- Whenever the going rate of interest falls below the coupon rate, a fixed-rate
bond’s price will rise above its par value. Such a bond is called a premium
bond. - Thus, an increase in interest rates will cause the prices of outstanding bond to fall
whereas a decrease in rates will cause bond prices to rise. - The market value of a bond will always approach its par value as its maturity date
approaches, provided the firm does not go bankrupt.
These points are very important, for they show that bondholders may suffer capital losses
or make capital gains, depending on whether interest rates rise or fall after the bond was
purchased.
- Bond Yields
9.1 If you examine a price sheet put out by a bond dealer, you will typically see
information regarding each bond’s maturity date, price, and coupon interest rate.
You will also see the bond’s reported yield. Unlike the coupon interest rate,
which is fixed, the bond’s yield varies form day to day depending on current
market conditions. Moreover, the yield can be calculated in three different ways,
and three “answers” can be obtained. These different yields are described in the
following sections.
- Yield to Maturity
10.1 The interest rate generally discussed by investors when they talk about rates of
return. The yield to maturity is generally the same as the market rate of interest.
10.2 The yield to maturity can also be viewed as the bond’s promised rate of return,
which is the return that investors will receive if all the promised payments are
made. However, the yield to maturity equals the expected rate of return only if
(1) the probability or default is zero and (2) the bond cannot be called. If there is
some default risk, or if the bond may be called, then the4re is some probability
that the promised payments to maturity will be called, then there is some
probability that the promised payments to maturity will not be received in which
case the calculated yield to maturity will differ from the expected return.
10.3 The YTM for a bond that sells at par consists entirely of an interest yield, but if
the bond sells at a price other than its par value, the YTM will consist of the
interest yield plus a positive or negative capital gains yield. Note also that a
bond’s yield to maturity changes whenever interest rates in the economy change,
and this is almost daily. One who purchases a bond and holds it until it matures
will receive the YTM that existed on the purchase date, but the bond’s calculated
YTM will change frequently between the purchase date and the maturity date.