CFA Level I

Study Session 15 Reading 52

Reading 53
Reading 54
Reading 55
Features of Debt Securities
Risks Associated with Investing in Bonds
Overview of Bond Sectors and Instruments
Understanding Yield Spreads
 CFA Level I: Fixed Income
LOS 55:
Understanding yield spreads
• identify the interest rate policy tools available to a central bank
• describe a yield curve and the various shapes of the yield curve
• explain the basic theories of the term structure of interest rates
• define a spot rate
• calculate, compare, and contrast the various yield spread measures
• describe a credit spread and discuss the suggested relation between credit spreads
and the well-being of the economy
• identify how embedded options affect yield spreads
• explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities
• calculate the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security
• define LIBOR and explain its importance to funded investors
Interest rate policy tools
In implementing monetary policy, the Fed uses the following interest rate
policy tools:

• open market operation

• the discount rate
• bank reserve requirements
• verbal persuasion to influence how bankers supply credit in businesses and
consumers

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 Yield curve

Yield curve represents Yield Yield

relationship between
maturity and
interest rates.
Flat
Inverted Term

Term to maturity Term to maturity

Yield Yield

Normal

Humped

Term to maturity Term to maturity

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Theories of the term structure of
interest rates

Three main theories:

1. Pure expectations theory – yield curve is determined by the expectations of future short – term interest rates.

2. Liquidity preference theory – yield curve is determined by the future expectations of rates and the yield
premium for interest-rate risk.

3. Market segmentation theory – supply and demand for a maturity determines the yield curve.

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Spot rate

Treasury spot rates is an appropriate discount rate for single payments of various maturities from Treasury securities.

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Yield spread measures

Absolute yield spread = higher yield – lower yield

Relative spread = (yield on subject bond/yield on benchmark bond) – 1

Yield ratio = yield on subject bond/yield on benchmark bond

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Credit spread

A Credit Spread is the yield spread between non-treasury and treasury securities. These are equal in all respects
except their individual credit ratings. This means that their maturities are the same and that there are no embedded
options.

Spreads narrow or tighten when the economy is growing, cash flows are increasing.

Spreads widen when economy is faltering or slowing down

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Embedded options
Options that benefit the issuer such as calls investor wants a yield spread that is higher than the bonds that do not
have options.

Options that benefit the holder, such as puts, investor will require a smaller yield spread than bonds that do not have
embedded options in them, such as treasury bonds.

When issues are less liquid, yield spreads tend to widen because there are fewer bonds to buy or it is harder to find a
buyer.

When issues are more liquid, such as on-the-run treasuries, yield spreads are tighter or narrower because there are
plenty of buyers and sellers.

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Taxability of interest income

After tax yield = pre tax yield * (1- marginal tax rate)

Question: Taxable bond yield is 6.5%

The Marginal tax rate for this investor is 30%

Tax equivalent yield = tax exempt yield/(1 – marginal tax rate)

Question: Tax exempt yield = 6.00%

Marginal Tax Rate = 30%

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LIBOR

An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank
market. The LIBOR is fixed on a daily basis by the British Bankers' Association.
The LIBOR is the world's most widely used benchmark for short-term interest rates.

Entities seeking to borrow funds pay a spread over LIBOR and seek to earn a
spread over that funding cost when they invest the borrowed funds.

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