The Sterling Bonds and Fixed Income Handbook. Mark Glowrey

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      Note – in the equity markets spread refers to the bid-offer spread – the difference between the buying and selling price. This is also true for the bond market, although the term is more usually employed to describe the incremental yield of a corporate bond when compared to a gilt of equivalent maturity or other benchmark interest rate.

      Chapter 5:What happens if interest rates move?

      Investors will generally buy a bond for two reasons. The first is to lock-in a known future income stream. The second is to attempt to benefit from rising bond prices. But what would cause the value of a bond to rise?

      As with all traded assets, it will be down to our old friends, supply and demand. There are two main variables affecting the price of bonds

      We’ll consider the effect of the former on bond prices in this chapter, and we’ll look at credit quality in the next chapter.

      As interest rates fall, a bond paying a fixed rate of interest every year will become increasingly sought after by investors and therefore the price of the bond will rise. Conversely, rising interest rates, perhaps accompanied by inflation, will make the fixed income stream unattractive to investors and the market price of the bond will fall. This relationship between price and yield is the key to understanding the factors moving the fixed income markets.

      Price & yield

      The key to understanding the return on all fixed income instruments is to view a bond as a series of discounted cashflows. Understanding discounted cashflows is the key to all investment analysis. The core concept is the current value of a future sum of money, after allowing for interest, capital growth and/or inflation.

      With equities, these future cashflows are unknown, but the accurate calculations can be performed for bonds. Consider that at the start of the investment, the investor pays out cash to purchase the bond. Over the course of the bond’s life, the investor will then receive several payments, usually one or two a year from interest payments, known as coupons, and a final repayment at the end of the bond’s life-span, known as redemption.

      Given that the future cashflows are known quantities, the relationship between the price of a bond and the yield received by an investor is governed by mathematical formulae. We are going to look at three methods of analysing a bond’s yield:

      1. Income (or running) yield

      Let’s take an example of a gilt, the UK Treasury 5% 2014. This bond pays a 5% coupon (divided into two semi-annual payment) and matures on the 7th September 2014. Thus, if we were able to buy the bond at the face value of 100% (or par), we know that we would receive an income 5% per annum on our investment until maturity.

      But what would happen if we paid less than par for the bond? Let us assume that we purchase the bond for 95% of face value. Our income (or running) yield would be:

      par/purchase price * coupon = running yield

      Or

      100/95 * 5% = 5.26% per annum

      In this example, the UK Treasury 5% 2014 is trading at a price of 110. This premium to par has the effect of reducing the bond’s income yield as follows:

      100/110 * 5 = 4.5% per annum

      The income or running yield (sometimes also known as the flat yield or current yield) does not take into account any profit or loss made by holding the bond to redemption, and simply assumes that the investor will be able to sell the bond at the same price that he or she purchased it for.

      For a more accurate measure of yield, we must turn to the yield to maturity – the standard calculation employed by market professionals (also sometimes known as the redemption yield).

      Before we turn to the more complex yield to maturity, it is worth considering the simple yield. This is a good rough guide to the return available on a bond, and can often be worked out in one’s head.

      2. Simple yield

      Let us take a theoretical bond with one year left to run until redemption. The bond has a 4% coupon and we have purchased it in the market for 97%. Our return will consist of two factors, the running yield over the 12-month period and the profit made on maturity. Let us assume that we invest £1,000. Thus, for our initial investment of £970, we will receive the following:

      Our return over the twelve month period is £70 on £970, or 7.2%. From the point of view of many investors, this type of calculation is perfectly adequate for assessing the return on a bond. Known as the simple yield, the formula can be expressed as follows:

      simple yield = running yield + (annualised) profit on redemption

      = (coupon/bond price) + (100 – bond price)/(bond price x years to redemption)

      or, expressed mathematically:

      simple yield = (C/P) + ((100-P)/P x t))

      where,