Question

1.Differentiate between the coupon yield, the current yield, and the yield to maturity of a bond. Why do we have three different measures of bond yields -- what are the pros and cons of each?

2. What are the risks of investing in bonds? How can each type of risk be measured and managed?

150 words per question please (:

Answer 1

1. Coupon Yield is the annual coupon payment received as cash in the hands of the investor.It is the fixed percentage on the Face value of the bond ,through-out the tenure of the bond.The % is stated on the Face of the bond.Formula is ---Coupon Yield= $ Annual coupon Amount/Face value of the Bond

Current yield is the same above coupon payment expressed as % of the current market price of the bond. Formula forCurrent Yield = Annual interest payment / Current Bond Price.

Yield to maturity (YTM) is the estimated rate of return assumed the bond is going to be held by the investor till maturity date .

Coupon yield helps us to know the actual cash flow that can be expected from investing in the bond.

But may not tell us the exact return for purposes of comparison & choosing over other investments.

Current yield gives the exact current return on the bond

But that is likely to fluctuate with the market& subject to market risks.

YTM is the most accurate return figure as it is based on the effective interest rate to the investor.

But, it assumes the bond is going to be held till maturity & also may not be called by the issuer.

Risks of investing in bonds

1. Interest rate risk

The foremost risk of investing in bonds is the interest rate risks.ie. when interest rates rise, price of the bond tend to fall. Vice -versa happens when interest rates fall--bond prices rise. When the bond needs to be sold in teh market, this risk affects the outcome of the sale,ie. the investor may end up in loss.

3. Market risk

This is for the entire bond market . When there is general bust scenario in the market,price of the bonds fall .This risk affects all the investors irrespective of the type of bonds , they hold.

2. Inflation risk

The longer a bond is held, thegreater the risk due to inflation -ie. the returns from the bond are made to look negative as the inflation rate increases,ie. value of money ,in real terms decreases as inflation increases.And when we get the principal back on maturity ,it is worth less in current day $.

4. Credit risk

Credit risk is also called the default risk --as this is risk lying round the corner, about the issuing company ,defaulting on interest & principal payments to the investor.This happens with a financially unsound issuer.

All the above can be managed by a cautious investor who can resort to any of the following measures.

1. Diversification

BThe investor can choose a mix/portfolio of bonds with different ratings from different sectors like government, corporations & also some strips or real return bonds.The investors' financial risk-taking tolerance   & also his knowledge about the bond-market & its trends ,play an important role here.

2.Bond laddering

The investor can choose bonds that mature at different time-periods, so that all is not lost when interest rates are down & low .Also, he can immediately reinvest one by one , at a normal pace ,rather than investing in a hurry & as one lump-sum.