption at maturity. Risk There are three types of risks associated with bonds in the securities market. These risks include the price risk or the maturity or yield risk. The other types of risks associated with bonds include the reinvestment and credit risk. This is unlike the common misconception among people who believe that bonds are not associated with any risks. However, risks exist in bonds because of the default risk especially in cases where a company cannot pay interest payments. The default risk exists where a company is unable to pay the bond’s face value. Credit risks exist where the bond issuer fails to make payments on time. The issuer of the investor’s bond might be unable to make payments in due time or fail to pay at all. Treasury bonds do not have the credit risk unlike the high yield bonds that are considered to have a high credit risk. The issuer might default if the payments are not done in accordance to the agreement. However, this type of risk is very minimal in asset backed securities because they usually have insurance. This is because they have bond insurance which creates some guarantee of payment. These bonds guarantee both interest and principal to the investor regardless of the prevailing situation. The other type of risk is the re-investment risk. There are times when the interest rates in the securities market decline. This means that investors reinvest income from the interest and returns of the principal regardless of whether it was scheduled or not (Baaquie 2009). This means that investors invest these returns at lower rates that prevail in the market. The main cause of this risk in bonds is when payments for bonds are made at an earlier date than the expected date. This means that the investment is stopped before their due date or cancelled. The price risk is a risk on the basis that prices of securities may decline. Bond prices in the market might decline below the price at which they were bought at. This is a risk to the investor because these prices can decline leading to a loss. The longer a bond stays before its selling, the higher the chances that the price will decline because of other factors in the market. For instance, it depends on such factors like inflation. This means that a bond sold after a long time has the risk of running a loss. This is because the bond is sold at a declined price. Couponed rate Coupon rate is the rate of interest that an issuer states on a bond when it is being issued to the investor. Payments are made periodically depending on the agreement between the issuer and the investor twice a year for bonds. Interest rates affect the coupon rates of bonds. This is because the interest rates affects prices of bonds, therefore, affecting the payments of bonds. This means that the coupon rate depends on the interest rates. This means that they determine whether the bond is sold at premium or at discount. In such cases, bonds can be a premium bond or a discount bond. In case the coupon rate is greater than the market interest rate, then the bond in such a case is a premium bond. This means that the investor sells the bond at a favourable rate because the coupon rate will be greater than the current market interest rate. If the coupon rate is less than the current market rate, then the bond is a discount bond. This implies that the investor receives a lower coupon rate. The payments for such a bond are lower due to the effect of the high market interest. For instance, a $5000 bond having a coupon rate of 5% pays $50 per year. In case of changes in the market interest rates, then the coupon rate will change accordingly. Three kinds of bonds yields There are three important types of bond yields, which include yield to maturity or the promised yield, the realised yield and the expected yield. These types depend on the expiry time of the bond. For this case, we consider a bond with a face value of 100 and a 5% coupon rate payable annually with 5 years to maturity. The realised bond is the amount that a bond earns over a certain period of time (Brigo & Mercurio 2006). The period of time in this case is the holding period which is usually differs because of the expected yield at maturity. This type of yield is composed of returns from reinvestment and dividends. Other cash distributions and payments also constitute the realized yield. This yield differs from yield at maturity in cases where the holding period is less than the maturity. This type of yield includes all the returns from reinvesting interests, dividends any other distributions of cash. However, it is important to note that this type of yield is different from the maturity yield. This yield measures returns of a bond with the market price which depends on the interest rates in the market. This yield is also known as the current yield and is different from the coupon yield because it measures returns on interest payments. It issues the returns on the basis of the investment and its amount. The expected yield describes the total amount that a bondholder gets during the life of the bond before its maturity. This type of yield is also the nominal yield and it involves issuing coupons to the investor. These coupons are issued on the basis of the face value of the bond before the maturity. In this bond, all other factors in the market are considered irrelevant while measuring it (Mobius 2012). This is unlike in the other types of yield that considers other factors like changes in the interest rates among others. The expected yield does not put into consideration any gains or loses that a bond gets after it matures. This is because the expected yield does not consider such factors like the time value of money. The expected yield only considers interest rates in the market. The maturity yield describes the total rate of return on an investment by a bondholder. It shows the internal rate of return on cash considering the initial price of the bond. It also includes the principal of a matured bond and the total earnings as at that particular date. The current price in the securities market affects the maturity yield of the bond (Baaquie 2009). This means that high prices in the market indicate lower maturity yields and vice versa. This creates equality between the price of the investment and the value of cash flows. The interest in this type of yield is compounded until its maturity with the aim of determining the value of the security as at that time. The maturity yield also puts into consideration extra amounts paid for the bond before its maturity. Therefore, the semi-annual discounts released before its maturity are considered in this type of yield. Expected yield Numerical examples This part explains the formula for calculating the three types of bond yield and expounds further by citing some numerical examples on the same. Realized yield= total annual interest/ nominal value of the bond Company A has a ten year bond with an interest rate of 20% and a nominal value of 500. The realized yield in this case would be 20/ 500= 0.04 = total annual interest/ current market value of the bond Take for instance a case where an investor buys a $3000 face value bond that pays 10% (300) coupon rate annually for $200. The expected yield in this case would be 300/200= 1.5 Maturity yield= total compounded rate of return/ initial purchase price. A purchase of $2000 face value bond for $100 the investor has $1000 extra income at the maturity of the bond. The interests are compounded so that the result is over the purchase price. However, this is different in the case of a premium bond. Effects of interest on bond price Interests and bond prices have an inverse relationship. This means that a fall in the interest rates in the securities market leads to an increase in the prices of the bonds. This mostly affects the maturity yield because it measures using the interest rates in the market. The increase of prices results from the fall in the interest rates which make the bond expensive to purchase (Brigo & Mercurio 2006). Investors use a certain policy regarding the changes on interest rates and their effect on the bond prices. Bonds with more time to maturity are mostly likely to be affected by changes in interest rates and vice versa. This means that a bond of 10 years will be affected so much by these rates than one of 5 years. For instance, after a period of 5 years a government bond pays 20% instead of the previous 10%. The most likely scenario is that investors will get the $5000 for 10%. The new investor will choose the bond that pays 20% and not the 5% bond. This shows how the change in interest rates affects the prices of bonds. Conclusion In conclusion, there are various measures of yield depending on the lifespan of a bond. The paper above, analyzes all the measures, some of their advantages and limitations. The effects of interest rates on bond prices also indicate that bond prices are affected by market conditions. Therefore, investors should consider such factors before purchasing bonds as a form of investment. References Baker, H. K & Powell, G. (2009): Understanding financial management: A practical guide: John Wiley & Sons. Baaquie, B. E. (2009): Interest rates and coupon bonds in Quantum finance: Cambridge University Press. Brigo, D & Mercurio, F. (2006): Interest rate models- theory and practice: with smile, inflation and credit: Springer. Choudhry, M. (2001): The bond and money markets: strategy, trading, analysis: Butterworth- Heinemann. Mobius, M. (2012): Bonds: an introduction to the core concepts: John Wiley & Sons. Ramaswamy, S. (2003): Managing credit risk in corporate bond portfolios: a practitioner’s guide: Wiley. Read More