CFA Level I

Study Session 16 Reading 56

Reading 57
Reading 58
Reading 59
Introduction to the Valuation of Debt Securities
Yield Measures, Spot Rates, and Forward Rates
Introduction to the Measurement of Interest Rate Risk
Fundamentals of Credit Analysis
 CFA Level I: Fixed Income
LOS 57:
Yield measures, spot rates and forward rates
• explain the sources of return from investing in a bond
• calculate and interpret the traditional yield measures for fixed-rate bonds and explain their
limitations and assumptions
• explain the importance of reinvestment income in generating the yield computed at the time of
purchase, calculate the amount of income required to generate that yield
• calculate and interpret the bond equivalent yield of an annual-pay bond and the annual-pay
yield of a semi annual-pay bond
• describe the methodology for computing the theoretical Treasury spot rate curve and calculate
the value of a bond using spot rates
• differentiate between the nominal spread, the zero-volatility spread and the option-adjusted
spread
• describe how the option-adjusted spread accounts for the option cost in a bond with an
embedded option
• explain a forward rate and calculate spot rates from forward rates, forward rates from spot
rates, and the value of a bond using forward rates
Sources of Return

Debt securities that make interest payments have three sources of return:

• the coupon interest payments made by the issuer

• any capital gain (or capital loss—a negative dollar return) when the security
matures, is called, or is sold
• income from reinvestment of interim cash flows (interest and/or principal
payments prior to stated maturity)

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Assumptions

The main underlying assumptions used concerning the traditional yield measures are:

1. The bond will be held to maturity.

2. Coupons can be reinvested at the yield to maturity.

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Traditional yield measures

Annual coupon interest

• Current yield =
Price

• The current yield will be greater than the coupon rate when the bond sells at a discount, the reverse is true for a
bond selling at a premium.
• For the bond selling at par. the current yield will be equal to the coupon rate
• Limitation - current yield considers only the coupon interest and no other source for an
investor's return.

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Traditional yield measures
• Yield to maturity (YTM) - is the interest rate that will make the present value of a bond's cash flows equal to its
market price plus accrued interest.

Example: Consider a 7%, 3-year, annual-pay bond priced at $950

950 = 70/(1+YTM) + 70/(1+YTM)2 + 1070/(1+YTM)3
TVM functions: N = 3; PMT = 70; FV = 1,000; PV = -950; CPT l/Y = 8.97%

• For a bond selling at par: Coupon Rate = Current Yield = Yield to Maturity
• For a bond selling at a discount: Coupon Rate < Current Yield < Yield to Maturity
• For a bond selling at a premium: Coupon Rate > Current Yield > Yield to Maturity

Limitation - it assumes that the coupon rate will be reinvested at an interest rate equal to the YTM.
Advantage - it does take into consideration the coupon income and capital gains or loss as well as the timing of the
cash flows.

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Traditional yield measures

• Yield to First Call - Yield to first call is computed for a callable bond that is not currently callable. The actual
calculation is the same as the Yield to Maturity with the only difference being that instead of using a par value
and the stated maturity, the analyst will use the call price and the first call date in calculating the yield.

Limitation - it assumes investor will hold the bond to the assumed call price and that the issuer will call the bond on
that date which both are unrealistic.
The comparison of different yields to call with the YTM are meaningless because the cash flows stop once the issuer
calls the bond.

• Yield to Refunding - Yield to refunding is used when the bonds are currently callable but there are certain
restrictions on the source of funds used to buy back the debt when a call is exercised. The refunding date is the
first date the bond can be called using a lower-cost debt. The calculation is the same as YTM.

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Traditional yield measures

• Yield to Put - Yield to put is the yield to the first put date. It is calculated the same way as YTM but instead of the
stated maturity of the bond, one uses the first put date.

Limitation - This assumes that coupon payments will be reinvested at the calculated yield and that the bonds will be
put on the first date.

• Yield to Worst - Yield to worst is the yield occurs when one calculates every possible call and put date that has the
lowest possible yield.

Limitation - This measure does not identify the potential return over some time horizon and fails to take into account
that the calculation for a YTM has different exposures to reinvestment risk.

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Traditional yield measures

• Cash Flow Yield - it deals with mortgage-backed and asset-backed securities. The cash flows of these securities
are interest and principal payments.
• Borrowers who make up the mortgage or asset pool can prepay their loans in whole or in part prior to the
scheduled principal payment.
• The cash flows have to be estimated and an assumption must be made as to when these principle pre-payments
may occur. The rate when the pre-payments occurs is called the pre-payment rate.
• Once this rate is estimated, a yield can be calculated. The yield is the interest rate that will make the present value
of the estimated cash flows equal the price plus accrued interest.

Formula used to convert monthly CFY into bond equivalent yield:

Bond equivalent yield = [(1+ monthly CFY)6 – 1] * 2

Limitation – actual prepayment rates may differ from those assumed in calculation of CFY.

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Reinvestment risk

Factors affecting reinvestment risk:

1. Coupon rate – higher the coupon, more cash flow to reinvest.

2. Maturity - longer the maturity, the more the bond's total return depends on reinvestment revenue to realize the
yield to maturity at purchase time.

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Bond equivalent yield

• Bond equivalent yield of an annual pay bond

= 2[(1 + yield on annual pay bond)0.5 -1 ]

Question: Assume that the YTM on an annual-pay bond is 7%.

• Yield on annual pay basis = [(1 + yield on bond equivalent basis/2)2 -1 ]

Question: The yield of a U.S. bond quoted on a bond-equivalent basis of 7%.

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Theoretical spot rates
Example: Suppose you have a bond that matures in 1.5 years that has a coupon rate of 8% and the spot curve is 5%
for six months, 5.25% for 1 year and 5.50% for 1.5 years.

Answer:
Bond price = 40/ (1.05) + 40 / (1.0525)^2 + 1040 / (1.055)^3
Bond Price = 38.09 + 36.12 + 931.06
Bond Price = 1005.27

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Bootstrapping

Example: We have a six month annualized yield of 4% and similarly of the 1 year Treasury Security the rate is 4.40%.
Compute the 1.5 year theoretical spot rate of a zero coupon bond. Use a coupon of 6% with them selling at par.

Answer:
cash flows:
0.5 year = .06 * $100 * .5 = 3.00
1.0 year = .06 * $100 * .5= 3.00
1.5 year = .06 * $100 * .5 = 3.00 +100(par value) = 103

3.00/ 1.02 + 3 / (1.022)^2+ 103 / (1 +x3)^3 = 100

2.94+ 2.88 + 103 / (1 + X3 )^3 =100
103/ (1 +x3)^3 = 94.18
(1 + x3)^ 3 = 103 /94.18

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Nominal spread
Nominal spread - is the spread between a non-treasury bond's yield and the yield to maturity on the comparable
Treasury security in terms of maturity.

This spread measure takes into consideration the extra credit risk, option risk and any liquidity risk that may be
associated with the non-treasury security.

Limitations:
• The yield does not take into consideration the term structure of spot rates.
• In the case of callable/puttable bonds, expected interest-rate volatility may change the cash flows of the non-
Treasury security.

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Zero – volatility spread

Z – spread measures the spread the investor would capture over the entire Treasury spot- rate curve if the bond was
held to maturity.
The Z-spread is calculated as the spread that will make the present value of cash flows from the non-treasury security
when they are discounted at the Treasury spot rates plus the Z-spread equal to the non-Treasury securities price.

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Option - Adjusted spread

Option adjusted spread(OAS) are the spreads that take out the affect of embedded options on yield.

It reflects the yield differences for differences in risk and liquidity.

Option cost = Z spread - OAS

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Forward rates

• Forward rate is a borrowing/lending rate for a loan to be made at some future date.
Compute forward rate, Given spot rates are:

Example: An investor purchased a 6 month T-bill for $X.

• Value = X(1 +Z1)
• Z1= one half of the BEY of the theoretical spot rate curve
• Let f be the one half the forward rate on a 6 - month T-bill, 6 months from now
Value = X(1 + Z1)(1+f)
• Alternately, Let Z2 represent one-half the BEY of the theoretical 1-year spot rate
Value = X(1 +Z2)2

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Forward rates

• Investor will be indifferent if,

X(1+Z2)2 = X(1+Z1)(1 + f)

(1+Z2)2
f= X(1+Z1)
-1

• Computing spot rates, given forward rates:

(1 + S3 )3 = (1 + f0)(1 + f1)( 1 + f2)

S3 =[(1 + f0)(1 + f1)(1 + f2) 1/3 -1]

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