Abstract
Individuals and business organizations with investment potential or the desire to become investors often find themselves having limited capital to undertake the desired projects. Additionally, most investors are often confused when carrying out analysis to assess the risk of the various portfolio in which they intend to invest their resources. The governments have developmental projects that require more financial resources than their revenue due to budget deficits. Having excess money in the circulation is dangerous to an economy because it results in excess aggregate demand that produces inflationary gaps. As such, the government must regulate money supply to ensure the economic stability of the country. The government uses monetary policies to regulate the economy in the desired way. If the objective is to reduce the money supply, the government through the central monetary authority sells bonds to the public and buys them back when the money supply is low. Private investors and individuals consider the coupon rate or the interest rate to estimate the expected returns on their investments. If the rates are favorable, they opt to lend money to the government by shifting their investments from other business activities such as real estate.
Introduction
A bond is a debt instrument often used by the government to regulate money in the economy. Also, companies use bonds to borrow money for various business activities. Individuals and private institutions buy bonds issued at different prices which yield different returns depending on the coupon rates. Bonds can have fixed coupon or floating rates. The fixed rate bonds are debt instruments that are offered at fixed interest rates. The holders of these bonds get their returns on fixed rates. Fixed rates bonds differ from the floating rates bonds in the sense that the latter is paid on adjustable or variable interest rates (Čerović et al. 54). Investors consider their gains in any investment. As such, they compare the returns on various investment projects when carrying out project evaluation before deciding the best project on which to invest their funds. This paper will discuss the price-yield relationship of a fixed rate bond. The report will illustrate the relationship between price and yields for fixed- rate bonds, discuss the limitations of fixed rate bonds, and the advantages of buying fixed rate bonds over a floating rate in the context of a price-yield relationship. The paper will conclude by making some important deductions from the discussions.
The relationship between the price and yield for a fixed rate bond
A fixed- rate bond pays the interests on a fixed rate throughout the life time of the bond until the expiry of the agreed time or the maturity. The government issues bonds at different amounts and individuals as well as private organizations can buy them depending on their financial ability. Fixed rates bonds are not sensitive to market interest rates and are considered to be less volatile than stocks by most investors (Čerović et al 54). Companies and the government tend to issue bonds whenever they require some financial bailouts. However, the prices at which these bonds are issued differ considerably depending on the prevailing market conditions. A fixed- rate bond is normally issued at a given par value and paid back after the maturity of the stated period. In most cases, bond price and yield have inverse relationships caused by changes in market conditions. The correlation between the price and yield of fixed- rates bonds can be explained by making some assumptions.
Depending on the category of people buying the bonds, the relationship between the price and yield of a fixed rate bonds can be inverse or direct. If the market conditions are assumed to remain constant and the individuals involved in the sale of bonds are mostly high- income earners, the yield will increase proportionally with the price. For example, suppose that a face value $ 2000 bond is issued at a fixed rate of 5% with a maturity of 5 years, the investors who buy this bond will be receiving the amount of interest equal to $ 100 per year until the maturity of the bond at the expiry of the agreed time. Suppose that another bond is issued at a face value of $ 4000 at the same rate, the buyers of this bond will be receiving $ 200 per year. This shows that the yield increases with the price increase. The same scenario can be illustrated under competitive market conditions. Bonds are usually sold in open markets, and they often come at different prices (Barber 83).
Suppose that another company offers the $ 2000 bond at a higher fixed rate of 8%, the yield on this bond will be $ 160 per year. On the other hand, the $ 4000 fixed rate bond at a coupon rate of 8% will yield 320. The yield for the same investment differs depending on the level of competition in the bond market. As such, the companies selling the bonds will engage in price competition where the company will issue low price bonds at higher coupon rates to attract more investors. In this case, the relationship between the price and bond’s yield will be negative since companies will be lowering their prices to attract investors.
The performance of the bond markets is another factor that must be considered when determining the relationship between the price and the yield of a fixed- rate bond. Bonds issued at high prices often have high credit risk where the investors may lose large amounts of investments in an event that the borrowers or the company selling the bonds default in repayment (Boundless n.p). Most investors often have limited funds to invest in bonds and they expect high returns. As such, they will buy the bonds offered at low prices since they cannot afford high –price bonds. For example, if a company issues two types of bonds one at$ 5000 and another one at $ 15000 at a coupon rate of 10%, the majority of investors will opt to buy the $ 5000 bond because they have limited financial abilities and the $ 5000 bond involve low credit risk. Thus, even if the $ 15000 bond has a higher yield, it has low demand. The company will therefore be compelled by the situation to lower the price of this bond by breaking it down into three $ 5000 units which have low yield to make it more sellable. From these observations, it is apparent that the relationship between the price of a fixed -rate bond and its yield can be analyzed under different scenarios, each illustrating different relationship. However, since the bonds are normally traded on open markets, the prices and yield of fixed- rate bonds will have negative relationships.
Advantages or benefits of buying fixed rate bonds and how they affect their price-bond relationship
Hull, Mirela, and Alan (2793) found that fixed rate bonds are viewed by most investors as a safe portfolio because they involve low risk. Unlike the floating rate bonds, the fixed rate bonds often involve low- interest rates risk since their returns do not vary with the interest rates (Hull, Mirela, and Alan 2793). Changes in bonds market frequently occur due to variations in demand for bonds relative to other investments. Individuals make speculations of the changes in interest rates depending on the prevailing rates.
When the interest rates for other investments are higher, companies selling bonds will increase their rates to attract investors. However, if there is high demand for bonds, the interest rates tend to reduce. When this happens, investors who have bought the floating rate bonds tend to suffer financial loss. However, the fixed rate bond owners are not affected by changes in interest rates, and the price-yield relationship may not be affected significantly.
Investors who buy fixed- rate bonds know exactly the returns expected from their investments. Since the coupon rate remains the same throughout the entire period, the buyers of the fixed rate bonds know the exact amount they will receive until the maturity of the bond. Additionally, the holders of fixed- rate bonds can make accurate predictions of the returns to their investments since the fixed rate bonds are insensitive to changes in interest rates in the bond markets. The coupon rates for these bonds are guaranteed and therefore, investors are not exposed to interest rates risk.
Limitations of fixed rates bonds and how their affect price-yield relationship
The fact that fixed rates bonds are issued at fixed coupon rates may be perceived as an advantage to the investors and bond sellers. However, these bonds are likely to lose demand when the floating rates bonds become more profitable in the markets as a result of an increase in interest rates (Boundless n.p). When the interest rates increase, investors will prefer the floating rates bonds to fixed rates ones. As a result, companies dealing with fixed rates bonds will suffer financial loss due to reduced demand for their securities.
When the government or a company that sells bonds default in repaying the interests or the principle as agreed, investors usually suffer credit risk. According to Barber (85), this type of risk normally determines the price that investors will be willing to pay for the issued bonds as well as their desire to buy bonds. Fixed rates bonds are usually offered at higher prices compared to floating rates bonds. As such, they involve high credit risk. High credit risk affects the relationship between the price and the yield of fixed rate bonds by influencing investors’ decisions in relation to these bonds. Investors are less willing to put their money on risky investments. As such, they will be reluctant to buy high-priced bonds due to high credit risk involved.
Conclusion
Bonds are issued by the governments and private companies as a way of borrowing money from the public. They pay interests that investors consider as returns to their investments. The interest rates paid can be fixed or adjustable in nature. The kind of interest rate paid on the bonds and the market conditions determine the marketability of the bonds. Additionally, the level of credit and interest rate risk involved affects the price-yield relationship of bonds significantly. Fixed rate bonds are not responsive to variations in interest rates. Therefore, the returns to investments in these bonds are not affected by market variations in interest rates. The relationship between the price and the yield of fixed- rates bonds can be analyzed under various scenarios that influence the bond market. However, the most stable analysis is the one based on open market conditions where bonds are normally traded. Fixed- rates bonds have various benefits and limitations that tend to affect the relationship between their prices and their yield. Therefore, investors should perform a thorough analysis to determine the type of bond to invest in based on the prevailing market conditions.
Works Cited
Barber, Joel R. "A General Relationship between Prices of Bonds and their Yields." Quarterly Journal of Finance and Accounting (2010): 75-85. Print
Boundless. Disadvantages of bonds. Boundless, 26 May 2016. Web. 18 Aug. 2016. <https://www.boundless.com/finance/textbooks/boundless-finance-textbook/bond-valuation-6/advantages-and-disadvantages-of-bonds-65/disadvantages-of-bonds-297-3888/>.
Čerović, Slobodan, et al. "Duration and convexity of bonds." Singidunum Journal of Applied Sciences 11.1 (2014): 53-66. Web. 18 Aug. 2016.
Hull, John, Mirela Predescu, and Alan White. "The relationship between credit default swap spreads, bond yields, and credit rating announcements."Journal of Banking & Finance 28.11 (2004): 2789-2811. Print
