This paper provides a concise overview of key fixed-income concepts relevant to bond investing. It defines zero coupon bonds and explains how their returns are derived from the discount to par value. The paper distinguishes among coupon yield, current yield, yield to maturity, and yield to call, illustrating each with a practical numerical example. It then examines how changes in expected inflation affect interest rates, bond prices, and the shape of the yield curve, including the phenomenon of yield curve inversion as a recession predictor. Finally, the paper explains bond duration as a measure of interest rate sensitivity and its importance in portfolio risk management.
A zero coupon bond is one in which there is no interest component. The bond only pays when the principal is returned to the holder. The price of the bond is therefore lower than its par value. The returns on zero coupon bonds are calculated on the basis of the differential between the purchase price of the bond and its maturity value.
The current yield is defined as the annual cash flows divided by the current market price of the bond (Investopedia, 2009). The relevance of current yield is that it measures the value of the bond if the investor holds it for one year. The total yield of the investment would depend, however, on the selling price. By contrast, the coupon yield is the value of the cash flow divided by the par value, reflecting the return on the investment if it was purchased at par.
Yield to maturity is the value of the bond's cash flows — both interest and principal repayment — based on the current purchase price of the bond. Yield to call is a concept that applies to callable bonds, whereby the yield is calculated on the basis of the expected cash flows until the call date, rather than the maturity date, divided by the current price of the bond.
For the bond in question, the coupon yield would be 7%. The current yield, however, would be 4.2%, reflecting the higher price of the bond. The yield to maturity would also be 4.2%, but the yield to call would be based on a two-year time frame. The yield to call would therefore be based on two interest payments of 70 each, assuming that the price received is the par value, giving a yield to call of 2.2%.
The call value would determine the actual yield to call, but in this example that figure is not known. The call value is typically set at a premium. The difference between yield to maturity and yield to call in this example illustrates why such a premium is needed in order to attract investors to callable bonds.
When the expected rate of inflation changes, expectations for future interest rates also change. An increase in inflation will bring an increase in interest rates, all else being equal, causing bond prices to fall. If the expected rate of inflation drops, bond prices will increase in anticipation of a potential interest rate cut. The intensity of the price change will depend on the maturity of the bond. Part of the bond's price is determined by its time value, which reflects the risk of an adverse change in interest rates. Longer-maturity bonds carry greater interest rate risk and are therefore subject to more intense price changes when inflation expectations shift.
One outcome of these dynamics is a change in the yield curve. If inflation is expected to drop, bond prices will increase and yields will fall. Because the long end of the curve reacts more sharply to such changes, long-term yields could fall below short-term yields. This is known as an inverted yield curve. It is considered a predictor of recession because a rapid decline in interest rates is correlated with a decrease in economic activity.
"Duration as a measure of interest rate sensitivity"
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