Teaching Note: Risk and Return/Yield Measures; Dr. K N.

Mukherjee, NIBM, Pune

CHAPTER 2

Risk and Return Measures

Learning Objective:
The objective of this chapter is to make the readers aware about different types of risk that a
fixed income portfolio manager is exposed to for investing in various fixed income
securities/instruments, and various possible measures to estimate the returns from such
investments. Since there is a strong tradeoff between Return and Risk of any investment, it is
very important for a portfolio manager to consider the right measure to estimate the return on
fixed income investment, and to capture the true set of risks in such investment.

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Risk and Return in Bonds: Meaning and Linkages

Bonds are an important component of investment portfolios for most of the investors,
especially for Institutional Investors. Bonds reduce the overall risk of a portfolio by introducing
diversity. Bonds produce steady current income—income that investors receive, say in every
year / six months / quarter. This steady stream of income is important to some investors,
depending on their asset-liability structure, their current needs. Bonds are low-risk investments
than stocks; may be at the cost of lower returns. Attractiveness of bond investment largely
depend upon the future movement of interest rates. Bonds are attractive options when the
market anticipates interest rates to fall. As interest rates fall, bond value rises, giving a positive
return to the investor. The main sources of return from a bond are: regular (Annual/Semi-
annual) coupon income, re-investment income (i.e. interest on coupon received), and bond’s
price appreciation (if any). Even if the coupon rate, the major source of return from a bond, is
fixed in a fixed-rate bond, there may be several risk factors causing different levels of variation
in the returns from a bond. Alternatively, bonds are susceptible to a number of risks, depending
on the nature of the bond issue. Like other investment opportunity in the financial market, the
Risk-Return linkage is also applicable in bond investment. If an investor wants to earn higher
return, he has to compromise with some risk factor (s), such as credit risk, interest rate risk,
liquidity risk, etc. There can be different measures available to capture the risk and return from
individual security, or a portfolio of many securities. These are discussed in the following
section.

Risks Associated with Fixed Income Securities

Investment in any financial asset generates a return subject to some uncertainty. This
uncertainty may be favourable or unfavourable to an investor. Any uncertainty if causes any
kind of financial losses for the investor is generally termed as ‘Financial Risk’. In other words,

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

Risk refers to the Chance of Financial Losses due to unforeseen or random changes in
underlying Risk Factors. Since the goal of investing is to get the best return possible from the
investment, investment risk is the possibility that the investor will get back less than his
investment or his expected return, or that he will get less than what he could have had if he had
invested his money elsewhere, commonly known as Opportunity Costs. Even if investment in
fixed income securities like bond generates a fixed income for the investor, such investments
are also exposed to several risk factors and may cause different degree of financial losses for
the investor. Some of such important risk factors are discussed in the following section:

Interest Rate Risk:

Since the value of a bond at any point of time is nothing but the present value (PV) of all the
future cash flows due on the security, and the PVs of future cash flows are inversely related
with the existing rate of interests of different respective tenors, there is an inverse relation
between the price of a bond and the rate of interest. These lead bond investors to be exposed to
interest rate risk. Alternatively, in the event of rise in interest rate (s), the price of a bond
decreases and the investor has to face a capital loss, leading to the Interest Rate Risk. Risk of a
certain fall in the price of a fixed income security only due to a possible rise in interest rate is
specifically called as the Price Risk. Change in interest rate also lead to another type of risk in
bond investment, and is known as Reinvestment Risk, as disused in the next section. There is a
possible trade-off between the price risk and reinvestment risk, arise due to change in interest
rates.
Suppose an investor has bought 06.79 GS 2029, a bond issued by the Government of
India, paying a coupon of 6.79 percent per annum, payable semi-annually, maturing in 2029,
at Par value. Now suppose, the market Interest Rate has gone up by 21 basis, from 6.79% to
7.00% and the investor want to sell the bond where the coupon rate would be same as 6.79%.
Since the bond is selling at Par, nobody would like to buy the bond at Par with a coupon rate
of 6.79%, where the market interest rate is 7.00%. Here neither the investor can change the
Coupon rate nor can he change the actual maturity of the bond so that the same would be
saleable in the market. Here what the bond seller can do is to reduce the bond price so that the
amount of coupon received on the bond at the bond’s par value would be equal to the amount
based on the new or revised interest rate on the new or revised price, so that without changing
the original coupon rate, the current market rate can be offered to the prospective buyer of the
bond.
The magnitude of interest rate risk largely depends upon the features of a bond issue,
such as: Maturity, Coupon Rate, Coupon Payment Frequency, Yield, presence of Options, etc.
In case of floating rate bond, even if the coupon rates are adjusted with the prevailing market
rates in every coupon reset dates (Annually, Semi-annually), the value of such bond is exposed
to interest rate fluctuation during two coupon reset dates. Interest rate risk of a bond can be
captured through different measures, such as: Macaulay Duration, Modified Duration (MD),
Effective Duration, Key Rate Duration, Price Value Basis Points (PVBP or PV01), and
Convexity, discussed in detail in the respective chapter.

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

Reinvestment Risk:

Reinvestment Risk is based on the assumption that interim cash flows (i.e. coupons) from a
fixed-income security are reinvested at every interval, so that further interest can be earned on
interest. But if the investor fails to reinvest the periodic coupons at a predetermined rate, the
actual Yield from the bond till its maturity will be different than whatever expected. For
example, an investor bought a Central Govt. security 6.79 GS 2027 with a face value of INR
10 crore, having an annual coupon of 6.79%, say payable annually. Every year, the investor
receives INR 67.90 lacs (6.79% × INR 10 Crore) which can be reinvested back into another
bond. But if over time the market rate suddenly falls to 6%, then INR 67.90 Lacs received from
the bond can only be reinvested at 6%, instead of the 6.79% rate of the original bond. This risk
is contrary to price risk, because when interest rates rise, price risk increases, but reinvestment
risk declines. Alternatively, due to rise in interest rates, there will be a fall in the price of a
security, but the investors can be in a position to reinvest their interim cash flows at a higher
rate and thereby can earn some gain, termed as reinvestment gain. Similarly, in the event of a
sudden fall in the interest rates, future values of interim cash flows may decline, leading to a
risk in the investment, called Reinvestment Risk. Since there is no interim coupon payment in
case of zero coupon bonds, such instrument do not have any reinvestment risk. How severe is
the reinvestment risk for a fixed coupon bond largely depends upon the maturity and the coupon
rate of the bond. Longer the maturity of a bond, higher will be the likelihood that reinvestment
income will be lower (due to fall in interest rates) for the remaining maturity, and therefore
severe would be the impact. On the other hand, the higher the coupon rate of a bond, bigger
will be the coupon payments to be reinvested at a lower rate, leading to a bigger loss due to fall
in interest rates.

Yield Curve Risk

Maturity of a bond is one of the important factors for its Price Sensitivity due to change in the
interest rate or the Yield. Therefore the value of a Portfolio of bonds with different maturities
depends on how the value of individual bonds with different maturity periods changes
following the change in interest rates. The rate of interest or the Yield of different bonds varies
according to their respective maturities, as may be depicted by the yield curve. The Graphical
relation between the Yield on similar type of securities and their respective Maturity is known
as Yield Curve. It is basically assume that in the scenario of changing interest rate, the yield of
different bond with different maturities changes by similar basis points, commonly known as
Parallel Shift in the Yield Curve. But in real market condition, when there is any change in the
rate of interest, even if all the rates change in a similar direction (rise or fall), the magnitude of
change is not necessarily be same for all bonds with different maturities, which can be
represented by a Nonparallel Shift in the Yield Curve. This non-parallel shift may result into
Steepening of the yield curve where the yield spread between long-term and short term yields
widens, or Flattening of the yield curve where such yield spread narrows.
For example, in India, if the 10-Year risk-free rate or base yield (i.e. yield on 10-Year GOI
bond) changes by 50 basis points, yields of all other maturities are expected to experience a
positive change, but need not to be exactly 50 bps. As a result, the risk-free yield curve will

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

shift upward, but need not be shifted upward parallel by 50 bps. Due to nonparallel shift, yield
curve may become more Flatter or more Steeper. The price sensitivity of the whole bond
portfolio, in the event of change in the interest rates, largely depends on market expectation
towards the type of shifts in the yield curve. Accordingly, a portfolio consisting of few short
term securities and some long term securities, and in a situation where long-term rates increases
more than the rise in short-term rates, i.e. in the event of steepening of the yield curve, the fall
in the value of long-term securities may be more than the losses incurred in short-term
securities, finally affecting the portfolio loss. Because of these unequal changes in the interest
rates of different tenors, a portfolio manager may fails to capture the actual loss in his bond
portfolio, assuming a parallel shift in the yield curve, causing a further risk for the institution.
Interest rate sensitivity measures, e.g. Modified Duration and PVBP/PV01, even if captures
how sensitive is the bond portfolio to a future change in interest rates, these measure are based
on the assumption of parallel shift in the yield curve. Therefore, bond investors, who invest in
several bonds throughout the maturity segment, and captures interest rate risk through the
aforesaid portfolio sensitivity measures, are exposed to another risk, called Yield Curve Risk.

Liquidity Risk:

If an investor doesn’t want to hold a bond till its maturity and intend to sell the same in between,
he is concerned whether the market is liquid enough to offer him a right/fair price. Market
liquidity can be measured through number of dealers, size of bid-offer spreads, market depth,
etc. Alternatively, Liquidity refers to the ease with which a reasonable size of a security can be
transacted in the market within a short notice, without adverse price reaction. Liquidity Risk is
the risk that the investor may have to sell his bond at a price which is actually lower than its
true market price based on the prevailing interest rate. The liquidity risk can be measured by
capturing the size of the Spread between the Bid Price (the Price which a buyer is willing to
pay) and the Ask Price (the Price which the seller intends to receive). The wider the Bid-Ask
Spread, the greater would be the Liquidity Risk. One measure of liquidity risk in the Govt. debt
market can also be the difference between the volume of trading of newly issued on-the-run
security and the volume of trading when the issue becomes old, called as off the run. But such
measure can be applied only when new securities of very similar maturity are issued in the
market, leading to make both on-the-run and off-the-run security of similar maturity available
in the market. Liquidity risk is an important concern for bond investors or traders, especially if
the underlying bond market does not experience sufficient number and volume of trading on a
regular basis. A player in the fixed income securities market needs to fix the extent of liquidity
premium for all illiquid securities, in order to undertake any trading on the same, or to calculate
how much worthy are those security under such illiquid market condition. Market players,
especially in illiquid market like in India, face a very significant challenge not only to capture
the liquidity risk even in case of Govt. securities, but also to price the same. Two similar bonds
with same maturity, but with different degree of liquidity, are expected to be priced differently.
Future cash flows of the bond with lesser liquidity are subjected to be discounted at a higher
interest rate due to the presence of illiquidity premium, leading the bond to be traded at a lower
price.

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

Call Risk (Timing Risk):

A coupon bond can be issued with a provision of Early Settlement before its scheduled
maturity. In case of a Callable bond, the issuer can call back the bond when the Interest rate of
similar bond available in the market falls below the coupon rate applicable to the original bond.
Therefore, the cash flow pattern of a callable bond is Uncertain because it is not known to the
investor when the bond will be called. If the bond is called due to a fall in the interest rate and
accordingly the coupon rate, the investor has to reinvest his proceeding at a lower rate
comparative to the original rate of interest and is therefore exposed to Reinvestment Risk. At
the same time, the potential for Price Appreciation, due to fall in the interest rate, will also be
lower comparative to a similar but option-free bond. This will lead to insufficient capital gain
for the investor because of Price Compression occurred due to the embedded option. This
Reinvestment Risk and the Risk of Price Compression can be treated as the Call Risk which is
present only in those bonds with embedded call option.

Credit Risk:

Since Govt. of India cannot be expected to default on its promised payments of coupons and
the principal amount against the Central Govt. securities, these securities do not carry any
counterparty/credit/default risk. However, there are bonds issued by various Non-Govt. entities
that carry a significant amount of counterparty/credit risk, in terms of inability to service all or
some of the promised obligations, depending upon their credit worthiness that may change due
to financial distress, reorganization, workouts, or bankruptcy.
When an investor buys some bond from a bond issuer other than the Government, he is
expected to be exposed to some credit risk based on the credit worthiness of the issuer or the
specific issue. The major types of credit risk are – Default Risk, Downgrade Risk, and Credit
Spread Risk. Default Risk can be defined as the risk that the issuer will fail to satisfy the terms
of the obligation with respect to the payment of interest and principal on due time. Default risk
can actually be calculated not only by considering the rate of Default but also the rate of
Recovery out of total default. Downgrade Risk refers to the migration of credit quality, as
exhibited by the different grade of Credit Ratings provided by different external Rating
Agencies in the form of Transition Matrix, from Higher or Good rating to Lower or Bad rating.
Credit rating of a bond issue or an entity indicates the potential default risk associated with a
particular bond issue or the issuer. This rating migration may lead to a fall in the market value
of a bond. It is well known that the price of a bond issue is inversely related with the yield of
the bond which actually comprises of two components – Yield on a Similar Default-free (e.g.
Government) bond, and the Risk Premium above such yield to compensate the concerned risk
associated with that bond. This risk premium is alternatively known as the Yield Spread and
the part of this yield spread attributable to the default risk is known as the Credit Spread. Since
credit spread is an integral part of the yield of a Non-Govt. security, any change (e.g. increase)
in such spread will lead to increase in the yield, resulting to a fall in the value of the bond. This
expected decline in the value of a bond due to rise in credit spread is known as the credit risk
or Credit Spread Risk, in the context of bonds.

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

Legal Risk:

Legal Risk is the risk that changes in the law may adversely affect the price of the bond. Most
legal risk is associated with the tax exemption of particular bonds, especially infrastructure
bond, municipal bonds, because these bonds are exempt from income tax. However, if tax rates
decline, the advantage of the tax exemption also declines, and therefore the price of the bond
in the secondary market as well. This is specifically known as tax risk. The second type of legal
risk occurs because tax-exempted securities have to satisfy specific legal requirements, and if
it is later determined that the security does not satisfy these requirements, its tax-exemption
status may be eliminated, which would reduce not only the effective return of the bond after
taxes, but it would reduce the price of the bond in the secondary market as well, and therefore
the concerned yield would have to be equal with the taxable yield of other comparable bonds.

Foreign Exchange Risk:

If an investor holds a bond the cash flows of which are not denominated in domestic currency,
he is supposed to expose to the risk of unfavorable change in the foreign exchange rate between
the two currencies, known as Exchange-rate Risk or Currency Risk. Though the amounts of
cash flows, either coupons or principal, are certain in foreign currency, they are uncertain in
domestic currency and depend on the prevailing exchange rate at the time of the cash flows. If
the foreign currency depreciates at the time of cash flows, though the investor gets a fixed
amount of payment in terms of foreign currency, the amount of payment in terms of domestic
currency would be less than whatever expected. This risk of receiving less (in domestic
currency), while investing in any bond issue where payment is made in foreign currency, is
represented as Exchange-rate Risk.

Volatility Risk:

Volatility, not of bond’s price but of the yield of the bond, significantly affects the price of a
bond issued with some embedded options (Call or Put). The larger the yield volatility, the
higher would be the price for the call and put options, supposed to be embedded with a bond
issue. Since the price of a Callable (Putable) bond is equal to the price of a similar option-free
bond Minus (Plus) the price of the Call (Put) option, an Increase (Decrease) in the yield
volatility will lead to Rise (Fall) in the price of the Call and Put option. Rise in yield volatility
therefore lead to a simultaneous Fall (Rise) in the price of the Callable (Putable) bond. This
risk of price decline of a bond with embedded option due to change in the yield volatility is
known as Volatility Risk.

Sovereign Risk (Country Risk, Political Risk):

Sovereign Risk (Country Risk, Political Risk) is the risk associated with the laws of the country,
or to events that may occur there. Particular events that can hurt a bond are the restriction of
the flow of capital, taxation, and the nationalization of the issuer. A particular form of sovereign
risk is convertibility risk, which is the prohibition of the exchange of the foreign currency for

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

domestic currency. The only hope for an investor in this situation is to accept local currency or
wait until the rules change. Because many countries, especially emerging countries, have
inadequate laws regarding financial disclosures or accounting rules, it may be difficult to assess
the true creditworthiness of the bond issuer. Disclosure risk results from this lack of disclosure
about an issuer or accounting rules that don't adequately reflect the true financial status of the
issuer.
Even if an investment in a fixed income security like bond may be exposed to all the
above risks, Call Risk, Credit Risk, Volatility Risk, Foreign Exchange Risk, Sovereign Risk
are almost absent in case of any domestic securities issued by the Government.

Return Measures for Fixed Income Securities

Given the three important sources of potential return from a Fixed Income security, such as
Coupon Income, Capital Gain (Loss), and Reinvestment Income, various yield measures,
expressed as a Percentage Return, can be applied based on a single or all of the above potential
sources. Accordingly, different return measures give different information regarding the FI
securities, at different possible scenarios. These measures may reflect the return for an
individual Fixed Income security or for the Portfolio of various FI securities. Return can be
calculated for a specific period (Monthly, Semi-annually, Annually), or for the Full Maturity /
Holding Period. Different such return measures include:

Nominal Return / Coupon Rate (CR):

Nominal Return is nothing but the Rate of Interest promised to be paid by the bond issuer to
the bond holder over a span of time. Nominal Return is normally expressed at annual basis, but
can be expected to be due and received Annually, Semi-annually, or Quarterly. In other words,
Nominal Yield is the stated interest rate of the bond as the percentage of bond’s par value.
Nominal Return can be Positive or Zero, based on the type of bond. In case of Zero-Coupon
bond, there is no nominal return. For example, a bond with a par value of Rs.1,00/- and paying
8% interest, pays Rs.8/- per year in 2 semi-annual payments of Rs.4/- each. Nominal Return
can be fixed throughout the maturity, or can vary based on some Benchmark Rate, depending
upon the nature of the security (Fixed or Floating Rate Bond). In case of Floating rate bonds,
nominal yield gets adjusted at every Coupon Re-set Date. The Nominal Yield is therefore
calculated as:

Current Yield (CY):

Bonds after their issuance in the primary market get traded in the secondary market, not
necessarily at the par value, but may be traded at a price less or more than the par value,
respectively known as trading at discount and at premium. Therefore, the return of an investor
on a bond issue purchased from a secondary market need not necessarily to be the nominal

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

return. Investment in secondary market may yield an interest rate that is different from the
nominal yield, called the Current Yield, or current return. Movement of such yield measure
depends on the movement in the market price of the concerned security, such that:


Even if nominal yield of a fixed rate bond is fixed throughout its maturity, the current yield
may be extremely volatile, depending on the price volatility of the concerned bond issue. If a
bond is traded at its par value, then the current yield will be equal to the nominal yield. Larger
the difference between the current market price of a bond and its par value, wider would be the
difference between the nominal and current yield, such that:
In case a bond is traded at a Discount, => Current Yield > Nominal Yield
In case a bond is traded at a Premium, => Current Yield < Nominal Yield
Current yield is important and is required to be considered along with the nominal return of a
bond issue, especially in case of fixed rate bond, in order to get the current market condition
reflected in the bond price, enabling investors to take their investment decision based on their
preference.

Average Return or Yield to Maturity (YTM)

YTM of a bond is the average rate of return that an investor earns from his investment in that
bond if the same is hold till its maturity. YTM can also be treated as the Internal Rate of Return
(IRR) or the Hurdle Rate of Return required to sale the bond at its ruling market price. Even if
the nominal and current yields consider only one source of income, i.e. the coupon income, to
estimate the return from a bond, the YTM takes into consideration all the possible sources of
income from a bond issue. YTM assumes that bonds are hold till maturity and interest receipts
are reinvested at the same rate.
Technically, YTM is that single Discounting Rate that makes the sum of present values of all
future cash flows due from a security till its maturity equal with the current market price.
Accordingly, once a security is traded, its market price, along with the amount and timing of
its interim cash flows due till the maturity may be used to extract the Yield to Maturity of that
security. Alternatively, if the YTM of a security on a given date is known, the price of that
security can be estimated.

Example:
Suppose, a GOI bond (7.28 GS 2019), offering an annual coupon of 7.28 percent, payable semi-
annually, maturing on June 03 2019, is currently (on July 11 2017) traded at a price of INR
101.6300/-. The market may like to know the YTM or the IRR of that security, for being traded
at the ruling market price (i.e. at Rs.101.6300/-).
Yield to Maturity of a bond may be estimated through different approaches or methods. It can
be solved manually (in MS Excel) through the bond pricing structure following a discounted
future cash flow methods, either by a trial-and-error process, or with the help of some Excel

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

optimization technique (e.g. Goal Seek or Solver), or may be by using a pre-specified financial
function available in MS Excel.
Given the Settlement and Maturity Date for the security, the Residual Maturity of the given
security is estimated as 1.8944 years or 3.7899 semi-annual periods. Therefore there will be
four semi-annual cash flows due in that security till the maturity. First three will be the semi-
annual coupon, followed by the last and final semi-annual coupon plus the principal redemption
due at maturity.
Considering the settlement date, maturity date, day count convention used, the actual due dates
for all the four future cash flows may be estimated, which can further be used while discounting
the future CFs, at an unknown interest rate known as YTM, as shown below:

Table 4. 9: Estimation of Bond Price using YTM

Semi-annual Semi-annual Yield to Discounted CF
Period Cash Flows Maturity [DCF =
(t) (CF) (YTM) CF/(1+YTM/2)^t]
0.7889 3.64 6.3478% 3.5514
1.7889 3.64 6.3478% 3.4421
2.7889 3.64 6.3478% 3.3362
3.7889 103.64 6.3478% 92.0688
Dirty Price ∑ DCF 102.3985
Clean Price = ∑ DCF - AI 101.6301
The first and second column of the above table is known and the sum of the DCF (i.e. the dirty
price) minus the Accrued Interest (i.e. the market price) is also known. Therefore, the single
unknown (i.e. YTM), to be used to discount all the cash flows may be estimated, by using the
Excel optimization with the following details:
Objective Function : Sum of DCF (i.e. Dirty Price) - Accrued Interest = Market Price (i.e.
Clean Price) = ∑ DCF - 0.7684 = 101.6300
Changing Parameter : YTM
Accordingly YTM may be estimated, with a close approximation, following a detail process.
The YTM arrived at through this process is 6.3478% per annum.
At the same time, YTM may also be extracted from the price with the help of a single Excel
function, given below:
=YIELD (Settlement, Maturity, Rate, Price, Redemption, Frequency, [Basis])
Providing details about the above required parameters, such as Settlement Date (=July 11
2017), Maturity Date (= June 03 2019), Coupon Rate (7.28%), Market Price (= Rs.101.63/-),
Redemption Value (Rs.100/-), Coupon Payment Frequency (= 2), and Day Count Convention,
represented as “Basis” (= 4, to represent 30/36 convention), the YTM of a security may be
directly estimated through the MS Excel function “YIELD”. The YTM of the above security,
extracted by using the Excel function is 6.3479%, which is very close to the YTM estimated
above, similar till the first three decimals.

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

Yield to Maturity of a portfolio of securities may be estimated as the weighted average YTM
of all the securities in the portfolio. Weights to be assigned with the security-wise YTM are
nothing but the market value of position in individual security divided by the market value of
the whole portfolio. Therefore the YTM of a portfolio, consisting of ‘i' number of securities is
defined as:

! "# ! $ " #. . . . . . # ! & "

$ &

When a bond is bought at a discount, yield to maturity will always be greater than the
current yield because there will be a gain when the bond matures, and the bondholder receives
par value back, thus raising the true yield; when a bond is bought at a premium, the yield to
maturity will always be less than the current yield because there will be a loss when par value
is received, which lowers the true yield. Interrelation between Different Yield Measures and
Trading Price of a bond is such that:

Table 4. 10: Relationship between Bond Price and Yields

Price of Bond Relationship
Bond Traded at Par CR = CY = YTM
Bond Traded at Discount CR < CY < YTM
Bond Traded at Premium CR > CY > YTM

Return till the Call (Put) Date (YTC / YTP)

Yield to Call (YTC) or Yield to Put (YTP) is applicable only to Callable (Putable) bonds. YTC
(YTP) is the Rate of Interest that equate the PV of all the interim cash flows, expected to be
received till the possible call (put) date, and its Call (Put) price received when the bond is Buy-
back (Sell-off). Alternatively, YTC (YTP) is the yield that will make the present value of the
cash flows up to concerned (First / Second / Last) call (put) date equal to the current market
price of the bond. Cash flows can be considered till the first call (put) date if the bond is
assumed to be hold only till the first call (put) date. YTC (or YTP) and YTM differ only due
to the difference in holding period. Just like YTM, these are also measures of Internal Rate of
Return (IRR), but are calculated for each of the Possible Call (Put) Dates when the bond is
expected to be Buy-back (Sell-off). Yield to First Call (Yield to First Put) is the YTC (YTP) at
the Earliest possible date when the bond is Buy-back (Sell-off). There can be as many numbers
of YTCs or YTPs as the total number of possible dates when the Issuer (Holder) is allowed to
exercise his Call (Put) option. In short, YTC or YTP are nothing but the bond’s YTM after
reducing the maturity to the possible call or Put date, and after converting the bond’s par value
to the call (put) price of the bond, as agreed upon in the bond, and provided in the Call (Put)
Schedule.

Yield to Worst (YTW) and Yield to Best (YTB):

Besides YTM, an investor can also calculate the Yield measures for all the possible Call (Put)
dates till the maturity. Given a specific YTM and all possible YTCs (YTPs) for Callable

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

(Putable) bond at the respective Call (Put) price of the bond, the investor can find out the Worst
or Best return that can be generated from such investment. Lowest (Highest) of the YTM and
all the YTCs (YTPs) is known as the Worst (Best) Return or Yield to Worst (Yield to Best).
Holder of a Callable (Putable) bond, in the event of Falling (Rising) market interest rates of
concerned tenor, can generate the YTW (YTB) if the Call (Put) option is exercised in the first
Call (Put) date. Therefore, YTW in case of callable bond is supposed to be the Yield to First
Call (YTFC), and YTB in case of a putable bond is also supposed to be the Yield to First Put
(YTFP). YTW can be treated as the minimum possible yield that an investor will definitely
earn from a callable bond at any possible circumstances. Similarly, YTB is the maximum
possible yield that an investor is expected to earn from a putable bond, if the put option is
exercised in the right time.

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

Self-Learning Exercise

Short Answer Type Questions:

1. What are the various risks that banks or other financial institutions are exposed to on their
bond portfolio?
2. How change in interest rates affect investment in any bond?
3. Explain the interest rate risk of a floating rate security and why such security’s price differ
from par value
4. Does an investor who purchases a zero-coupon bond face reinvestment risk?
5. How a fixed coupon bond and a zero coupon bond are different to an investor in terms of
interest rate risk (if any), even if both the bonds are expected to hold till the maturity?
6. What is Liquidity Risk, even in a Govt. Security?
7. Why call risk is very common in Corporate Bonds?
8. How a bank, investing in Govt. securities with different maturities, may be exposed to
Yield Curve Risk?
9. What are the various sources of returns from a bond?
10. Interpret the traditional yield measures for fixed rate bonds and explain their limitations
and assumptions.
11. Critically evaluate various measures to calculate the return from a bond.

Numerical Questions:
1. What is the yield to maturity of a 5-year bond with a nominal value of Rs.100, an 8%
coupon rate, an annual coupon frequency and a price of 98.5634? Same question for a
price of Rs.100/- and Rs.104.3695/-.
2. What is the yield to maturity of a 5-year bond with a nominal value of Rs.100, an 8%
coupon rate, semiannual coupon payments and a price of 98.5634? Same question for a
price of Rs.100/- and Rs.104.3695/-.
3. Answer the below questions: (a) Show the cash flows for the following four bonds, each
of which has a par value of Rs.1,00/- and pays interest semiannually. (b) Calculate the
yield to maturity of the bond portfolio, assuming that the face value of the bond portfolio
is INR 5 lakhs, divided equally in all the five positions.
Bond Coupon Rate Res. Mat. Market Price
(%) (Years) (Rs.)
W 7 5 85.030/-
X 8 7 105.090/-

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Teaching Note: Risk and Return/Yield Measures; Dr. K N. Mukherjee, NIBM, Pune

Y 9 4 96.575/-
Z 0 10 45.025 /-
4. Consider the following bonds and their features:
Coupon rate = 11%; Maturity = 18 years; Par value = Rs.1,000/-
First par call in 13 years
Suppose that the market price for this bond Rs.1,169/-.
(a) Show that the yield to maturity for this bond is 9.077%.
(b) Show that the yield to first par call, callable in eight years at Rs.1,055/-, is 8.793%.
(c) Show that the yield to put is 6.942%, only put date in five years and putable at par
value.
5. Suppose a bond portfolio manager, as on 1st February 2019, holds positions in the
following five central govt. securities. Estimate different possible return/yield that he is
expected to generate from the portfolio as on the given date. Follow the necessary market
convention to do your estimation.
Sl. Maturity Market Face Value
Security
No. Date Price (INR) (INR Cr.)
1 7.17% GS 2028 08/01/2028 97.49 50
2 7.37% GS 2023 16/04/2023 101.41 30
3 7.26% GS 2029 14/01/2029 99.34 10
4 7.95% G.S 2032 28/08/2032 101.67 5
5 7.32% GS 2024 28/01/2024 101.16 5
Portfolio 100

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(End of Chapter)

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