Term Structure of Interest Rates and its Relationship to Bonds

Question: Discuss about the Term Structure of Interest Rates and its Relationship to Bonds. Answer: Introduction: A bond is referred to as a debt investment that investors use as a financial instrument to earn a fixed or variable interest for a defined period of time. An article by Gary Porter and Curtis Norton (2010) describes a bond as a security or a financial instruments that allow firms to borrow money and repay over a long period of time. McGraw Hill (2015), defines a bond as interest only loan. To understand the bond market it is essential to comprehend the terminologies used in bond market, bond prices and interest rates, effects of demand and supply on bond prices and the risks inherent the bond market. Zero coupon bond, fixed payment loan, coupon bond and consol are the common types of bonds. Zero Coupon Bond According to the street (2017), Zero Coupon Bonds are discounted bonds that accrue zero coupons. Take a bond that has a face value of $100 with an interest rate of 10% for five years the investor will buy the bond at discounted rate of $62.09. The discounted price represents the interests that compounded automatically until bond matures. The price of zero coupon bond is calculated as the present value of the bond. The value of the bond is inversely related to the interest rate, when the value of bonds decreases the interest rate of the bonds increases. A $100 bond of 10% yield and coupon of 10% would be at a lower price of $49.72 if the interest rates would increase to 15%. Fixed - payment Mortgages Fixed rate mortgages are amortized loans that borrowers pay a fixed amounts at specified dates as agreed in the contract. The value of the mortgage is equal to the present value of fixed payments. Assuming an investor borrows $100 for 5 years at a monthly fixed rate of 10%, the investor will be required to pay $2.12 yielding the lender a total interest of $27.48. The other types of mortgage is adjustable rate mortgage where the payments are dependent on changes in interest rates. Coupon Bonds Bonds that investors are promised a series of periodic interest payments determined by a coupon rate and the face value at the end of the bond tenure are referred to as Coupon Bonds. According to Lee. M. Dunham PhD, (2014), coupon rates is used because historically coupons were printed on coupons. A coupon bond with an annual coupon rate of 10% and a yield 8% for a period of 5 years has a bond value of $107.99. Consols According to the American heritage dictionary of the English language (2011), a consol also known as a bank annuity is a government bond which pays perpetual interest with no maturity. The price of the console is usually the present value of interest received. Bond Yields Bond yields is the amount of return an investor realizes on a bond (Investopedia, 2017). It is usually considered as the cost of borrowing or the reward of lending. There are various ways of determining the bond yields depending on the investors preferences of investment; based on the tenure of the bond (yield to maturity), coupon payments (current yields), trading of bonds (holding period returns). Yield to maturity is the return that bond holders receive as a reward of holding the bond to its maturity (principal payback period). The price and yield of bonds have inverse relationship. When the yields of the bonds go up then, the value of the bond goes down. This rise in value of bonds is referred to as a capital gain and the fall of value is referred to as capital loss. The current yield is defined as the returns that bond holders receive mainly related to coupon payment. It is usually calculated as the annual coupon paid divided by the purchasing price. Where the price of the bond is at a discounted price to the value of the bond then the current yield becomes higher than the yield to maturity. Assume an investor purchases a bond of $100 at 10% coupon rate and maturity yield of 15%. The value of the bond is $83.24. When the bond is sold at a lower price than the value of the bond say $60 then the current yield of the bond will be 24.82%. If the bond is sold at a higher price t han its value say $115, then the current yield will be 6.4%. If the bond is sold at the value of the bond then the current yield will be equal to the yield of maturity. Bond Supply, Demand and Equilibrium Supply and demand determine the prices and returns (yields) of bonds. The relationship between the quantity the market is willing to sell versus the price forms the bond supply curve. The supply curve states that the price of a bond and quantity supplied are positively correlated. The demand and supply of bonds are also in tandem to the type of buyer. As for investors they would prefer higher prices to sell whereas corporates issuing the bonds view the high prices as an advantage in getting finances or loans. The relationship between the quantity the market is willing to buy versus the price forms the bond demand curve. Investors will be willing to buy bonds when the yields are high so that they can enjoy from the discounted prices of bonds. In economics equilibrium, is when the market demand is equal to the supply. The bonds demand and supply play along the equilibrium in that when there is excess demand the prices of the bond are pushed up and when the supply becomes excess then the investors push the prices down. The shifting in bond market supply is mainly related to changes in government borrowing, where when the government borrows excessively then the bonds quantity increases shifting the curve right. Changes in general business and anticipated increase in inflation also creates influx in the supply of bonds causing a shift of the supply curve to the right. The shifting in bond market demand is attributed to wealth, anticipated fall in inflation, increase in expected returns, reduced risk in bond markets and liquidity preferences. Risk Management in Bonds Bonds are termed risk primarily due to default risk, inflation and volatility in interest rates. As for default risk, securitization has been used as a risk mitigant. Noel Ransom (2013), defines securitization as the process of turning assets into securities. Examples have been seen in mortgages where investors channel proceeds of rent instead of payment of coupons. Government institutions use inflation indexed bonds as a reward of this risk to investors. Inflation and interest rate affect bonds interchangeably. Interest-rate risk arises from uncertainties of holding a long-term bond. The riskiness of bonds created inventions of bond ratings with the likes of Moodys and Standard Poors who monitor the credit worthiness of bond issuers and assess the default rate of bondholders. Bond holders who are risky are rated higher. Bonds can be categorized in accordance to their riskiness. Investment-grade bonds are commonly government bonds whose credit worthiness is almost a 100% guaranteed. Speculative grade bonds are bonds issued by companies and countries that are stake of non-immediate default risk. The other types of bonds are the highly speculative bonds which include loans that have high risk of default and Junk bonds that are high speculative grade bonds. Other risky bonds are subprime mortgages and commercial papers. Investors who are risk tolerant (have high risk appetite) require rewards for accepting those risks, they demand discounted prices in bonds and hence high yields. Taxes are generally an unintentional fee imposed on people and institutions that is enforced by a government entity (Investopedia, 2017). Cash flows from bonds are also taxed by the government. This propagates investors to base their decisions on the after-tax yield. For example, an investor who buys a $100 bond whose yield is 6% and a taxable rate of 30% considers the yield of a bond to be 4.2% after tax. Interest rates terms structure is a major concern to bond investors. The relationship between bonds with similar features but dissimilar maturities is called the interest rate term structure (Geneva Business School, 2017). Bond yields of different maturities have positive correlations. Research has also proven that yields of short term bonds are riskier than long term bonds and the return of long term bonds is usually higher than short term bonds. According to Creswell, J. W. (2003), the most common theories of interest rate term structure are expectation hypothesis, liquidity preference and information on interest rates theory. As for expectation theory, investors are seen to be indifferent in holding bonds with different maturities. The theory purports the research that have been done on bonds yields apart from the yield on long term bonds is usually higher bonds with lower tenure which is catered for by the liquidity premium theory. Information on the other hand is seen to be a ri sk indicator of bonds. References Consol. (n.d) (2011), American Heritage Dictionary of the English Language, Fifth Edition. Creswell, J. W. (2003). Research design: Qualitative, quantitative, and mixed method approaches, 421 -429. Gary P and Curtis N (2010), Financial Accounting: The Impact on Decision Makers, 482, Cengage learning Centre. Geneva Business School (2017), Bonds, Bond Prices and the Determination of Interest rates, 4-9 Investopedia (2013), Bond Yields, Retrieved, from https:// https://www.investopedia.com/terms/b/bond-yield.asp. Investopedia (2017), Retrieved from https://www.investopedia.com/terms/t/taxes.asp#ixzz4WfiId2cK. Lee. M. Dunham PhD, (2014), Debt Securities, 2, Claritas Investment Certficate. McGraw Hill (2015), Interest Rates and Bond Valuation. Retrieved from https:// www.mcgrawhill.ca/college/ross McGraw-Hill (2015), New York, NY, 28, Thousand Oaks. USA Nowel R (2013), Securitization: Definition, Theory Process, 2, study Street (2017), what is a Zero coupon bond? Retrieved from https://www.thestreet.com/topic/47362/zero-coupon-bond.html.