Fixed Income

Yield Measures, Spot Rates &

Forward Rates
Reading - 57

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Sources of Return
• Coupon interest payment: Periodic coupon interest is paid on
the par value of the bond carrying a coupon.

• Capital gain or loss: When a bond is sold, called or is held till

maturity and if the received proceeds is greater than the
original purchase price, a capital gain is recognized.

• Income from Reinvestment: The bond which has coupon

attached to it, gives periodic coupon interest payments that
can be reinvested.

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Traditional Yield Measures
Types of Yield measures
1. Current Yield

2. Yield to Maturity

3. Yield to call

4. Yield to Put

5. Yield to worst

6. Cash Flow Yield

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Traditional Yield Measures
Current Yield

Facts
• Current Yield > Coupon Rate, if bond is issued at a discount.
• Current Yield < Coupon Rate, if bond is issued at a premium.
• Current Yield = Coupon Rate, if bond is issued at par.

Drawbacks:
• It considers only one source of yield i.e. Coupon Interest.
• No consideration is given to capital gain or loss if bond is
purchased at a premium or discount.
• Also, the income from reinvestment is neglected.
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Traditional Yield Measures
Yield to Maturity: It is the interest rate that will make the
present value of a bond’s cash flow equal to the sum of current
market price and accrued interest.

Calculation of Yield-to-Maturity

Find interest rate that

will equate the present
Determine the expected value of cash flows to
cash flow sum of current market
price and accrued
interest.

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Yield-to-Maturity
Example
What would be YTM 6% (annual coupon), 5 year Rs.100 par
value bond selling at Rs.97.92.

Solution:

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Yield to Maturity
Relationship
• If a bond is selling at par, coupon rate = current yield = yield to
maturity.
• If a bond is selling at premium, coupon rate > current yield >
yield to maturity.
• If a bond is selling at discount, coupon rate < current yield <
yield to maturity. Note:
• The convention of doubling the
Pros & Cons of YTM semi-annual bond yield for
calculating yield to maturity is
called as ‘Bond-Equivalent
Yield’.

• It assumes that the coupon

payments are reinvested at a
rate equal to the YTM.

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Yield to Maturity
Assumptions for investors to realize YTM
• Coupon payment cab be reinvested at YTM
• Bond is held to maturity by investor.

Factors affecting Reinvestment Risk

• Keeping Coupon rate and YTM constant, longer the maturity
period, greater is the reinvestment risk.
• *Keeping holding maturity and YTM constant, higher the
coupon rate, greater is the reinvestment risk.
* Bonds selling at a premium are prone to
higher reinvestment risk as the reinvestment
income has to make for the amortization of the
price premium for the bond held to maturity.
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Yield to Maturity
Comparison of Semiannual-pay and Annual-pay bonds
Different convention are followed in
• Given a YTM on an annual-pay different parts of the world for coupon
bond, payment. Some follow annual payment
and other may follow semi annual
Bond equivalent yield payment.
= 2 [(1 + Yield on annual-pay bond)0.5 – 1]

• Conversion of Bond-equivalent yield to annual-pay basis

Yield on annual-pay basis
= [(1 + (Yield on bond-equivalent basis/2)2 )- 1]
Note:
Bond-equivalent yield will always
be less than annual bond yield.
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Yield to Call
If a bond carries a callable option, then Yield to Call and Yield to
Maturity are calculated.
Example
Consider a 6% (annually) 5 year Rs.100 par value bond selling at
Rs.105 has a call option. Suppose the first call date is 2 years
from now and the call price is Rs.102. Calculate the Yield to Call
for the bond?
Solution
PV = -Rs.105 Assumptions:
FV = Rs.102 • Investor will hold the bond
to the assumed call date.
N = 2 years
PMT = 6% of Rs.100 i.e. Rs.6 per annum. • Issuer will call the bond on
call date.
Yield to Call (I/Y) = 4.32%
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Types of Yield to Call
Dsdsd
Yield to • It is computed for an issue which is not
currently callable.
First Call
Yield to • It is computed for an issue which is currently
callable.
Next Call
Yield to • It is computed for bonds that a re currently
callable but have some restrictions on the
Refunding source of funds used to buy back the debt.

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Other Yields
Yield to Put:
It is the interest rate that will make the PV of the cash flows to
the first put date equal to the price plus accrued interest.

Yield to Worst:
The lowest of all the possible yields (yield to call, yield to put and
yield to maturity) is known as the Yield to Worst.

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Cash Flow Yield
Facts
• It is used to measure the rate of return on mortgage-backed
securities and asset-backed securities as they have
prepayment risk.

• It assumes that all the cash flows (principal plus interest) can
be reinvested at the calculated yield and that the assumed
prepayment rate will be realized over the security's life.

• It is necessary to calculate the ‘prepayment rate’ (the rate at

which prepayment will occur) for calculating the yield on
these securities.

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Cash Flow Yield
Calculation of Cash Flow Yield
Step 1
Effective semiannual yield = (1 + Monthly yield)6 – 1

Step 2
Cash Flow Yield = 2 x Effective semiannual yield
= 2 [(1 + Monthly yield)6 – 1]

Limitations
• It assumes that the cash flow are reinvested at cash flow yield.
• The mortgage backed securities are held until final payoff.

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Spread/Margin measures for Floating-Rate Securities

Facts
• Margins Measures are calculated for floating rate securities.
• As coupon rate for floating rate securities changes with
change in reference rate and FV of reference rate is unknown,
determination of CF is impossible. Hence Margin Measures
are calculated.
• Margin is the spread above the floaters reference rate.

Commonly used margins

• Spread for life
• Discount margin
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Margin Measures - Spread for Life
Facts
• When there is a premium or discount on a floater, it is
considered to be an additional source of dollar return.
• It is a measure of potential return that accounts for the
accretion (amortization) of the discount (premium) as well as
the constant quoted margin over the security’s remaining life.
Calculation

Where,
Price = market price per Rs.100 of par value
Maturity = number of years of maturity
Quoted margin = quoted margin in the coupon reset formula
measured in basis points.
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Margin Measures – Discount Margin
It estimates the average margin over the reference rate that an
investor can expect to earn over the life of the life of the bond.
Steps to calculate Discount Margin
• Calculate the cash flows assuming that the reference rate does not change over the life of the
security.
1

• Select an appropriate margin.

2

• Add up the reference rate and the margin selected above and discount the cash flow calculated
in step 1 with this number.
3

• Now, compare the discounted value of step 3 with the current market price plus accrued
interest. If both are equal, then the margin assumed discount margin was accurate. But both
4 are not the same, then change the margin and recalculate.

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Yield on Treasury Bills
Treasury bills are zero coupon instruments with a maturity of
one year or less.

Variables for determining the yield

• Settlement price per Rs.1 of maturity value
• Number of days to maturity calculated as number of days
between the settlement date and the maturity date.

Calculation of Yield on a discount basis

d = (1 – p)(360/N)
Where,
d = yield on discount basis
p = settlement price per Rs.1
N = number of days to maturity
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Theoretical Spot Rates – Bootstrapping
In this process, we use yields to get the theoretical Treasury spot
rate curve.

Process
• Solve for spot rates using the prices of coupon bonds.
• Calculate the spot rate for next longer period using the known
spot rate.
• Knowing the two spot rates, third can be calculated by
equating the present value of the cash flows of bond with the
market price.

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Yield Spread Measures Relative to a Spot Rate Curve

Traditional Yield:
• It is also known as nominal spread.

• It is computed as the difference between the bond’s yield and

yield to maturity of a benchmark coupon security.

• It is a compensation for additional credit risk, option risk and

liquidity risk to which an investor is exposed to by investing in
a non-treasury security.

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Zero Volatility Spread (Z-spread)
Facts
• It is a measure of spread that the investor would realize over
the entire Treasury spot rate curve if the bond is held to
maturity.
• Not a spread off point on the Treasury yield curve (as nominal
spread).
• Calculated as a spread that will make the present value of the
cash flows from non-Treasury bond when discounted at the
treasury spot rate plus spread equal to the non-Treasury
bond’s price.
• Trial and error procedure is required to determine the Z-
spread.

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Option-Adjusted Spread (OAS)

1 • It is a measure of spread that the investor would realize over the entire Treasury spot rate
curve if the bond is held to maturity.

2 • It is a spread over the Treasury spot rate curve.

3 • It is not calculated by using a single spot rate curve. Instead, a series of curves are used in
the OAS calculation to reflect the changes in interest rates caused by the embedded options.

4 • It incorporates the premium or discount value of the bonds into a spread over the future
possible spot rate curves.

5 • It is known as Option adjusted because it allows for future interest rate volatility to affect the
cash flows.

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Option Cost
The cost of the embedded option is measured as the difference
between the Z-spread and the OAS.

Option Cost = Z-spread – OAS

Facts
• For callable bonds and bonds with prepayment options (e.g.
most mortgage-backed and asset-backed securities), option
cost > 0 and thus OAS < Z-Spread.
• For putable bonds, option cost < 0 and thus OAS > Z-Spread.

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Forward Rates
Facts
• It refers to the interest rate on a loan beginning some time in
the future.
• They are usually calculated based on the theoretical spot rate
curve.
Example
Based on the table below, calculate the annualized six-month
forward rate 2.5 years from now.

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Forward Rates
Solution:
Spot rate for the 6th period = 0.0665
Spot rate for the 5th period = 0.0635
Annualized 6-month forward rate for 2.5 years from now
= [(1 + 0.0665/2)6/(1 + 0.0635/2)5] -1
= 4.08%.
Valuation using Forward Rates
PV of Rs.1 in X Periods = 1/(1 + zX)X
Where,
Z = one half the bond equivalent yield (BEY) of the theoretical 6-
month spot rate

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