Yield Measures and Total

Return
Lecture 4

Price is what we give and Value is what

we get
Warren Buffet

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Key Concepts and Skills

Understand the concept of different

measures of Bond yield .
Understand bond values and why they
fluctuate.
Learn methods of computing Current Yield,
Yield to Maturity, Yield to Zero Coupon Bond,
and Yield to Call.
Total Returns
Tax equivalent yield and Municipal Bonds

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Yield Measures

The common measures used by market

participants to assess the potential return
from investing in a bond are as follows:
Current Yield
Yield to Maturity
Yield for Maturity of Zero Coupon Bond
Yield to Call

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Current Yield
Current Yield = annual dollar coupon interest
price
Illustration:
Suppose we have a 10% coupon bond, with
semiannual coupons,
Face value of 1000,
Maturity 20 years,
Price $1197.93 price
Current yield = 100 / 1197.93 = .0835 = 8.35%
The Current yield will consider only the coupon
rate and no other source of return that will effect 5
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the investors return.

Bond Yields
The current yield measures only the cash
income provided by the bond as a
percentage of the bond price and ignores
any prospective capital gains and losses.
To measure the rate of return that
accounts for the both current income and
loss or gain during the life of the bond
yield to maturity is a standard measure,
but it is not perfect.

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Yield to Maturity
The Yield to Maturity or internal rate of
return (IRR) of any investment is the
internal rate that will make the present
value of the cash flows equal to the price
or initial investment.
The calculation of the YTM involves a trial
and error procedure. Practitioners usually
use calculators or software to obtain a
bonds yield to maturity.

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Yield to Maturity

Suppose we know the current price of a bond, its

coupon rate, and its time to maturity. How do we
calculate the YTM?
Let us find by trial and error the semi-annual interest
rate that will make the present value of the cash flow
equal to $700.89 So there are 36 coupon payments of
$30 for every six months for 18 years from now
We can use the straight bond formula, trying different
yields until we come across the one that produces the
current price of the bond.

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Yield to Maturity

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Price Risk and Reinvestment Rate Risk

Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term
bonds
Low coupon rate bonds have more price risk than high
coupon rate bonds
Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows can be
reinvested
Short-term bonds have more reinvestment rate risk than
long-term bonds
High coupon rate bonds have more reinvestment rate
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risk than low coupon rate bonds

Yield to Maturity
The YTM considers the coupon income
and any capital gain or loss that the
investor will realize by holding the bond till
maturity.
The YTM considers the timing of the cash
flow and the interest on interest however it
assumes that the coupon payments can
be re-invested at the same rate as the
YTM.

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1.

2.

Yield to Maturity(Re-investment
Two characteristics of bonds determine re-investment
Risk)
risk.
For a given YTM and Coupon rate the longer the
maturity the greater is the dependence on interest on
interest rate and hence greater the re-investment risk.
For a given maturity and YTM higher the coupon rate
the more dependent the dollar return will be on the reinvestment of coupon payment to receive the return on
the YTM at time of purchase. For Zero- coupon Bonds
there is no re-investment risk.

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Yield to Maturity( Interest Rate

As interest rate falls( rises), the price of
Risk)
the bond rises (falls). This is of no concern
for an investor holding the bond to
maturity, however if he wishes to sell it in
the interim period he will face interest risk.
Because a rise in interest rate will lead to
a capital loss. Not all bonds have same
level of interest risk.
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Yield to Maturity
Although YTM is used widely it is not
always the best tool to identify the best
bond. The answer to choosing the best
bond lies in the investors expectation and
specifically on the interest rate at which
the coupon payments can be re-invested.
Secondly for investor horizon longer then
the maturity of the bond, it depends on the
investors expectation of interest rate at
the end of the investment horizon.

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Current Yield vs. Yield to

Maturity

Current Yield = annual coupon / price

Yield to maturity = current yield + capital gains
yield
Example: 10% coupon bond, with semiannual
coupons, face value of 1000, 20 years to
maturity, $1197.93 price
Current

yield = 100 / 1197.93 = .0835 = 8.35%

Price in one year, assuming no change in YTM =
1193.68
Capital gain yield = (1193.68 1197.93) / 1197.93 =
-.0035 = -.35%
YTM = 8.35 - .35 = 8%
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Yield to Maturity Zero coupon

The zero coupon bond is characterized by a single cash
Bonds
flow. To compute the YTM of a zero coupon bond we
apply the following formula:
y = [ maturity value /price] 1/n -1

Doubling y gives the yield to maturity. Note that the

number of periods used in the formula is double the
number of years.
Illustration: A zero coupon bond selling for $274.78 with
a maturity value of $1000 in 15 years is computed.

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Premium and Discount

Bonds, I.

Bonds are given names according to the

relationship between the bonds selling
price and its par value.
Premium bonds: price > par value
YTM < coupon rate
Discount bonds: price < par value
YTM > coupon rate
Par bonds: price = par value
YTM = coupon rate

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Premium and Discount

Bonds, I.

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Relationships among Yield

Measures
for premium bonds:
coupon rate > current yield > YTM
for discount bonds:
coupon rate < current yield < YTM
for par value bonds:
coupon rate = current yield = YTM
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Yield to Call

Yield to call (YTC) is a yield measure that assumes a

bond will be called at its earliest possible call date.
The formula to price a callable bond is:

Callable Bond Price

C
1
1
YTC
1 YTC

2T

CP
1 YTC

2T

In the formula, C is the annual coupon (in $), CP is the

call price of the bond, T is the time (in years) to the
earliest possible call date, and YTC is the yield to call,
with semi-annual coupons.
As with straight bonds, we can solve for the YTC, if we
know the price of a callable bond.

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Yield to Call

Definition

The term Yield to Call is often abbreviated as

YTC, defined that the bond is called on the
next eligible call date. The yield is calculated
from the cash flows from the coupon payments
plus the cash flow of the redemption proceeds
at the time of the call. Where the coupon
payment refers to the total interest per year on
a bond. Yield to call can be mathematically
derived and calculated from the formula.

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Yield to Call
When it comes to helping you estimate your return on a
callable bond, yield to maturity has a flaw. If the bond is
called, the par value will be repaid and interest payments
will come to an end, thus reducing its overall yield to the
investor. Therefore, for a callable bond, you also need to
know what the yield would be if the bond were called at
the earliest date possible. That figure is known as its
yield to call.
The calculation is the same as with yield to maturity, except
that the first call date is substituted for the maturity date.
YTC is therefore a good measurement gauge for the
expected investment return of a bond at a callable time.
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Yield to Call
To find by trial and error the semi-annual interest rate that will make the
present value of the following cash flows equal to $700.89. 10coupon
payments of $ 30 every six months $ 1030 10 six months period from now.
Annual
Interest
Rate
11.20%
11.70
12.20
12.70
13.20
13.70
14.20
14.70
15.20
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Semiannual
Rates
0.06
5.85
6.10
6.35
6.60
6.85
7.10
7.35
7.60

PV of 10
payments
of $30
$225.05
222.38
219.76
217.19
214.66
212.18
209.74
207.34
204.99

PV of
$1030 10
periods
from now
$597.31
585.35
569.75
556.50
543.58
531.00
518.73
508.78
495.12

PV of
cash
flows
$ 822.36
805.73
789.51
773.69
758.24
743.18
728.47
714.12
700.11

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Yield to Call
According to conventional approach,
conservative investors will compute the Yield to
Call and Yield to Maturity for a callable bond
selling at a premium, selecting the lower of the
two yield as a measure of potential return.
Some investor compute all the YTC for every
coupon anniversary following the first call date
and compare them along with the YTM . The
lowest of these yields are called the yield to
worst investors
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Yield to Call ( closer look)

The YTC considers all the three sources of potential

return from owning a bond. Like YTM it assumes that
all cash flows can be invested at the computed yield
i.e. the YTC until the assumed call date. The YTC
assumes that
a) The investor will hold the bond to the assumed call
date and
b) The issuer will call the bond on that date.
The assumptions are often unrealistic
Suppose we have two bonds:

Bond A 5 yr non-callable bond with YTM of 10%

Bond B callable after 3 years with a YTC of 10.5%

Which bond is better for an investor with a 5 year

horizon?
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Total Return Analysis 1

The total return requires that the investor
specify:
An investment horizon
A re-investment rate
A selling price for the bond at the end of
the horizon

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Total Return Analysis 2

Step 1:
Compare total coupon payments plus interest on
interest based on an assumed re-investment
rate. The re-investment rate is half the annual
annual interest that the investor believes can
be earned on re-investment coupon payments.
Coupon plus interest on interest
= semiannual coupon{ [(1+r)h 1)]/r}

where
h =length of investment horizon(semiannually)
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r = assumed semiannual re-investment rate.

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Total Return Analysis 3

Step 2:

Determine the projected sale price at the end of the

investment horizon. The projected sale price will
depend on the projected yield on comparable bonds at
the end of the same investment horizon.
Step 3:
Add the values computed in step 1 and 2. The sum is
the total future dollars that will be received from the
investment given the assumed re-investment rate and
required yield at the end of the investment period.

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Total Return Analysis 4

Step 4
To obtain the semi-annual total return, use the
following formula

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Total Return Analysis 5

Step 5:
Because the coupon interest rates are assumed to be
semiannual, doubling the interest rate found in step 4
above. The interest rate found is the total return
expressed on a bond equivalent basis.
Some portfolio managers object to this technique as it
requires to make assumptions about re-investment rates
and future yields and forces them to think in terms of
investment horizons. Other portfolio managers
investigate multiple scenarios and observe how sensitive
the bond is to different scenarios.

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Municipal and Corporate Bonds

By computing the taxable equivalent yield the taxexempt municipal bond can be compared with taxable
corporate bonds.

Taxable equivalent yield

= (tax exempt yield)

1- marginal tax rate

For example an investor in the 35% marginal tax bracket

is considering investing in a 10 year municipal bond of
4.5%.
The taxable equivalent yield
= 4.5%/(1- 0.35) = 6.92%
Hence a comparable quality corporate bond with YTM
more than 6.92% will be recommended .If instead a
YTM is less than 6.92% investment in Municipal bond
will be recommended.
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NEXT
ZERO COUPON BONDS

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