Bond yields are crucial for understanding investment returns and market conditions. Yield measures like current yield and yield to maturity help investors assess potential returns and risks associated with bonds.

These measures are influenced by factors such as interest rates, inflation, and credit risk. Understanding yield measures and their relationships is essential for making informed investment decisions in the bond market.

Yield Measures and Interpretation

Calculating Yield Measures

• Current yield is calculated by dividing the annual coupon payment by the bond's current market price, expressed as a percentage
  • Measures the bond's annual return based on the current price and coupon rate
• Yield to maturity (YTM) is the total return anticipated on a bond if it is held until maturity, assuming all coupon payments are reinvested at the same rate
  • Considers the bond's current market price, par value, coupon interest rate, and time to maturity
  • Calculated using the following formula: $P = \frac{C}{(1+r)^1} + \frac{C}{(1+r)^2} + ... + \frac{C+FV}{(1+r)^n}$
    • P = bond's current price
    • C = annual coupon payment
    • FV = face value (par value) of the bond
    • r = periodic interest rate (YTM/2 for semiannual payments)
    • n = number of periods until maturity

Interpreting Yield Measures

• YTM is a more comprehensive measure of a bond's return than current yield
  • Accounts for the time value of money and the reinvestment of coupon payments
• Interpreting yield measures helps investors assess the potential returns and risks associated with a bond investment
  • Compare different bonds with varying coupon rates, maturities, and credit qualities
  • Higher yields generally indicate higher risk (default risk, interest rate risk)
  • Lower yields suggest lower risk but also lower potential returns

Bond Prices vs Yields

Inverse Relationship

• Bond prices and yields have an inverse relationship: when bond prices rise, yields fall, and vice versa
  • Known as the "seesaw effect"
• The inverse relationship is due to the fixed coupon payments and the time value of money
  • As interest rates change, the present value of the bond's future cash flows (coupon payments and principal) also changes, affecting the bond's price

Impact of Interest Rate Changes

• When interest rates rise, the present value of a bond's future cash flows decreases, causing the bond's price to fall
  • Investors demand higher yields to compensate for the opportunity cost of holding the bond
• When interest rates fall, the present value of a bond's future cash flows increases, causing the bond's price to rise
  • Bonds become more attractive as their fixed coupon payments offer higher relative returns
• The sensitivity of a bond's price to changes in interest rates is measured by its duration
  • Bonds with longer durations are more sensitive to interest rate changes than bonds with shorter durations

Comparing Yield Measures

Types of Yield Measures

• Current yield: considers the annual coupon payment and the bond's current price
• Yield to maturity (YTM): takes into account the bond's current price, par value, coupon rate, and time to maturity
• Nominal yield (coupon rate): the interest rate stated on the bond's face value
  • Does not consider the bond's current market price or the time value of money
• Realized yield: the actual return earned by an investor over the holding period of the bond
  • Takes into account the purchase price, sale price, and coupon payments received
• Yield to call (YTC): the return an investor would receive if the bond is called by the issuer before maturity
  • Assumes the bond is redeemed at the call price on the call date

Implications for Investors

• Investors should consider multiple yield measures when evaluating bond investments
  • Each measure provides different insights into the potential returns and risks associated with the bond
  • Current yield and nominal yield offer a simple snapshot of the bond's annual return
  • YTM and YTC provide a more comprehensive assessment of the bond's total return potential
  • Realized yield reflects the actual return earned by the investor based on their specific holding period and transaction prices

Factors Affecting Bond Yields

Economic Factors

• Interest rates are a key factor affecting bond yields
  • When interest rates rise, bond prices fall, and yields increase
  • When interest rates fall, bond prices rise, and yields decrease
• Inflation expectations can impact bond yields
  • Investors demand higher yields to maintain their purchasing power when inflation is expected to rise
• Economic growth and monetary policy decisions by central banks can influence interest rates and bond yields

Bond-Specific Factors

• Credit risk, or the risk of default by the bond issuer, affects bond yields
  • Bonds with higher credit risk typically offer higher yields to compensate investors for the increased risk
  • Credit ratings (AAA, AA, A, BBB, etc.) assess the creditworthiness of bond issuers
• The bond's maturity and duration also affect its yield
  • Longer-term bonds generally offer higher yields than shorter-term bonds
  • Investors require compensation for the increased risk associated with holding the bond for a longer period
• Liquidity risk, or the ease with which a bond can be bought or sold in the market, can impact bond yields
  • Less liquid bonds may offer higher yields to compensate investors for the difficulty in trading the bond

Market Factors

• Supply and demand dynamics in the bond market can influence yields
  • When there is high demand for bonds (e.g., during economic uncertainty), prices rise and yields fall
  • An oversupply of bonds (e.g., when governments or corporations issue large amounts of debt) can lead to falling prices and rising yields
• Geopolitical events, changes in market sentiment, and shifts in investor preferences can also affect bond yields