Fis 1 2

F- 506: Fixed Income Securities
Chapter # 6
Yield Measure, Spot Rates and Forward Rates
Yield Measures, Spot rates and Forward rates
q Sources of Return
1. Coupon interest payment
2. Capital gain/loss
3. Reinvestment of interim cash flows
q Traditional 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
Current Yield
• The current yield relates the annual dollar coupon interest to a bond’s
market price.
��
Current yield =
��
Example: A 7% bond having 8 years of maturity , face value $100, whose market price is 94.17 is 7.43%
$7
Current yield =
$ 94.17
= 7.43% Annual dollar coupon interest Current yield > coupon rate; when
100*0.07=7 selling at discount
Current yield < coupon rate; when
selling at premium
Limitation:
Ø capital gain/loss and reinvestment income is
overlooked
Yield to Maturity
q YTM is the interest rate that makes the present value of bond’s cash flows equal to its market price .
q It is a special kind of IRR calculation where the cash flows are those received if the bond is held to
maturity.
1. Determine the expected cashflows
2. Through trial and error, find the interest rate that will make the PV of CFs equal to market price.
Example: Consider a 7% bond with 8 years of maturity having face value of 100 is selling for 94.17; pays
coupon semiannually.
Cashflows: coupon : 100*.035 = 3.5 ; principal= 100
Semiannual interest rate Present Value

3.0% 106.30
�� − ��
3.5% 100 Trial and Error: LR+ (�� − ��)
�� −��
4.0% 94.17
4.5% 88.77
So, the YTM is 8% (doubling the semiannual rate)
Limitation of YTM
It assumes that coupon payments are reinvested at an interest rate equal to the YTM which is not always
true. If coupon needs to be reinvested at a lower rate, then YTM will be an overstated figure.
Take the previous example.
We have found the YTM of 8% (4% semiannually) i.e. the coupon is supposed to be reinvested at 4%
every six months.
Now, suppose you deposit 94.17 dollar in a bank which promises you to pay 4% interest every six
months and matures in 8 years. After 8 years, you will generate,
94.17 * ((1.04)16 = 176.38 Now, consider the bond,
Total future dollar = 176.38 Coupon payment: 3.5 for 16 payments = 56

Capital gain at maturity = (100-94.17) = 5.83
Return of principal = 94.17
Dollar return without reinvestment = 61.83
Total interest from the investment = 82.21
Shortfall of return = (82.21 – 61.83) = 20.38
Limitation of YTM
You have to reinvest the coupon interest until the maturity
No. of payment Reinvestment Coupon payment Reinvestment income

time
1 15 3.5 3.5*(1.04)^15 - 3.5 = 2.80
2 14 3.5 3.5*(1.04)^14 - 3.5 = 2.56
3 13 3.5 3.5*(1.04)^13 - 3.5 = 2.33
16 0 3.5 0.00
Total 20.39
(1.04)16
Another way is to calculate from annuity rules : � = 3.5 ∗ = 76.38 ( interest + reinvestment income)
.04
Yield to Maturity
Factors affecting reinvestment risk
1. The long the maturity of the bond, the higher the reinvestment risk
2. The higher the coupon rate, the more dependent the bond’s total return on reinvestment return
3. Bond selling at premium is more dependent on reinvestment income than selling at par
4. Bond selling at discount is less dependent on reinvestment income than selling at par
5. A zero coupon bond has no reinvestment risk if held to maturity.
Relationship with current yield:

§ Traded at par: CR = CY = YTM
§ Traded at discount: CR < CY < YTM
§ traded at premium: CR > CY > YTM
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 ﬁrst date the bond can be called using lower-cost debt.
Measuring Yield
Yield to Put
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
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. 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.
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-on-interest 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.
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.
1
�� (��)
Total return = ( ) - 1
��
Measuring Yield
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%.
6-year investment horizon, 13-year, 9% coupon

bond
Bond price Bo = 1000
Face Value = 1000
Coupon Rate = 9%
Annual coupon = 90
Semiannual coupon = 45
Annual reinvestment rate= 8% 10%
Semiannual reinvestment 4% 5%
YTM for the 7-year bond 10.6%
Semiannual YTM 5.3%
Measuring Yield
Total future value of coupon
and interest on interest
First 2 years’ coupon 45 =282.33
(1.04)4 − 1 (1.05)8
. 04
Corresponding 4 years’ coupon 45 = 429.71
(1.05)8 − 1
. 05
Price at the end of investment 45 1 1000 = 922.31
1− +
horizon . 053 (1.053)14 (1.053)14
Total return amount = 1634.35
Total rate of return(semi-annual) 1634.35 1/12 = 4.18%
−1
1000
Total rate of return(annual) 8.36%
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 17-year bond will be selling to offer a yield to maturity of 7%,
determine the total rate of return of the bond.
3-year investment horizon, 20-year
8% coupon bond
Bond price Bo = 828.4
Face Value = 1000
Coupon Rate = 8%
Annual coupon = 80
Semiannual coupon = 40
Annual reinvestment rate= 6%
Semiannual reinvestment 3%
YTM for the 17-year bond 7%
Semiannual YTM 3.5%

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F- 506: Fixed Income Securities

q Traditional Yield Measures

Semiannual interest rate Present Value

94.17 * ((1.04)16 = 176.38 Now, consider the bond,

Total future dollar = 176.38 Coupon payment: 3.5 for 16 payments = 56

No. of payment Reinvestment Coupon payment Reinvestment income

Relationship with current yield:

6-year investment horizon, 13-year, 9% coupon

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