Fixed-Income Securities

Measuring Yield

Computation of Yield
The yield of an investment is the interest rate that will
make the present value of the cash flows from the
investment equal to the price or cost of the investment.
The yield is also called the internal rate of return.

Special Case: Only One Future Cash Flow

The yield computation of zero-coupon bond.

Annualizing Yields
Simple annual interest i.e. simply multiplying the
semiannual rate by 2 and vice versa.
Annualizing to obtain the effective annual rate (more
accurate).

Measuring Yield
Conventional Yield Measures
The commonly quoted and used different yield measures
are as follows:

Current Yield
The current yield relates annual coupon to the market
price of the bond. It only considers the annual coupon
and no other factor that may influence the yield.

Yield to Maturity
The average rate of return available from bond
investment if the bond is held till maturity. If coupons are
paid semiannually, then semiannual yield to maturity
will be determined. The practice is to double the
semiannual yield to maturity in order to determine annual

Measuring Yield
yield to maturity. The yield to maturity computed as per
the market convention is called bond-equivalent yield.
The yield to maturity or the bond-equivalent yield is less
than the effective annual yield. There exists the following
relationship among the coupon rate, current yield and the
yield to maturity:
Bond selling at
Par
CR = CY = YTM
Discount
CR < CY < YTM
Premium CR > CY > YTM
Problems and limitations of yield to maturity.

Measuring Yield
Yield to Call
For callable issues, the practice is to calculate yield to
call as well as yield to maturity. The yield to call is
calculated on the assumption that the issuer will call the
bond on some call date and at the call price as per the
call schedule. Typically, investors calculate yield to first
call or yield to next call, yield to first par call and yield
to refunding. The yield to first call is computed if the
bond is not currently callable while yield to next call is
computed for an issue which is currently callable. The
yield to refunding is calculated assuming the issue will
be called on the first refundable date.

Measuring
Yield
Yield to Call
Yield to refunding is used when bonds are currently
callable but have some restrictions on the source of funds
used to buy back the debt when a call is exercised. Namely,
if a debt issue contains some refunding protection, bonds
cannot be called for a certain period of time with the
proceeds of other debt issues sold at a lower cost of money.
As a result, the bond holder is afforded some protection if
interest rates decline and the issuer can obtain lower-cost
funds to pay off the debt. It should be stressed that the
bonds can be called with funds derived from other sources
(e.g., cash on hand) during the refunded-protected period.
The refunding date is the rst date the bond can be called
using lower-cost debt.

Measuring
Yield to Put Yield
A putable issue has a put schedule which specifies
when the issue can be put and the put price. When an
issue becomes putable, the yield to put can be
computed. The yield to put is the interest or discount
rate that makes the total present value of the projected
cash flows to the assumed put date and the put price on
that date as per the put schedule equal to the price of
the bond. The yield to put can be calculated the same
process as the yield to maturity or yield to call.

Yield to Worst

Yield to maturity, yield to every possible call date and

put date can be computed. The minimum of all of these
yields is called the yield to worst.

Measuring
Yield
Cash Flow Yield

The cash flows or installments of amortizing securities

consist of three components i) coupon, ii) scheduled
principal repayment, and iii) prepayments. For these
securities, cash flow yield is computed. The cash flow
yield is the interest rate or the discount rate that makes
the total present value of the projected cash flows equal
to the current market price. The difficulty in calculation
is to forecast the amount of prepayment in each time
period.

Yield for a Portfolio

First, the cash flows of the bond portfolio is determined.

The yield of a portfolio is the interest or the discount
rate that equates the total present value of the cash flows
to the current market value of the bond portfolio.

Measuring
Yield
Yield Spread Measures
Securities

for

Floating

Rate

The coupon rate of a floater changes time to time as per

the coupon reset formula that consists of the reference
rate and the quoted margin. Since the future value of the
reference rate is unknown, it is not possible to determine
the cash flows. As such, the yield to maturity can not be
computed. Instead, several conventional spread or
margin measures are used: these include simple margin
or spread for life, adjusted simple margin, adjusted total
margin, and discount margin. However, the most
commonly used measure is the discount margin.
The discount margin estimates the average margin over
the reference rate that the investor can expect to earn
during the life of the security.

Measuring
Yield
The calculation process
is as follows:
Determination of the cash flows assuming that
the reference rate does not change over the life of
the security
Selection of margin or spread
Determination of the total present value of the
cash flows discounted by the sum of the current
reference rate and selected margin.
If the computed present value is equal to the
price of the security then the discount margin is
equal to the selected margin. If not equal,
selected
margin should be changed unless and until it equates
the above two values.

Measuring
Yield
A
security that is selling
at par, the discount margin is
simply the spread over the reference rate.
A limitation of the discount margin as a measure of
yield is that it assumes the reference rate will not
change during the life of the security. Another
drawback is that if there is cap or floor, this is not taken
under consideration.
Sources of Bond Return in Amount
A bondholder can expect return in amount from one or
more of the following sources:
the periodic coupon payment
any capital gain or loss when the bond matures
or is called back or sold
interest income from reinvestment of the
periodic cash flows

Measuring Yield

The last component of the potential return in amount is

referred to as reinvestment income. For a regular bond
that pays only coupon, the reinvestment income is
simply the interest earned from reinvesting coupon this
is also called interest-on-interest component. For
amortizing security, reinvestment income is the interest
income generated from reinvestment of coupon and
periodic principal repayment before the maturity date.
Any measure of a bonds yield should take into
consideration each of the above three potential sources
of return.

Measuring Yield

Interest on Interest Return in Amount

The potential total return in amount from coupon and
interest on interest can be computed by applying the
future value of annuity formula.
Total coupon plus interest on interest constitute the
total return in amount. From this amount if the amount
of total coupon is subtracted, then the amount of
interest on interest will be determined.

YTM and Reinvestment Risk

An investor will realize the yield to maturity at the time
of bond purchase only if the bond is held till maturity
and the coupon payments can be reinvested at the
computed yield to maturity.

Measuring
Yield
There are two bond characteristics that determine the

extent of reinvestment risk one is the maturity and the

other is coupon.
For given yield to maturity and coupon rate, the longer
the maturity the more dependent the bonds total return
is on interest-on-interest component in order to realize
the yield to maturity at the time of purchase. In other
words, the longer the maturity the greater the
reinvestment risk.
For a given maturity and given yield to maturity, the
higher the coupon rate the more dependent the bonds
total return will be on the reinvestment of the coupon
payment for producing the anticipated yield to maturity
at the purchase time.

Measuring Yield

This implies premium bonds are more dependent and

discount bonds are less dependent than par bonds on
interest-on-interest component. The zero coupon bonds have
no reinvestment risk. Therefore, yield earned on a zerocoupon bond held to maturity is equal to the promised yield to
maturity.

Cash Flow Yield and Reinvestment Risk

The reinvestment risk is even greater for amortizing
securities. The reason is that, in addition to the periodic
coupon, the periodic principal repayments must be
reinvested. Besides, in case of some amortizing securities
payments are made monthly. The more frequent
payments increase the reinvestment risk further.
Usually, the borrower prepays the principal when interest
rates decline. This further increases the reinvestment risk
as the prepaid principal must be invested at lower rate.

Measuring Yield
Total Return:

It is difficult to determine the best investment

alternative out of several bond investment opportunities,
keeping in view the investment horizon of the investor,
on the basis of yield to maturity or yield to call because
of some problems (page 50 FJF) inherent in the
measures. However, the total rate of return measure
does not involve those problems and can be applied to
determine the best bond investment alternative for the
investor on the basis of the investors personal
expectations.

Measuring Yield
Total Rate of Return:

The total rate of return is a measure of yield that

incorporates an explicit assumption regarding the
reinvestment rate. First, it computes the total future
cash flows that will result from bond investment
assuming a particular reinvestment rate. The total return
is then determined as the interest rate that will make the
initial investment grow equal to the computed total
future cash flows. The total future cash flows are
calculated on the basis of the assumed reinvestment rate
considering the periodic coupons and interest-oninterest component for the investment horizon and the
par value or the bond value as computed on the basis of
the market yield at the end of the investment horizon.

Measuring Yield

Example: An investor with a three-year investment

horizon is considering purchasing a 20-year, 8%

coupon bond for 828.40. The yield to maturity for this
bond is 10%. The investor expects to be able to reinvest
the coupon payments at an annual interest rate of 6%
and at the end of the investment horizon the then 17year bond will be selling to offer a yield to maturity of
7%, determine the total rate of return of the bond.
Example: Six-year investment horizon, 13-year, 9%
coupon bond selling at par and the expected
reinvestment rates are: the first four semiannual
coupons can be reinvested at a simple annual interest
rate of 8%, the last eight coupons at 10% and the
required yield to maturity on 7-year bond is 10.6%.

Measuring
Yield
Horizon Analysis:
The use of total rate of return to assess bond
performance over some investment horizon is called
horizon analysis. When total return is computed over
an investment time period, it is referred to as horizon
return. The terms total return and horizon return are
frequently used interchangeably.
Horizon return is also used in evaluating bond swaps.
In bond swap, bond held in the portfolio is replaced
with another bond on the basis of the total return.
Often cited as the limitations of the total return measure
that it requires to formulate assumptions regarding
reinvestment rate and future yields as well as to
perform analysis in terms of an investment horizon.
However, the horizon analysis framework helps in
analyzing bond performance under different yields and

Measuring
Yield
reinvestment rates scenarios and in understanding the

sensitivity of the bond performance under each

scenario.

Calculation of Yield Changes:

When interest rates or yields change between two time
periods, there are two ways, in practice, the change is
calculated: the absolute yield change and the
percentage yield change. The absolute yield or rate
change is measured in basis points and is simply the
absolute value of the difference between the two yields.
Absolute yield change = |initial yield new yield| x 100
The percentage yield change is calculated as the
natural logarithm of the ratio of the yield change as
follows:

Measuring
Yield
Percentage yield change = 100 x ln (new yield / initial
yield)
where ln is the natural logarithm.