Evaluating bond prices and returns

Factors that affect bond prices and returns to the investor include interest rates, premiums
and discounts, current yield, and yield to maturity.
Interest Rate Risk Results in Variable Value A bond’s price, or its value on any given day, is affected by a host of factors. These include its type, coupon rate, availability in the marketplace, demand for the bond, prices for similar bonds, the underlying credit quality of the issuer, and the number of years before it matures. Most important, the price also varies because of fluctuations in current market interest rates in the general economy. The state of the economy and the supply and demand for credit affect market interest rates. These are the current long- and shortterm interest rates paid on various types of corporate and government debts that carry  similar levels of risk.
 

Long-term rates are largely set by bond investors’ buying and selling decisions, primarily based on their expectations of future inflation. Short-term interest rates are manipulated by the Federal Reserve Board, which is popularly known as the Fed. When the economy slows, the Fed often lowers the interest rates on short-term Treasury issues in an attempt to stimulate economic activity by making borrowing  cheaper. When inflation rises, the Fed often raises interest rates.

interest rate risk is the risk that interest rates will increase and bond prices will fall, thereby lowering the prices on older bond issues. This decline in value ensures that an older bond and a newly issued bond will offer potential investors approximately the same yield. Bonds generally have a fixed yield (the interest income payment remains the same) but a variable value. For example, assume that you buy a 20-year, $1000 bond with a stated annual interest rate of 8 percent, or an annual return of $80 ($1000 0.08). If interest rates in the general economy jump to 10 percent after one year, no one will want to buy your bond for $1000 because it pays only $80 per year. If you want to sell it at that time, the price of the bond will have to be lowered, perhaps to $800 [Equation (14.4), the bond-selling  price formula, shows the calculation involved].

Conversely, if interest rates on newly issued bonds slip to 6 percent after one year, the price of your bond will increase sharply (perhaps to $1333). This occurs because investors will be willing to pay a premium (a sum of money paid in addition to a regular price) to own your bond paying 8 percent when other rates are only 6 percent. Remember that bond yields and prices move in opposite directions—as one goes up, the other goes down. Bond prices are most volatile in the following circumstances: (1) when bonds are sold at less than face value when first issued, (2) when the stated rate is low, and (3) when the bond maturity time is long. The investor who holds a bond to maturity might ignore such information, but the person considering selling before maturity might be shocked to see price swings of 20 percent or more, . A person with a moderate or aggressive investment philosophy might regard such rapid price changes as opportunities.

Premiums and Discounts When a bond is first issued, it is sold in one of three ways: (1) at its face value (the value of the bond stated on the certificate and the amount the investor will receive when the bond matures), (2) at a discount below its face value, or (3) at a premium above its face value. After a bond is issued, its market price changes in order to provide a competitive effective rate of return for anyone interested in purchasing it from the original bondholder. As an example, assume that Running Paws Cat Food Company decided to issue 20-year bonds at 8.8 percent. While the bonds were being printed and prepared for sale, the market interest rate on comparable bonds rose to 9 percent. In this instance, Running Paws will sell the bonds at a slight discount to provide a competitive return. Discounts and premiums on bonds reflect changing interest rates in the economy and the number of years to maturity.

Current Yield The current yield equals the bond’s fixed annual interest payment divided by its bond price. It is a measure of the current annual income (the total of both semiannual interest payments in dollars) expressed as a percentage when divided by the bond’s current market price. When you buy a bond at par, its current yield equals its coupon yield. For example, a bond with a 5.5 percent coupon yield purchased at par for $1000 has a current yield of 5.5 percent. As bond prices fluctuate because of interest rate changes and other factors, the current yield also changes. For example, if Leslie paid $940 for a $1000 bond paying $55 per year, the bond’s current yield is 5.85 percent, as shown by the current yield formula, Equation (14.5).

A bond’s current yield is based on the purchase price, not on the prices at which it later trades. The current yields for many bonds based on that day’s market prices are available online and are published in the financial section of many newspapers. The total return on a bond investment consists of the same components as the return on any investment: current income and capital gains. In Leslie’s case, she will receive $1000 at the maturity date (20 years from now), even though she paid only $940 for the bond; therefore, her anticipated total return (or effective yield) will be higher than the 5.85 percent current yield. How much higher is accurately revealed by the yield to maturity (discussed next).

Yield to Maturity Yield to maturity (YTM) is the total annual effective rate of return earned by a bondholder on a bond if the security is held to maturity. The YTM is the internal rate of return on cash flows of a fixed-income security. The YTM reflects both the current income and any difference if the bond was purchased at a price other than its face value spread over the life of the bond. The market price of a bond equals the present value of its future interest payments and the present value of its face value when the bond matures. Three generalizations can be made about the  yield to maturity:

1.  If a bond is purchased for exactly its face value, the YTM is the same as the coupon rate printed on the certificate.
2. If a bond is purchased at a premium, the YTM will be lower than the couponrate.
3. If a bond is purchased at a discount, the YTM will be higher than the coupon rate.

For example, because Leslie bought her 20-year bond with a coupon rate of 5.5 percent at a discount for $940, her yield to maturity must be greater than the coupon rate because she will receive $60 more than she paid for the bond when she receives the $1000 at maturity. Exactly how much greater can be determined by calculating an approximate yield to maturity when contemplating a bond purchase because bonds that seem comparable may have different YTMs. The yield to maturity (YTM) formula, Equation (14.6), which is duplicated on the Garman/Forgue website, factors in the approximate appreciation when a bond is bought at a discount or at a premium:

all factors. The current yield on a bond is not an effective measure of the total annual return to the investor; in fact, the fewer years until maturity, the worse an indicator it becomes. As just calculated, Leslie’s 20-year bond with a coupon rate of 5.5 percent and a current yield of 5.85 percent has a YTM of 5.98 percent. If the same bond had been purchased with only 10 years until maturity, the YTM would be 6.29 percent; with 5 years until maturity, the YTM would be 6.90 percent; and with 2 years until maturity, the YTM would be 8.76 percent. Exact YTMs are online and listed in detailed bond tables available at large libraries and at brokers’ offices.

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