Bond Yield Measures - Essay Example

Bond Yield Measures Institution Affiliation Date One of the important things to consider before making investments decisions is evaluating the rate of return or yield. It helps to assess the risks and expected returns and to know whether investments or projects are worth investing in. There are different methods of calculating returns for the various types of bonds. Running yield It is a measurement of a bonds return yield and is the usually as a fraction of the bonds current market value. It measures what return an investor can get in the current market value. It is an annual return on the principal amount paid for a bond regardless of the time the bond matures. If a bond is bought at per value, the current yield or return is the same as the current interest rate stated. But if the market value of the bond changes, the current yield will change. For example, if a bond's current market value rate is 12%, then the yield is also 12%.However, if the interest rates change, the yields also change. Nominal yield It is the return of a bond which useful by a percentage fraction of the face value of the yearly amounts of coupon payments. The nominal yield is simply the bond's coupon rate which can change or stay constant for different bond types. For fixed rates, the nominal return is the same and does not alter throughout the bonds existence. For floating types of bonds, the nominal yield changes over the bonds lifetime according to the prevailing changes in interest rates. For indexed bonds, the nominal yields change through the time frame of the bond regarding changes in its related index. Yield to maturity (YTM) It refers to the average return that can be expected from an investment annually if one acquires an investment at its market value and stays with it until it matures. The value is calculated using the coupon payments, the value of the issue at maturity and capital gains or losses incurred throughout the bonds lifetime if any (Johnson,2004). However, this method assumes that all the coupon payments for the bond are invested back and are not distributed within the bond. This measure is important for comparing different bonds as an investor tries to decide the best investment among various available. Indeed, it takes into account and considers more variables that the other measures. For example, when comparing the nominal yield of two different bonds, the comparability can only be accurate and correct when the two bonds have the same characteristics that are: they have the same cost, the same life duration, and the same returns. If any of the features are different, the information will not be accurate, and the yield to maturity can be used to get exact figures. Yield to call (YTC) It refers to the bonds yield at the time of its call date. However, this value does not count if the bond is kept until it matures. The value is determined by the coupon rates of the bond, its current market value and the duration of the call date. Yield to worst (YTW) It describes the worst scenario possible for a bond, without the issuer of the bond defaulting just as the name points out. Here investors calculate this by assuming the worst that can happen for the issue of the bond. These assumptions include all provisions in a bond like a call, prepayment or sinking funds any occurrence that can negatively affect the bonds return. When investors know the worst yield possible, they can know how their income will be affected. Therefore, this helps them decide whether or not the income is worth considering the issue. Yield to worst calculations is determined for all possible call dates to offer investors with all information they need. It assumes all possible provisions and conditions that can reduce the yield have been assumed to prevail for example regulations to lower the coupon rate determined by market conditions. The assumption is the worst case in that, even if recalculations cannot happen for the investor. Yield to sinker (YTS) Over a period, some bonds can be redeemed by a sinking or a mandatory redemption fund that an issuer provides for retiring the debt at sinking funds dates over a period specified in the redemption plan of the bond contract for specific sinking fund prices usually at par value. These bonds are selected at random for redemption on such dates. Yield to sinker is calculated assuming the bond will be retired at the next sinking fund time (Veale, 1988). .If the bond is retired, the bond holder then receives the sinking fund price. It is then calculated the same way as the yield to maturity but only substituting the sinking fund date with the maturity date. If they are different, then sinking fund price is substituted for the par value of the bond. In the case of yield to call. Return to sinker may not be useful if the interest rates have changed over time since the time the bonds were issued. Nevertheless, this is because the bonds would be selling at less than the par value in the market. In this case, the issuer can just buy back the bonds in the market-saving money. Therefore, this helps to support bond prices for bondholders who are interested in selling the bonds. Yield to average life This measure calculates the bond yield using the average of a sinking bond issue. For example for a 20-year bond that has a specified interest rate of 10% must be retired annually from the 10th to the 20th years of the bond's term, the average life for the bond would be 15 years. Yield to average life is mostly used for assets with securities such as mortgages and long-term loans because their lifetime depends on how fast their prepayments are made. Yield to put option Some bonds have a put option which enables the holder of the bond to receive the principal of the bond from the issuer when the bondholder chooses to exercise the put option. In that case, the yield to maturity would be calculated the same way as the yield to maturity, but the date for the put is substituted with the maturity date. However, this is because the bondholder receives the par value on the stated date just like the bond matured. Bond equivalent yield In the market, there exist short-term money instruments which mean they have a maturity period of less than one year such, small loans. For this, the interest is paid at maturity. They are also referred to as discount yields, investment rate yield or coupon equivalent yield because the short-term instruments are issued at a discount. To find the bond equivalent yield, we take the face value of the bond less the price paid and then divide by the price paid. We then divide the actual number of days in a year by the remaining days until the maturity date and multiply the results with the outcome from the first figure arrived at (Brown, 1998) BEY =Face value-price paid x actual number of days in the year Price paid number of days remaining till maturity Change in interest rates is caused by many factors such as inflation, change in economic conditions and government regulations whereby the government sets a required rate of interest which should not be exceeded. The impact of the change in interest rates has the same effect on bonds and investors. The rise in interest rates reduce the bond values of the existing bonds while falling interest rates increase the value of the existing bonds all other factors assumed to be constant. The price that a bond sells currently in the market is the sum of all future cash flows discounted in value because they are expected in the future and are not available today. A pound tomorrow is worth less than a pound today (Maeda, 2009). The discount rate used is usually the rate of interest currently prevailing in the market for bonds that have the same maturity. When interest rates change, they affect the prices of all bonds differently. The longer the maturity of a bond in investments, the greater the effect of a change in interest rate will have on it. Nonetheless, this is because the maturity value of long-term bonds and benefits being paid are future cash flows that are very far in the future. If interest rates rise, the future cash flows of the long-term bonds are discounted leading to significant falls in the prices of the long-term bonds in the market. Coupon rates which are interest payments paid by the issuer periodically also affect the price of bonds. A higher coupon rate means more interest payments will be given to the investor before the maturity than the case with a lower coupon bond. Therefore the most affected bonds by a change in interest rates are thong with longer maturities above five years and lower coupon rates. Investors should avoid these bond types to avoid incurring losses if interest rates change. References Brown, P. J. (1998). Bond Markets: Structures and yield calculations. Chicago: Glenlake Pub. Co. Johnson, R. S. (2004). Bond evaluation, selection, and management. Malden, MA: Blackwell Pub. Maeda, M. (2009). The complete guide to investing in bonds and bond funds: How to earn high rates of return--safely. Ocala, Fla: Atlantic Pub. Group. Mobius, M. (2007). Debt markets: An introduction to the core concepts. Chichester: John Wiley. Veale, S. R. (1988). Bond yield analysis: A guide to predicting bond returns. New York, NY: New York Institute of Finance. Read More