Week 2 - Case Analysis - UK Gilts Analysis of Bond Investments

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1 Week 2 - Case Analysis - UK Gilts: Analysis of Bond Investments University of the Cumberland Lahcen Boujadi Capstone - Strat Finan Mngmt (BADM-691-B01) 10/29/2023

2 The difference between the coupon rate and yield to maturity, and how the difference affects bond prices The coupon rate is the fixed annual interest rate that is paid by the issuer of the bond to the bondholder (Schoenmaker & Schramade, 2023). It is usually expressed as a percentage of the bond's face value and remains constant over the life of the bond. On the other hand, the yield to maturity (YTM) is the total rate of return earned by an investor if the bond is held until its maturity date (Syamsu & Endri, 2022). It takes into account not only the fixed interest payments (coupon rate) but also the discount or premium at which the bond was purchased and the length of time until maturity. The difference between the coupon rate and YTM affects bond prices in the following ways: 1. If the coupon rate is higher than the YTM, it means the bond is selling at a discount (Lartey et al., 2019). This is because the bond's price is lower than its face value, as the bond's YTM is lower than the coupon rate. Investors are willing to pay less for the bond because they are receiving a lower return compared to the bond's stated interest rate. 2. If the coupon rate is lower than the YTM, it means the bond is selling at a premium (Gray & Yozzo, 2022). This is because the bond's price is higher than its face value, as the bond's YTM is higher than the coupon rate. Investors are willing to pay more for the bond because they are receiving a higher return compared to the bond's stated interest rate.

3 3. If the coupon rate is equal to the YTM, it means the bond is selling at par (Lartey et al., 2019). This is because the bond's price is equal to its face value, as the bond's YTM is the same as the coupon rate. Investors are willing to pay the exact amount of the bond's face value because they are receiving the same return as the bond's stated interest rate. In summary, the difference between the coupon rate and YTM affects bond prices because it reflects the bond's discount, premium, or par value. Using Exhibit 1 in the case, fill in the missing values. Assuming that Exhibit 1 is referring to annual bond payments, the missing values can be filled in as follows: Maturity Coupon Rate YTM Price 1 year 0% 0.5% £1025 3 years 2% 2.5% £1051 5 years 4% 4.5% £1084 7 years 6% 6.5% £1118 10 years 8% 8.5% £1163 Plot the yield curve that results from the given bonds. A yield curve is a line graph that plots the yields (or interest rates) of bonds with different maturities (Crump & Gospodinov, 2019). It is usually upward-sloping, indicating that long-term bonds have higher yields compared to short-term bonds. Using the data from Exhibit 1, the yield curve for the given bonds can be plotted as follows:

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4 In this yield curve, the x-axis represents the bond maturities (in years) and the y-axis represents the bond yields (in percentages). As the maturities increase, the yields also increase, resulting in an upward-sloping curve. What happens to the bond prices if all the yields move up by 1%? If all the yields move up by 1%, the bond prices will decrease. This is because bond prices and yields have an inverse relationship. When yields increase, it means that investors can earn a higher return on their investment. As a result, they are less willing to pay the current bond price, which has a lower yield. This decrease in demand for the bond leads to a decrease in its price. Conversely, if all the yields move down by 1%, the bond prices will increase. This is because bond prices and yields have a positive relationship. When yields decrease, it means that

5 investors are able to earn a lower return on their investment. As a result, they are willing to pay a higher price for the bond, which has a higher yield, to increase their total return. In general, bond prices are sensitive to changes in interest rates. The longer the bond maturity, the more sensitive it is to changes in interest rates (Abadi et al., 2023). This is because longer-term bonds have a longer time period over which the interest rates can change, and this leads to more uncertainty for investors.

6 References Abadi, J., Brunnermeier, M., & Koby, Y. (2023). The reversal interest rate. American Economic Review , 113 (8), 2084-2120. Crump, R. K., & Gospodinov, N. (2019). Deconstructing the yield curve. FRB of New York Staff Report , (884). Gray, H., & Yozzo, J. (2022). Distinguishing a long-duration bond from a distressed bond in a rising-interest-rate environment. American Bankruptcy Institute Journal , 41 (6), 26-51. Lartey, V. C., Li, Y., Lartey, H. D., & Boadi, E. K. (2019). Zero-coupon, forward, and par yield curves for the Nigerian bond market. SAGE Open , 9 (4), 2158244019885144. Lartey, V. C., Li, Y., Lartey, H. D., & Boadi, E. K. (2019). Zero-coupon, forward, and par yield curves for the Nigerian bond market. SAGE Open , 9 (4), 2158244019885144. Schoenmaker, D., & Schramade, W. (2023). Discount Rates and Scarcity of Capital. In Corporate Finance for Long-Term Value (pp. 93-114). Cham: Springer International Publishing. Syamsu, E. R., & Endri, E. (2022). Determinant Yield To Maturity of Banking Sector Bonds Listed On The Indonesia Stock Exchange For The Period 2015-2020. Jurnal Syntax Admiration , 3 (1), 83-108.

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