What are the differences between the bond’s couponrate, current yield, and yield to maturity?A bond is a long-term debt of a government or corporation.When you own a bond, you receive a fixed interestpayment each year until the bond matures. This paymentis known as the coupon. The coupon rate is the annualcoupon payment expressed as a fraction of the bond’s facevalue. At maturity the bond’s face value is repaid. InCanada most bonds have a face value of $1,000. Thecurrent yield is the annual coupon payment expressed asa fraction of the bond’s price. The yield to maturitymeasures the average rate of return to an investor whopurchases the bond and holds it until maturity, accountingfor coupon income as well as the difference betweenpurchase price and face value.
How can one find the market price of a bond given itsyield to maturity and find a bond’s yield given itsprice? Why do prices and yields vary inversely?Bonds are valued by discounting the coupon payments andthe final repayment by the yield to maturity on comparablebonds. The bond payments discounted at the bond’s yield tomaturity equal the bond price. You may also start with thebond price and ask what interest rate the bond offers. Thisinterest rate that equates the present value of bond paymentsto the bond price is the yield to maturity. Because presentvalues are lower when discount rates are higher, price andyield to maturity vary inversely.
Why do interest rates change over time?The general level of interest rates varies over time withchanges in the real rate of interest and expected inflation.The Fisher effect says that the nominal interest rateequals the real rate of interest plus expected inflation.
What determines the difference between yields onlong-term and short-term bonds?The yield curve is a snapshot of yields on bonds of differentmaturities at a point in time. Typically, it is upwardsloping but can also be downward sloping or humped.According to the expectations theory, bonds are priced sothat the expected return over any period is independent ofthe maturity of the bonds held. Consequently, a higheryield on a longer-term bond implies that investors expectfuture short-term interest rates to rise. However, theexpectations theory ignores interest rate risk, whicharises from the fact that bond prices rise when marketinterests fall, and fall when market rates rise. Long-termbonds exhibit greater interest rate risk than short-termbonds. According to the liquidity-preference theory, longtermbonds earn extra return to compensate for interestrate risk, resulting in higher yields on long-term bondsand a tendency for the yield curve to be upward sloping.
Why do investors pay attention to bond ratings anddemand a higher interest rate for bonds with lowratings?Investors demand higher promised yields if there is a highprobability that the borrower will run into trouble anddefault. Credit risk implies that the promised yield tomaturity on the bond is higher than the expected yield.The additional yield investors require for bearing creditrisk is called the default premium. Bond ratings measurethe bond’s credit risk.
