The higher the yield to maturity, the less susceptible a bond is to interest rate risk. There are other risks, besides interest rate risk, that can increase yield to maturity: the risk of default or the risk of a bond getting called before maturity.
Interest rates and bond prices have an inverse relationship in which prices decrease when interest rates increase, and vice versa. Therefore, when interest rates change, the yield curve will shift, representing a risk, known as the yield curve risk, to a bond investor.
Maturity can also affect interest rate risk. The longer the bond's maturity, the greater the risk that the bond's value could be impacted by changing interest rates prior to maturity, which may have a negative effect on the price of the bond.
The Risk Free Rate (rf) is the theoretical rate of return received on zero-risk assets, which serves as the minimum return required on riskier investments. The risk-free rate should reflect the yield to maturity (YTM) on default-free government bonds of equivalent maturity as the duration of the projected cash flows.
The relationship between the current YTM and interest rate risk is inversely proportional, which means the higher the YTM, the less sensitive the bond prices are to interest rate changes. The most noteworthy drawback to the yield-to-maturity (YTM) measure is that YTM does NOT account for a bond's reinvestment risk.
In most analyses, such as the Discount Rate or WACC calculation, the Risk-Free Rate equals the yield to maturity (YTM) on 10-year government bonds denominated in the same currency as this company's financial statements.
The YTM is a snapshot of the return on a bond because coupon payments cannot always be reinvested at the same interest rate. As interest rates rise, the YTM will increase; as interest rates fall, the YTM will decrease.
Investors holding long term bonds are subject to a greater degree of interest rate risk than those holding shorter term bonds. This means that if interest rates change by 1%, long term bonds will see a greater change to their price—rising when rates fall and falling when rates rise.
Most bonds pay a fixed interest rate, so existing bonds become more attractive if interest rates fall, driving up demand for them and increasing their market value.
High-yield bonds tend to be junk bonds that have been awarded lower credit ratings. There's a higher risk that the issuer will default. The issuer is forced to pay a higher rate of interest to entice investors. High-rated bonds are known as investment grade.
TAKEAWAYS: Not losing money by holding a bond until maturity is an illusion. The economic impact of market rate changes still impacts investors holding bonds until maturity. A bond index fund provides an investor with greater diversification and less risk.
The Inverse Relationship Between Bond Yield and Price
Thus, as the price goes up, the yield decreases, and vice versa. This relationship exists because the bond's coupon rate is fixed, which requires the price in secondary markets to change to align with prevailing interest rates in the market.
Bonds with longer durations are more sensitive to changes in interest rates, meaning their YTM will fluctuate more significantly with interest rate movements. Hence, when the interest rate rises, YTM shall increase, and the bond price will fall, and vice versa.
As these payment amounts are fixed, you would want to buy the bond at a lower price to increase your earnings, which means a higher YTM. On the other hand, if you buy the bond at a higher price, you will earn less - a lower YTM.
A positive correlation exists between risk and return: the greater the risk, the higher the potential for profit or loss. Using the risk-reward tradeoff principle, low levels of uncertainty (risk) are associated with low returns and high levels of uncertainty with high returns.
Bonds that investors think will be difficult to sell to other investors in the market will have a higher yield.
The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk.
These include repricing risk, yield curve risk, basis risk and optionality, each of which is discussed in greater detail below.
It's the percentage return an investor can expect to earn over the next year if the bond is purchased at its current market price. Continuing with the example above, if the bond's market price is currently $900, the Current Yield is $50 / $900 = 5.6%.
Junk Bonds
Junk bonds are high-yield corporate bonds issued by companies with lower credit ratings. Because of their higher risk of default, they offer higher interest rates, potentially providing returns over 10%. During economic growth periods, the risk of default decreases, making junk bonds particularly attractive.
A bond's yield to maturity rises or falls depending on its market value and how many payments remain. The coupon rate is the annual interest amount that the bond owner will receive.
Usually, any Sharpe ratio greater than 1.0 is considered acceptable to good by investors. A ratio higher than 2.0 is rated as very good. A ratio of 3.0 or higher is considered excellent. A ratio under 1.0 is considered sub-optimal.
What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.