Bond Yield Market Analysis - Example

Student number: Name of Lecturer: Subject: BOND YIELD MARKET ANALYSIS When a bond realizes a yield then it means that it has been left to mature and the expected return on it has been realized (Ariel, 2010). High yield bonds in many cases form the debt securities in the financial markets with lower interest rates. Lower interest rates on the other hand most is determined by the time period the bond has stayed in the market. Yields realized, according to (Vasicek, 2003), are expressed as a percentage on the return on investment. It is therefore very advisable for any investor who wishes to invest in the bond market to have a better knowledge of the instruments used in the money market. Thus, this paper tries to explain the different measures used in bond yielding in the bond market. In most cases, high yield bonds are described as the debt securities in financial markets that have lower interest rates but last for a longer period of time. Chambers and Carleton, (2001) add that institutions and or organisations issuing high yield bond in most cases do this to raise more capital to expand the businesses and also to improve the cash flow in the company. The general formula for yield calculation is; P = From the formular; CFt = cash flow for the year t P = price of that investment, N = number of years There are also various types of yields in the bond market. These include yield to maturity, yield to cost, yield to call, cash flow yield, yield spread measures, yield to portfolio, yield to worst and current yield. a. Yield to maturity According to Rogers, (2003) the term means the sum of the total amount of return on investment an investor expects to get at the end of investments period. (Ariel, 2007) also describes yield to maturity as "the interest rate which can be used to equate the present value of the invested cash to the cost of the initial investment" (p.25). The difference between the bonds and stock yield of an investment is that bonds are paid as par value of the investment and thus making it even more complicated. The yield on the bond reflects both the return on investment and the capital loss or gain on an investment by the end of the investment period. Mathematically, it can be calculated a; It is calculated as follows: P = Where P represents bond price C- Coupon interest M- Maturity value N- Periods Example Consider the following debt obligation of Mr. Don to be paid as follows; Number of years Cash flow in $ 1 20 2 10 3 15 4 35 If the interest rate is 20% annually, calculate the yield to maturity. = 20/ (1+0.2)1 + 10/ (1+0.2)2 + 15/ (1+0.2)3 + 35/ (1+0.2)4 =16.67 + 6.94 +8.68 +16.88 = $ 49.17 1. Current yield Current yield can be described as the annual yield income expressed as a total percentage of overall cost of the bond or return on the investment expressed in market price (Carleton and Chambers, 2001). In this case, the investor finds the percentage rate of return on the invested bond annually. It usually relates to the interest rates of the coupons annually and that of market price and is usually calculated based on $100 par value. For instance, Current yield = interest rate of coupon annually/price of bonds. Researches such as (Protte, 1990), have a divergent view on this aspect. Protte argues that the calculation of current yield considers only one important factor; and that is interest rate of the coupon. Working from this assertion; The coupon annual interest rate is 25% and the price of the bonds is $400. Calculate the current yield Solution = 25/400 = 6.25% 2. Yield to put The bond issue in this situation is said to be putable, meaning the bond holder can force the person issuing the bond to quote the specific bond price. Yield to put can therefore be defined as that rate of interest that can make the current value of inflow cash be overlooked until the put date where after it will be added to the put price of that said date (Tavella and Randall, 2000). It can be stated mathematically as; YP = Where M* is the put price and n* is the time Example The following are bonds with maturity of 10 years; coupon rate is 5%, per value is $2000 and the first call is in the 6th year. Calculate the first call Solution YP = = 2000(1/ (1+0.05)6) = $1492.43 3. Yield to call This can be defined as that return an investor will get at the end of maturity of a bond or until date of call (Jamshidian, 2000). The investor, in this case is assumed to be in a position to call the bond after a particular time period thus making it possible to calculate the call price---the price at which the bond is called. Calculation of yield to call is more or less similar to that of as yield to put only that the M* in this case will represent the call price. 4. Cash flow yield In this case, the cash inflow consists of the interest rate and the repayment principle, which is the original money that the investor used to invest on the bonds and also the cumulated interest at that particular time. This interest rate makes the current value of the projected cash be equal to the price in the market. 5. Yield to portfolio Yield to portfolio can be calculated by finding the total cash flow of the portfolio and then the interest rate that will make the current value of cash inflow and the floated market value of that same portfolio equal (Kidwel et al. 2011). 6. Yield to worst This is the case whereby at maturity of the bond or when it is called the investor at this point gets the lowest interest yield. In other words, it is the lowest rate on return an investor can get. Various risks associated with bond a. Default risk. Default, as the name suggests refers to a situation where the person who borrowed the bond does not pay the principle amount and the interest rate in time exposing the investor to unplanned risk. The security markets in different countries are affected by inflation due to unstable economic performance. There is a constant change of the interest rate either upwards or down wards. The changes in the interest rates are what are known as interest rate risk. A research study by (Rogers, 2003) describes interest rates as being inversely related to the bond price. This means that increase in the interest rates will subsequently lower the bond prices and also that any decrease in the interest rates will increase the bond prices. In trying to explain this point, we take a point where one holds a bond worth $20,000 for the next 10 years at an interest rate of 15% and the coupon is paid half yearly. Due to inflation, the interest rate of the bond market increases to 20% after 5 years. The person who wants to buy the bond at this stage must be willing to incur the extra 5% increase in price since the bonds are issued at fixed interest rates for a fixed period of time. But in the case where the market interest rates of bonds has reduced to 10% then it is regarded as cash flow which translates to higher prices in the market as this means that the bonds held is fetching higher return compared to other bonds in the markets. Time factor also affect the bond prices in relation to interest rates where long term bonds are more risky compared to short term bonds due to future uncertainty in economic changes. b. Real interest risk Investors are exposed to risks such as inflationary risk and the change in the real interest rates in the market. These risks are brought about by economic factors of demand and supply of the bonds in the market (Rogers, 2003). If the interest rates change from 20% to 10% due to government policies like tax or other factors, it is true that 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. (Kidwell et al., 2010) explains this risk as that which comes as the effect of interest changes which cannot be precisely predicted. c. Various types of issuers of the bond More often than not markets are classified according to the people who are issuing out 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. d. Inclusion of Options There is no written proof of contract between the bond issuer and the holder of the bond hence there is no way one can take legal action against the other. This is also part of the risks that the investor faces. The perception of the security of the bonds also affects the yield return and the investors should consider evaluating the option of investing in bonds and other security markets. How to calculate 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) However, there are various challenges associated with measuring the yield using the internal rate of return. To start with is the assumption in the way cash flows in a given period are invested in the market. Second, using annual simple rate of interest in calculating internal rate of return just as an estimation and not as accuracy. Third and lastly, Kidwell et al. (2010) describes this method as being tedious and cumbersome. 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- Verlag 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 Read More