Yankee Bonds Definition Example Advantages Disadvantages

Yankee Bonds Definition

Reverse Yankee bonds are also available, traded, and issued outside the US and the respective country’s currency.

Yankee Bonds Correlation to Bond Price

Duration, coupon, and yield are major factors responsible for the price of the Yankee bond. Yield and bond pricesBond PricesThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more are inversely related. As the price of the bond increases, the yield falls, and the bond becomes expensive for an investor due to the price rise. Similarly, bond price falls when yield increases as more and more investors are willing to invest in bonds.

Where,

C = periodic payment of the couponY = yield to maturityYield To MaturityThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond’s returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more (YTM)F = face value of the bondT = time

In short, the price of the Yankee bond is the present value of all future cash flows of the bond.

If coupon payments are made semi-annually, then the coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more and YTM are divided in half. Depending on the frequency of coupon payments, coupon rate and yield are to be adjusted.

YTM is used as a discounting rate to arrive at the present value of the bond.

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Example

Yankee bond with a face value of 1000$, a coupon rate of 4%, YTM of 4%, and maturity of 5 years.

The price of the bond using the above formula will be 1000 $. This is because coupons and YTM are the same. When coupons and YTM differ, bonds are sold at a premiumBonds Are Sold At PremiumA premium bond refers to a financial instrument that trades in the secondary market at a price exceeding its face value. This occurs when a bond’s coupon rate surpasses its prevailing market rate of interest. For instance, a bond with a face value (par value) of $750, trading at $780, will reflect that the bond is trading at a premium of $30 ($780-750). read more or discount.

If YTM is 3% and 5%, the rest of the other variables remaining the same, bond price will be 1037.17$ and 964.54$, respectively. When YTM falls, the bond price will rise and vice-versa on the increase in YTM. When YTM falls, bonds having fixed coupon rates become popular in the market; hence bonds will be available at a premium.

On the flip side, when YTM rises, bonds having a fixed coupon rate become less attractive than other market investments, then bonds will be available at a discount.

Advantages

It helps in portfolio diversificationPortfolio DiversificationPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio.read more for investors to invest in different emerging economies as bond issuersBond IssuersBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures.read more are different entities outside the US investing in US bond markets by issuing Yankee bonds.Bondholders are protected from currency risk as bonds are issued in home currency USD, and repayments are also in USD; hence there will be negligible currency risk.These bonds are actively traded in US debt markets; hence Yankee bonds offer the highest liquidity to bond investors.It has a lesser impact due to political and economic factorsEconomic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.read more prevailing in the US. Bond prices will not change drastically.The issuer gets access to the US market after fulfilling the complicated requirements of the SEC.The issuer has a fund available for a longer duration due to the longer tenure of bonds.The market can frequently provide funds with lower costs than any other market.It also acts as a natural hedge if the bond issuer has longer tenure receivable in US markets.It offers a higher yield than the lower yield on other American investment portfolios.

Disadvantages

The basic principle of financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more – the higher the risk, the higher the reward. Lowering the risk lowers the reward; hence, investors should have a huge risk appetiteHuge Risk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more to bear losses.Some Yankee bonds may turn into junk bonds if the Company’s financial performance is not satisfactory. Also, foreign companies are governed by the laws of their nation; any unfavorable changes in the country’s economy would have an impact on the performance of the Company.Currency mismatches may happen in foreign companies. Companies have borrowed in US Dollars, but the majority of earnings may not be in US Dollars, it will be in the company’s home currency, and if the home currency depreciates against Dollars, then the company has to manage its open risk position effectively to pay bondholders and minimize currency losses.A bond issuer must go through the complicated procedure of registration with SEC and other legal formalities, so issuing Yankee bonds becomes time-consuming.After the subprime crisis, Yankee bonds have become popular in American markets due to better yield offerings than domestic bonds. So these bonds are sold well when interest rates in the US are lower.

Conclusion

We can conclude that Yankee bonds have become popular in the US post-global crisis in 2008. American investors get opportunities to tap emerging economies and diversify their investment portfoliosInvestment PortfoliosPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor’s risk profile.read more. However, these bonds are not risk-free investments. Investing in Yankee bonds is not everybody’s cup of tea. Through understanding, due diligence of the company, its local laws, and financial statements is required before taking a big investment step.

Yankee bond issuer also gets the advantage of the most stable capital marketCapital MarketA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets.read more in the US to raise funds for long-term requirements. Also, the issue of such bonds may act as a natural hedge for future collections against receivables to the company.