Plain Vanilla Definition
As with any asset valuation, the investor would be willing to pay, at the most, the present value of the future income stream discounted at the required rate of return or yield. Thus, the value of the bond can be determined as follows: Thus, there is an inverse relationship between the yield of a bond and its price or value.
The higher rate of return or yield required, the lower the price of the bond, and vice versa. However, it should be noted that this relationship is not linear, but convex to the origin. The plain vanilla bond with annual coupon payments in the above example is the simpler type of bond. Yield to maturity YTM also known as the [Gross] Redemption Yield GRY If the current price of a bond is given, together with details of coupons and redemption date, then this information can be used to compute the required rate of return or yield to maturity of the bond.
Estimate its yield required rate of return. The internal rate of return approach can be used to obtain r.
Advanced Bond Concepts: Bond Type Specifics
The YTM is the rate of return at which the sum of the present values of all future income streams of the bond interest coupons and redemption amount is equal to the current bond price. It is the average annual rate of return the bond investors expect to receive from the bond till its redemption. YTMs for bonds are normally quoted in the financial press, based on the closing price of the bond. For example, a yield often quoted in the financial press is the bid yield. The bid yield is the YTM for the current bid price the price at which bonds can be purchased of a bond.
Term structure of interest rates and the yield curve The yield to maturity is calculated implicitly based on the current market price, the term to maturity of the bond and amount and frequency of coupon payments. The required yield is based on the term structure of interest rates and this needs to be discussed before considering how the price of a bond may be determined.
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It is incorrect to assume that bonds of the same risk class, which are redeemed on different dates, would have the same required rate of return or yield. In fact, it is evident that the markets demand different annual returns or yields on bonds with differing lengths of time before their redemption or maturity , even where the bonds are of the same risk class.
This is known as the term structure of interest rates and is represented by the spot yield curve or simply the yield curve. In this case, the term structure of interest rates is represented by an upward sloping yield curve. The normal expectation would be of an upward sloping yield curve on the basis that bonds with a longer period of maturity would require a higher interest rate as compensation for risk. Note here that the bonds considered may be of the same risk class but the longer time period to maturity still adds to higher uncertainty.
Plain Vanilla Definition
However, it is entirely normal for yield curves to be of many different shapes dependent on the perceptions of the markets on how interest rates may change in the future. Three main theories have been advanced to explain the term structure of interest rates or the yield curve: Although it is beyond the remit of this article to explain these theories, many textbooks on investments and financial management cover these in detail.
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Valuing bonds based on the yield curve Annual spot yield curves are often published by the financial press or by central banks for example, the Bank of England regularly publishes UK government bond yield curves on its website. Both corporate investment grade and high yield bonds come in different varieties: Split-coupon issues in which the interest rate increases in later years are also called step-up notes.
Pay-in-kind PIK bonds allow the issuer the option of paying the bondholder interest either in cash or in additional securities. Floating-rate and increasing-rate notes IRNs pay fluctuating or adjusted rates of interest based on an interest rate benchmark or a schedule of payments. Deferred-interest bonds pay no interest to the bondholder until a future date. Convertible bonds may be converted into another security under stated terms. Multi-tranche bonds offer bondholders several tiers of investments within the same issue.
Typically, the tiers may vary in their targeted maturities and credit quality.
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