ABSTRACT
This chapter extends the analysis of bonds. There are three key components – par value, coupon and term to maturity – that establish the contractual relationship between the bond buyer (lender) and the issuer (borrower). The calculation of the flat yield and the gross redemption yield (GRY) or yield to maturity (YTM) are examined in detail. The GRY takes account of the future cash flows associated with a fixed interest bond. There is an inverse relationship between a bond’s price and GRY. This is a precise mathematical relationship and enables further calculations of a bond’s duration and convexity. Bonds of different maturities issued by the same issuer (e.g. the UK Treasury) may be analysed as a bond market. This allows us to construct the term structure of interest rates. This is usually plotted as a scattergram of pairs of yields and time to maturity, usually referred to as a yield curve. Normally the yield curve slopes upwards, although it can take on many shapes depending on the stage of the business cycle. Term structure theories include: the pure expectations theory; expectations with a risk premium theory; the market segmentation theory. When considering bonds as an asset class, inflation risk and reinvestment risk are important. Credit risk is a further consideration and is important in assessing corporate bonds.
