On what factors the bond’s coupon rate, current yield, and yield to maturity differ from each other?
A bond can be explained as a long-term debt of a government or corporation. When you own a bond, you receive a fixed interest payment each year until the bond matures. This payment is known as the coupon. On the other hand, coupon rate is the annual payment of coupon justified as a fraction of face value of the bond. At maturity the bond’s face value is repaid. The current yield is the annual coupon payment expressed as a fraction of the bond’s price. Riddhi Siddhi Multi Service explains the yield to maturity measures the average rate of return to an investor who purchases the bond and holds it until maturity, accounting for coupon income as well as the difference between purchase price and face value.

How to determine the market price of a bond provided with its yield to maturity and find a bond’s yield provided with its price? Why do prices and yields vary inversely?

Bonds are valued by discounting the coupon payments and the final repayment by the yield to maturity on comparable bonds. The payment by bonds discounted at the bond’s yield to maturity is equal the price of bond. You may also start with the bond price and ask what interest rate the bond offers. This rate of interest that equalizes the present value of bond payments to the bond price is termed as the yield to maturity. In case of lower present values when discount rates are higher, price and yield to maturity vary inversely.

Why do bonds exhibit interest rate risk?

Bond prices are subjected to rate of interest risk depending on market conditions as the rise when market interest rates fall and falls when market rates rise. Long-term bonds exhibit greater interest rate risk than short-term bonds.

Why do investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings?

Riddhi Siddhi Multi Service experts understand that investors demand higher promised yields if there is a high probability that the borrower will run into trouble and default. Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. Default premium can be termed as the additional yield investors require for bearing credit risk. Bond ratings measure the bond’s credit risk.

CURRENT YIELD

Annual coupon payments divided by bond price. Because it focuses only on current income and ignores prospective price increases or decreases, the current yield mis-measures the bond’s total rate of return. It gives an overstate approach to the premium bonds returns and understates towards the discount bonds.


YIELD TO MATURITY

Interest rate for which the present value of the bond’s payments equals the price. The yield to maturity is defined as the discount rate that makes the present value of the bond’s payments equal to its price.

Riddhi Siddhi Multi Services conclude that when the market interest rate exceeds the coupon rate, bonds sell for less than face value. When the market interest rate is below the coupon rate, bonds sell for more than face value.