When credit risk is absent (no chance of default), the value of that stream of future inflow of money, is just a function of the required return based on prevailing inflation. You don’t have to worry if this statement seems confusing. This article offers detailed information and breaks down bond pricing, right from definition to demonstrating how inflation and interest rates determine the value of bond.
Measures of Risk
There are only two major risks that must be thoroughly assessed by investors planning to invest in bonds. They are interest rate risk and credit risk. Although our focus must be on how interest rates affect bond pricing, the bond investors must also have information on credit risk.
Interest rate risk is the risk involved with the changes in pricing of a bond, due to fluctuations in the prevailing interest rates. Fluctuations in the short term vs long term interest rates can have effects on various bonds in multiple ways.
Credit risk is a risk of whether or not the bond issuer pays out interest and principal as scheduled. The possibility of credit default affects the pricing of bond, higher the risk of a negative credit, higher would be the interest demanded by the bond investors to assume that risk.
The treasury department of USA issues bonds to raise funds for the operations of the US Government. US treasury bonds are one of the World’s most trusted and sought after bonds. US treasury bonds are classified into bills, notes and bonds depending on the maturity.
Bond Market in India after the liberalization in the 1990s has been transformed completely. The bond market in India is diversified and is a major contributor to the economy. The bond market has potential to raise funds to support the infrastructural development activities of the government and expansion and growth of companies.
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There are two major factors that impact pricing of the bond:
The time to maturity of bonds change daily and it reduces when inching towards the maturity date. To know the value of the bond, you must measure the distance of each cash flow towards the maturity date. This means that the value of the bond changes with fluctuations in tenure, regardless of other factors being constant.
The rate of discounting of a bond is the bond yield and determined by the market forces. Value of the bond is never an arbitrary rate. The rates of bond rely on market rate for bond tenure and the quality of credit. The discounting rate is never static. It fluctuates on the basis of time left to maturity (residual tenor) and the bond’s credit quality.
Bond yield is the annual return on investment. It depends on the buying price of the bond and the coupon payment which is the interest promised by the bond issuer.
Bond pricing and interest are inversely proportional. This means when a bond price falls, interest rises and vice versa.
SEE ALSO: Bond Yield in India
Yield of bonds = Coupon amount / Bond Price * 100
A bond has face value of Rs 1,000 and the investor can earn 6%. This coupon rate is 6% and the investor who purchases the bond and holds it till maturity earns Rs 60 each year across the bond tenure.
Consider the price of the bond drops to Rs 980. The current yield of the bond is obtained by dividing Rs 60 by Rs 980, which turns out to be 6.12%.
If the bond price rises to Rs 1,030 then the current yield of the bond is 60/1030 = 5.82%.
If the price of the bond rises, then the yield decreases. As the price of the bond falls, the yield increases.
Current yield is calculated by taking the ratio of bonds coupon rate to purchase price. For example: if the bonds coupon rate is 6% on face value of Rs 1,000 then the current yield is Rs 60 / Rs 1,000 = 6%.
What if you purchase the bond at a discount to face value? If you purchase the bond at a discount to face value of Rs 900, then the current yield is:
Rs 60 / Rs 900 = 6.67%.
A bond yield to maturity, YTM, reflects interest payments from the time of purchase till maturity. This includes even interest on interest.
Understanding YTM with an example:
Par value of bond = Rs 1,000.
Coupon rate = 10%
Years to maturity = 10 years.
Market Price = Rs 920.
Annual Interest = Par value of bond * Coupon rate = Rs 1,000 *10% = Rs 100.
YTM = 100 + (1000 – 920) / 10 / 1000 + 920 / 2
YTM = 11.25%.
The term of a bond considerably affects the bond yield. To understand this, you must first understand the yield curve. The yield curve represents the yield to maturity of a class of bonds. In most interest rate environments, the bonds with longer terms yield higher returns.
Inflation is a factor that affects bonds the most. Inflation reduces the ability of a bond's future cash flows. In simple words, yields are directly proportional to the current inflation rate and expected inflation rates in the future. This is because investors would demand higher yield to counter the risk of inflation.
The current inflation rate as well as the expected inflation rate is a function of the dynamics between the short term and the long term rates of interest. Globally, the short term interest rates are governed by the country’s reserve bank. In the United States, the Federal Reserve's Federal Open Market Committee (FOMC) sets the federal funds rate. In India, the RBI sets the bond interest rates. Traditionally, other dollar-denominated short term interest, like LIBOR, has high correlation with the fed funds rate.
Timing of a bond's cash flows is an important factor for consideration. This covers the term to maturity of a bond. If market participants feel there is higher inflation, then interest rates and bond yields would rise and prices will reduce to compensate for the loss of the purchase power of future cash flows. A bond with a longer cash flow would see their yields rise and prices collapse the most.
SEE ALSO: Invest in Bonds and Debentures
Interest rates, bond yield and inflation expectations correlate to each other. Changes in short term interest rates, as directed by a country’ central bank, would impact various bonds of different maturities in a different way, depending on the market expectations of future inflation rates.
For example, a fluctuation in short-term interest rates that does not affect long-term interest rates would have negligible impact on the pricing and yields of a long term bond. However, a fluctuation in short term rates that affects long term rates can considerably cause an effect on the pricing and yields of long term bonds.
In simple words, movements in short-term interest rates show greater effects on short term bonds than long term bonds, and movements in long term interest rates have an effect on long term bonds, but don’t have an impact on short term bonds.
The key to understand how a movement in interest rates affects a certain bond's price and yield is to realize where on the yield curve that bond lies and to know the dynamics between short and long term interest rates.
With this information, you can utilize various measures of tenure and convexity to become a smart bond market investor.
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