4. Price & Yield
When the price goes up, the yield goes down
A corporate bond is usually issued at a price of 100 and the price is stated as a percentage of the par value. The market price of the bond goes up or down primarily when the company’s credit risk changes but also when the market’s risk appetite changes.
A bond is traded in the secondary market at its “clean” price. This is the price of the bond excluding accrued interest (interest that has not yet been paid). Accrued interest is added as an additional cost to the buyer during the transaction. It is compensation to the seller for the period during which the seller has not received a coupon but has been the owner of the bond. The buyer then recoups the extra cost at the next coupon payment when a coupon is paid for the whole period.
A bond’s “dirty” price is the bond’s clean price plus accrued interest. The dirty price takes into account the entire value of the bond and is used to value a portfolio of bonds, for example. It is important to know the dirty price when buying bonds on the secondary market because it reflects the entire purchase price.
Yield is the return on the bond if it is held to maturity. At the time of issue the yield is equal to the coupon of the bond, but as soon as the bond starts trading on the secondary market, the yield changes as the bond price rises or falls.
More specifically, the yield is the bond’s internal rate of return – i.e. the discount rate at which the present value of the bond corresponds to the market value of the bond. Yield can also be described as the market’s required return on a corporate bond.
The yield changes with the market’s risk appetite and with fundamental variables. If the issuer is doing well, the market’s required return decreases; i.e. the yield decreases and the price increases. A bond’s yield is only the same as its coupon when the price is 100. If the price is higher than 100, the yield is lower than the coupon and vice versa.
There are three yield measures that are often used. Investors use more than one yield measure because bonds often have call options. A call option changes the bond’s lifespan and the price to redeem the bond. The formula for the yield measure remains the same; what do change are the number of future coupons and the price paid to redeem the bond, which is often a couple of percentage points above 100 (the normal price on maturity).
YIELD TO MATURITY (YTM)
Yield to maturity is the most commonly used yield measure. It is the return on the bond up to maturity.
YIELD TO CALL (YTC)
Yield to call is the return on the bond up to the call date. It becomes the bond’s return if the issuer chooses to redeem or “call” the bond. As an investor it is important to evaluate the probability of the bond being called. The call option has a value for the issuer and changes the bond’s return potential (see graph below). If the issuer performs very well, the bond price would go up a lot but the bondholder would miss out on the value if the issuer chose to call the bond at a predetermined price.
If the price of the bond exceeds 100, there is a greater probability of the bond being called. The issuer can then lower its borrowing costs by calling the old bond and issuing a new bond with a lower coupon. The figure above to the right shows that a bond with a call option has both a yield to maturity and a yield to call.
YIELD TO WORST (YTW)
Yield to worst is the lower of yield to call and yield to maturity. It is a conservative yield measure and is often used to stop a bond’s return potential being overestimated.
An issuer with more than one bond has a yield curve. The curve usually slopes upward; i.e. the yield (return) is higher for longer bonds from the same issuer (see graph below). A shorter bond is considered to be a lower risk than a longer bond, which means the yield is lower. Investment-grade companies usually have more positively sloped curves than high-yield companies. The main reason for this is that the refinancing risk is lower for companies with higher credit ratings.
If the yield curve slopes upwards there is a roll-down effect. This means that the yield falls (the price rises) as the time to maturity becomes shorter. This is a valuable effect for investors, who receive a price increase on the bond simply because time is passing. However, the roll-down effect does not exist for all issuers; it is more apparent for issuers with a strong balance sheet and a high percentage of liquid assets.
Credit spread is the extra yield that the bond gives over the government base rate. It is used to compare corporate bonds with each other. Different maturities and currencies can complicate a comparison, but the credit spread isolates the extra yield generated by the corporate bond. More specifically, the credit spread is the difference between the corporate bond’s yield and the underlying government base rate that corresponds to the maturity of the bond.
As with yield, the credit spread is usually higher for a longer bond. The company’s creditworthiness is the single most important factor in the size of the credit spread.
Sometimes the credit spread is calculated in relation to the swap rate instead of the government base rate. The swap rate is the interest rate that the banking system lends at, known as the interbank rate. In Sweden it is called Stibor, in Norway Nibor and in the eurozone Euribor. In most cases, the difference between the swap rate and the government base rate is not large enough to have a major impact on the credit spread of high-yield bonds.
As an economy strengthens, the corporate bond’s credit spread usually falls while government base rates rise. These two factors eliminate each other to some extent and dampen fluctuations in the bond’s price. A lower credit spread causes the price to rise and a higher government base rate causes the price to fall, and vice versa. This attractive feature results in a more stable investment for investors.
COMPARISON CREDIT SPREAD
The upper graph shows the credit spreads for US high yield and Euro high yield in 2014- 2018, and the largest credit spreads in the graph are related to the collapse in the price of oil. The lower graph shows the spread (difference) between the two credit spreads. We can see that on average the credit spread for US high yield was approximately 75 basis points larger than for Euro high yield over the period. Had we compared the yields in the same markets, the difference would have been even greater, because the US government base rate was higher than that in the eurozone for the period. The higher spread for US high yield can mainly be explained by different sectoral splits, longer maturities and the fact that issuers on the European high-yield market have a slightly higher credit rating on average.
BEAR IN MIND
När konjunkturen stärks brukar företagsobligationens kreditspread falla samtidigt som statsräntorna stiger. Dessa två faktorer tar till viss del ut varandra och har en reducerande effekt på obligationens prissvängningar. Den lägre kreditspreaden får priset att gå upp och den högre statsräntan får priset att gå ner och vice versa. Denna attraktiva egenskap ger investeraren en stabilare investering.