Bond Valuation, Yield Measures, and the Term Structure - Essay Example

Bonds Name: Institution: Bonds Bonds are part of the three main categories of assets, together with cash equivalents and stocks. They are investments that involve lending money and earning interest over time. Investments in bonds can be made individually or in groups through mutual funds (Burton, 2010). Investors loan money to an entity for a specified period at a fixed interest rate. Some of these entities include corporate organizations and different arms of government. Institutions that borrow money through bonds use it to finance a variety of activities and projects (Crabbe et al, 2002). Credit quality and duration are the core determinants of a bond’s interest rate. Interest on bonds is paid semi-annually or in other cases once a year, depending on the agreement. The time may be as short as a ninety-day treasury bill or extend to a thirty-year government bond. Bonds are considered one of the safest ways to invest money and it can serve as a means of saving unused income. There are several noteworthy features of bonds such as face value, redemption date, coupon rate and redemption value. Face value is the initial denomination stated when the bond is issued. The redemption or maturity date refers to when the bond or loan will be repaid. The coupon rate is the rate at which the loan accumulates interest on its face value, often at regular periods. Redemption or maturity value is the amount the bond issuer pledged to pay on the maturity date. This value remains the same as the initial denomination in most cases, implying that the bond is redeemed at par (Parameswaran, 2007). However, there are instances when the bonds do not have a definite maturity date, in which case the issuer is free to repay the loan at an earlier date. This may alter the redemption value and is subject to a clause in the bond agreement between the issuer and investor. Such bonds are known as callable bonds. Additionally, there are bonds that do not remit periodic payments on accrued interest. The interest here is calculated as the difference between maturity and face values. These are referred to as zero-coupon bonds or zero interest bonds. Yield refers to the monetary return on an investment. This may be the interest or dividend earned from a particular security, calculated on a yearly basis as a percentage (Thau, 2002). This expression of yield is based on the cost of investment and its current value. Yield is not fixed, as is the case in interest rates, it changes in concurrence with price movements that are caused by fluctuating interest rates. Yield is a critical aspect of investment on bonds as it provides vital information to investors, helping them to make important decisions regarding which bonds to purchase. It is a concept used to compare the return of one bond to another. There are various methods of measuring yield, all of which are of importance to investors. They include coupon, current yield, yield to maturity, and yield to call. Coupon yield refers to the fixed annual interest rate paid for a bond, regardless of its maturity date. This is the rate stated at the issuance of the bond. This means that if a bond is bought for 1000 dollars with an interest rate of 10%, the coupon yield equals this stated percentage. Current yield is obtained by dividing the stated annual interest by the market price of a bond. The only source of return that is taken into consideration when calculating the current yield is the coupon interest. This is deemed as the only factor that will affect an investor’s yield in this type of yield measure. The capital gain in case a subsequent buyer purchases the bond, or the loss if a bond purchased at a premium is held to maturity do not matter. The period in which the bond is effective is also not considered when calculating current yield. The current yield becomes different if the face value of the bond is affected by prevailing market prices. A rise and, or decline in market price of the bond as compared to its face value alters the current yield. If for instance the prevailing interest rate rises above 10%, then the amount paid will be less than par. Assuming the market price of the bond is 950, the current yield increases to 10.5%. The yield to maturity provides figures that are more concrete. It gives the total return to be received if an investor holds a bond until its maturity. It is effective for drawing comparisons of bonds with different maturities and interest rates. It therefore offers a clear representation of the real value of the bond. Yield to maturity includes all the interest earned plus any other capital gains realized by the time of maturity, such as purchasing the bond below par. All the capital losses suffered during this period, for example purchasing the bond above par, are deducted. The objective of using this measure is to find an interest rate that will ensure that the present flow of money from the investment is equal to its face value (Fabozzi, 2002). This implies that the calculations take into account the prevailing market price of the bond, using it to derive a percentage that will earn the same redemption value as the face value. Investors are encouraged to analyze the yield to maturity of bonds they are considering to buy in order to make informed decisions as regards their profitability. Relying on current yield value may not be prudent because of its inaccuracy in representing the real value. Yield to call is yet another measure of returns on financial securities. This measure provides the amount an investor will receive once they buy and hold a bond or security until its call date. The call date refers to when the bond is repaid (Thau, 2000). This type of yield is only valid if the bond is called before maturity, a factor for which investors should be aware. Yield to call is calculated using the interest rate, length of time to the call date and the present market price of the bond. The call date is entered as the redemption date while the call price will be used as the redemption value. The yield to call equals the yield to maturity result. One of the main determinants of bond prices is rates of interest. The price of a bond at any given time is affected by fluctuations in interest rates (Maxwell et al, 2010). The relationship between the two is inversely proportionate. Therefore, when the figure of a bond is high, interest rates are low and when rates of interest are high, the prices of bonds are low. This concept presents a lot of difficulty to investors in terms of its comprehension. As an illustration, a bond certificate is issued and the investor buys it with the following conditions: face value worth 1000 dollars, interest rate of 10% for a maturity period of 3 years. Given the manner in which securities are traded frequently, the interest rate in the market suddenly rises after a week to 15%. This prompts the investor to sell the bond in order to cash in on the new interest rate. However, a problem arises because no one is willing to buy the bond for the same amount as the face value. This is because it will present a loss since it will not yield the same returns as the prevailing market price. Reducing the price of the bond becomes necessary, in which case it will be trading at a discount (Steiner, 2007). The original investor in a bond earns his returns on top of the bond’s par value. At the rate of 10%, they will incur returns of 100 dollars a year for as long as they hold the bond. On the other hand, a subsequent investor may not get competitive returns on top of the face value at the same rate of 10%. Instead of purchasing this offer, they may hence opt to buy bonds with higher coupon rates present in the market. This is so that he or she does not miss the lucrative returns that are offered in the current market plan. However, if the subsequent buyer is still interested in the original investors bond, they can agree to purchase it at a lower price. The selling price may be 756 dollars, which at 15% interest rate will earn returns of 122 dollars a year for every year the bond is held. The logic behind this is that the buyer needs to achieve returns similar to those they would have earned if they had purchased bonds with interest rates of 15%. The current interest rates are the sole determinants of the bond price as shown in this example. People who have invested in bond funds are at greater risk when interest rates fall, a situation referred to as redemption risk. The funds have to be sold prematurely to retrieve money to pay the individual investors. In the case where interest rates plummet, bond prices rise (Ilmanen, 2011). However, investors should be careful not to price their bonds too highly or they risk scaring off potential buyers. Once the prevailing interest rates in the market lower, the bond with 10% interest becomes attractive, thus inviting a number of potential buyers. The face value of the bond rises hence it can only be traded at a premium. This is because investors cannot afford a new issue bond with a high coupon. If the above-mentioned subsequent buyer opts to sell his bond at this time, he/she will do so for a higher sum. In this case, the bond may be sold at 907 dollars; at an interest rate of only 5% per annum, it will earn approximately 46.5 dollars as returns. This is until the new buyer is able to receive the full sum of face value at 1000 dollars. The rise and fall in interest rates in bond trading is caused by changes in demand and supply. In the event that demand for bonds is too high that it cannot be met by the present supply, their price increases. Bond issuers lower the interest rate to dissuade potential investors. Investors will be forced to spend on costly bonds or wait for market prices to drop. On the other hand, when there are numerous bond offers in the financial market yet buyers are not as many, their prices will be lowered to attract investors. This is accompanied by high interest rates, an aspect that investors find desirable. This may be used as a strategy by corporate institutions or the government whenever they need to borrow from the public. Since coupons are direct determinants of expected yield, it can be assumed that the higher the anticipated returns, the lower the price of a particular bond. The opposite is true in concurrence with the inversely proportional relation between bonds and interest rate. However, high interest rates are not favorable to all investors, especially those in bond funds. Bond funds consist of individuals who, more often will invest large sums of money in long-term bonds. Bonds with a longer maturity period are hit hardest in the case that interest rates rise. Investors seeking to shield themselves from rising interest rates are advised to purchase short-term bonds and ensure that the issuer has a strong financial basis. This is incase their finances are threatened and there is no way to repay their loans. Fluctuations in interest rates are considered among the worst predicaments for bondholders (Patton, 2013). Profitability that accompanies investment in bonds is one major factor, which necessitates buying and selling of bonds. Other than yield, interest rates also affect the pricing and valuation of bonds. The knowledge derived from studying financial markets is important to potential investors in the bonds and securities market. Attention should be paid to how these factors are significant when deciding on the type of bond to purchase, including when to do so. References Burton, J. (2010). Deciphering Fund Yields. The Wall Street Journal. Retrieved from http://online.wsj.com/news/articles/SB10001424052748704362004575000850271646756 Crabbe, L. E., & Fabozzi, F. J. (2002). Corporate bond portfolio management. New York: J. Wiley & Sons. Fabozzi, F. J. (2002). Interest rate, term structure, and valuation modeling. Hoboken, N.J: Wiley. Ilmanen, A. (2011). Expected returns: An investor's guide to harvesting market rewards. Chichester, West Sussex, United Kingdom: Wiley. Maxwell, W. F., & Shenkman, M. R. (2010). Leveraged financial markets: A comprehensive guide to high-yield bonds, loans, and other instruments. New York: McGraw-Hill. Parameswaran, S. K. (2007). Bond valuation, yield measures and the term structure. New Delhi: Tata McGraw-Hill. Patton, M. (2013). Why Rising Interest Rates Are Bad For Bonds And What You Can Do About It. Forbes. Retrieved from http://www.forbes.com/sites/mikepatton/2013/08/30/why-rising-interest-rates-are-bad-for-bonds-and-what-you-can-do-about-it/ Steiner, B. (2007). Mastering financial calculations: A step-by-step guide to the mathematics of financial market instruments. Harlow, England: Financial Times Prentice Hall. Thau, A. (2000). The bond book: Everything investors need to know about treasuries, municipals, GNMAs, corporates, zeros, bond funds, money market funds, and more. New York: McGraw-Hill. Thau, A. (2002). Bond Basics: An Investor’s Guide to the Many Meanings of Yield. AAII Journal. Retrieved from http://www.aaii.com/journal/article/bond-basics-an-investor-s-guide-to-the-many-meanings-of-yield Read More