Price-yield relationship
1. Price-yield relationship
There is an inverse relationship between a bond's price and its yield.2. Inverse relationship
When yields go up, bond prices go down. This is because when yields go up, an investor purchasing that bond can earn some additional return only when the bond price is lower. Otherwise, the investor would not buy the bond because it offers below market returns. Conversely, when yields go down, bond prices go up.3. Credit ratings
Bond yields are related to the risk of investing in bonds. One important way to determine the relative riskiness of different bonds is by looking at the bond's credit rating. Credit ratings are issued by firms called "Rating Agencies." The three most prominent ones are Standard & Poor's, Fitch, and Moody's. Credit ratings can be divided into two broad groups: Investment Grade and High Yield. Investment Grade are bonds rated BBB or higher by S&P and Fitch or Baa and higher by Moody's. Alternatively, high yield bonds are essentially everything below investment grade and are sometimes known as "junk bonds". This distinction between investment grade and high yield is important. Many institutions, such as some banks, are permitted to only invest in investment grade bonds. This is partly because the probability of default of the issuer increases dramatically between bonds in the lowest investment grade rating compared with bonds in the highest high-yield rating.4. Determining a bond's yield
Credit ratings also play a role in bond valuation. They allow investors to compare the riskiness of different bonds. For example, bonds with a Baa rating could be viewed as having a similar risk profile. So, to identify the yield necessary to discount a bond's cash flows, you can consider using the yield of bonds with a comparable credit rating. For example, to value a Baa-rated bond you can use the Moody's Baa index. You can obtain US Treasury yield data from the Federal Reserve Electronic Database or FRED. This can be accessed through the quantmod package, which is an R package designed around financial modeling. To load FRED data into your R workspace, use quantmod's getSymbols command. In this case, the ticker is "DBAA." Once you have the index saved into R, you can view its value at any date and even extract particular dates relevant to your analysis.5. Let's practice!
In the following exercise, we use the Moody's Baa yield on September 30, 2016 to value the bond from the prior chapter.Create Your Free Account
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