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8 Aufrufe5 SeitenBond yields and interest rates are the same concept. Therefore, we begin our discussion of
bond yields with a brief consideration of interest rates.

Feb 25, 2018

BOND YIELDS AND PRICES

© © All Rights Reserved

PDF, TXT oder online auf Scribd lesen

Bond yields and interest rates are the same concept. Therefore, we begin our discussion of
bond yields with a brief consideration of interest rates.

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

8 Aufrufe

BOND YIELDS AND PRICES

Bond yields and interest rates are the same concept. Therefore, we begin our discussion of
bond yields with a brief consideration of interest rates.

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

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Lesson # 29

Bond Yields:

bond yields with a brief consideration of interest rates.

Interest rates measure the price paid by a borrower to a lender for the use of resources over

some time period—that is, interest rates are the price for loanable funds. The price differs

from case to case, based on the demand and supply for these funds, resulting in a wide

variety of interest rates. The spread between the lowest and highest rates at any point in time

could be as much 10 to 15 percentage points. In bond parlance, this would be equivalent to

1,000 to 1,500 basis points, since 1 percentage point of a bond yield consists of 100 basis

points.

.

It is convenient to focus on the one interest rate that provides the foundation for other rates.

This rate is referred to as the short-term riskless rate (designated RF in this 'text) and is

typically proxied by the rate on Treasury bills. All other rates differ from RF because of two

factors:

1. Maturity differentials

2. Risk premiums

Explaining interest rates is a complex task that involves substantial economics reasoning

and study. Such a task is not feasible in this text. However, we can analyze the basic

determinants of nominal (current) interest rates with an eye toward recognizing the factors

that affect such rates and cause them to fluctuate. The bond investor who understands the

foundations of market rates can then rely on expert help for more details, and be in a better

position to interpret and evaluate such help.

The basic foundation of market interest rates is the opportunity cost of foregoing

consumption; representing the rate that must be offered to individuals to persuade them to

save rather than consume. This rate is sometimes called the-real risk-free rate of interest

because it is not affected by price changes or risk factors. We will refer to it simply as the

real rate and designate it RR in this discussion.

Thus, for short-term risk-free securities, such as three-month Treasury bills, the nominal

interest rate is a function of the real rate of interest and the expected inflationary premium.

This is expressed as, which is an approximation:

RF ≈ RR + EI

Where;

.

RF = short term Treasury bill rate

RR = the real risk-free rate of interest

El = the expected rate of inflation over the term of the instrument

Investment Analysis & Portfolio Management (FIN630) VU

Several measures of the yield on a bond are used by investors. It is very important for

bond investors to understand which yield measure is being discussed, and what the

underlying assumptions of any particular measure are. To illustrate these measures, we will

use as an example a three-year, IC-percent coupon, AAA-rated corporate bond, with interest

payments occurring exactly six months from now, one year from now, and so forth.

Current Yield:

The ratio of the coupon interest to the current market price is the current yield, and, this is

the measure reported daily In The Wall Street Journal for those corporate bonds shown

under the sections "New York Exchange Bonds" and "AMEX Bonds." The current yield is

clearly superior to simply citing the coupon rate on a bond, because it uses the current

market price as opposed to the face amount of a bond (almost always $1,000). However,

current yield is not a true measure of the return to a bond purchaser, because it does not

account for the difference between the bond's purchase price and its eventual redemption at

par value.

Yield to Maturity:

The rate of return on bonds most often quoted for investors is the yield to maturity (YTM),

a promised rate of return that will occur only under certain assumptions. It is the compound

rate of return, an investor will receive from a bond purchased at the current market price if:

2. The coupons received while the bond is held are reinvested at the calculated yield to

maturity.

Barring default, investors will actually cam this promised rate if, and only if, these two

conditions are met. As we shall see, however, the likelihood of the second condition

actually being met is extremely small.

The yield to maturity, is the periodic interest rate that equates the present value of the

expected future cash flows (both coupons and maturity value) to be received on the bond to

the initial investment in the bond, which is its current price. This means that the yield to

maturity is the internal rate of return (IRR) on-the bond investment, similar to the IRR used

in capital budgeting analysis.

.

Yield to Call:

Most corporate bonds, as well as some government bonds, are callable by the issuers,

typically after some deferred call period. For bonds likely to be called the yield to maturity

calculation is unrealistic. A better calculation is the yield to call. The end of the deferred

call period, when a bond can first be called, is often used for the yield to call calculation.

This is particularly appropriate for bonds selling at a premium (i.e. high-coupon bonds with

market prices above par value).

.

Realized Compound Yield:

After the investment period for a bond is over, an investor can calculate the realized,

compound yield (RCY). This rate measures the compound yield on the bond investment

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Investment Analysis & Portfolio Management (FIN630) VU

actually earned over the investment period, taking into account all intermediate cash flows

and reinvestment rates. Defined in this manners it cannot be determined until the investment

is concluded and all of the cash flows are known. Thus, if you invest $1,000 in a bond for

five years, reinvesting the coupons as they are received, you will have X dollars at the

conclusion of the five years, consisting of the coupons received, the amount earned from

reinvesting the coupons, and the $1,000 par value of the bond payable at, maturity. You can

then calculate your actual realized rate of return on the investment.

The RCY for a bond can be calculated by dividing the total ending wealth (including the

purchase price) at the bond's maturity by the amount invested; and raising the result to the

1/n power, where n is the number of compounding periods. Next, subtract 1.0 from the

result. Finally, because of the semiannual basis for bonds, multiply by 2 to obtain the bond

equivalent rate.

The semi-annual realized compound yield can be calculated using the following formula:

BOND PRICES:

A security's intrinsic value, or estimated value, is the present value of the expected cash

flows from that asset. Any security purchased is expected to provide one or more cash flows

some time in the future. These cash flows could be periodic, such as interest or dividends, or

simply a terminal price or redemption value, or a combination of these. Since these cash

flows occur in the future, they must be discounted at an appropriate rate to determine their

present value. The sum of these discounted cash flows is the estimated intrinsic, value of the

asset. Calculating intrinsic value, therefore, requires the use of present value techniques.

n

i=1

Where;

Cash flows = the future cash flows resulting from ownership of the asset

k = the appropriate discount rate or rate of return required by an investor for an

investment of this type

n = number of periods over which the cash flows are expected

To solve and derive the “intrinsic value of a security”, it is necessary to determine the

following:

1. The expected cash flows from the security. This includes the size and type of cash

flows, such as dividends, Interest, face value expected to be received at maturity, or

the expected price of the security at some point in the future.

2. The riming of the expected cash flows. Since the returns to be generated from a

security occur at various times in the future, they must be properly documented far

discounting back to time period 0 (today). Money has a time value, and the timing of

future cash flows significantly affects the value of the asset today.

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Investment Analysis & Portfolio Management (FIN630) VU

3. The discount rate, required rate of return demanded by investors. The discount rate

used will reflect the time value of the money and the risk of the security. It is an

opportunity cost, representing the rate foregone by an investor in the next best

alternative with comparable risk.

Bond Valuation:

The price of a bond should equal the present value of its expected cash flows. The coupons

and the principal repayment of $1,000 are known, and the present value, or price, can be

determined by discounting these future payments from the issuer at an appropriate required

yield, r, for the issue. To solve for the value of an option-free coupon bond.

n

P = ∑ ct / (1 + r) t + FV / (1 + r) n

i=1

Where;

c = the semiannual coupons or interest payments

FV = the face value (or par value) of the bond

n = the number of semiannual periods until the bond matures

r = the appropriate semiannual discount rate or market yield

In order to conform with the existing payment practice on bonds of paying interest annually

rather than annually, the discount rate being used (r), the coupon (ct on the bond, and the

number of periods are all on a semiannual basis.

For expositional purposes, we will illustrate the calculation of bond prices by referring to

the present value tables at the end of the text; in actuality, a calculator or computer is used.

The present value process for a typical coupon-bearing bond involves three steps, given the

dollar coupon on the bond, the face value, and the current market yield applicable to a

particular bond:

1. Using the present value of an annuity table, determine the present value of the

coupons (interest payments).

2. Using the present value table, determine the present value of the maturity (par) value

of the bond; for our purposes, the maturity value will always be $1,000.

3. Add the present values determined in steps 1 and 2 together.

We now know how to calculate, the price of a bond, using the cash flows to be received and

the YTM as the discount rate. Assume that we calculate the price of a 20-year bond issued

five years ago and determine that it is $910. The bond still has 15 years to maturity. What

can we say about its price over the next 15 years?

When everything else is held constant, including market interest rates, bond prices that

differ from the bond's face value (assumed to be $1,000) must change over time. Why? On a

bond's specified maturity date, it must be worth its face value or maturity value. Therefore,

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Investment Analysis & Portfolio Management (FIN630) VU

over time, holding all other factors constant, a bond's price must converge to $1,000 on the

maturity date because that is the amount the issuer will repay on the maturity date.

After bonds are issued, they sell at discounts (prices less than $1,000) and premiums (prices

greater than $1,000) during their lifetimes. Therefore, a bond selling at a discount will

experience a rise in price over time, holding all other factors constant, and a bond selling at

a premium will experience a decline in price over time, holding all other factors constant, as

the bond's remaining life approaches the maturity date.

Bond prices change because interest rates and required yields change. Understanding how

bond prices change given a change in interest rates is critical to successful bond

management. The basics of bond price movements as a result of interest rate changes have

been known for many years. For example, over 40 years ago, Burton Malkiel derived five

theorems about the relationship between, bond prices and yields. Using the bond valuation

model, he showed the changes that occur in the price of a bond (i.e., its volatility), given a

change in yields, as a result of bond variables such as time to maturity and coupon. We will

use Malkiel's bond theorems to illustrate how bond prices change as a result of changes in

interest rates.

Investors must always keep in mind the fundamental fact about the relationship between

bond prices and bond yields. Bond prices, move inversely to market yields. When the level

of required yields demanded by investors on new issue changes, the required yields on all

bonds already outstanding will also change. For-these yields to change, the prices of these

bonds must change. This inverse relationship is the basis for understanding, valuing, and

managing bonds.

,

Effects of Maturity:

The effect of a change in yields on bond prices depends on the maturity of the bond. An

important principle is that for a given change in market yields, changes in bond prices are

directly related to time to maturity: Therefore, as interest rates change, the prices of longer

term bonds will change more than the prices of shorter term bonds, everything else being

equal.

In addition to the maturity effect, the change in the price of a bond as a result of a change in

interest rates depends on the coupon rate of the bond. We can state this principle as (other,

things equal): Bond price fluctuations (volatility) and bond coupon rates are inversely

related. Note that we are talking, about percentage-price fluctuations; this relationship does

not necessarily hold if we measure volatility in terms of dollar price changes rather than

percentage-price changes..

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