Bond Yields And Prices Lec1-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Bond Yields And Prices Lec1-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 29 BOND YIELDS AND PRICES Bond Yields: Bond yields and interest rates are the same concept. Therefore, we begin our discussion of 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 loan able 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 The Basic Components of Interest Rates: 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 Measuring Bond Yields: 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 docsity.com y g ( ) 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: 1. The bond is held to maturity, and 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 actually earned over the investment period, taking into account all intermediate cash flows and reinvestment rates. Defined in this mannerist 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. docsity.com