Question

Is deflation bullish or bearish for the bond market? Explain your answer by showing which terms in the yield to maturity formula are affected and how these change.

Formula:

Yield To Maturity (YTM) of a Bond While bonds have stated interest rates, those are not generally the yield that is followed in the bond market. Instead, an internal rate of return is used. We saw that the present value of the fixed income stream from the bond we discussed earlier was:

PV = 50/(1+r) + 50/(1+r)2 + … + 50/(1+r)5 + 1,000/(1+r)5

At any point in time, we know the price of the bond (Pb) from its value in the secondary bond market. If we equate this current bond price to the present discounted value of its fixed income stream:

Pb = 50/(1+r) + 50/(1+r)2 + … + 50/(1+r)5 + 1,000/(1+r)5

the only unknown value is r. If we solve this equation for r (after substituting the value of current bond price), we arrive at its Yield to Maturity (YTM): Yield to Maturity: the rate of discount that equates the present discounted value of the fixed income stream from a bond with its current price. - This reflects the return from this bond if purchased now and held until maturity.

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Answer 1

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