CHANDLER ASSET MANAGEMENT
A Discussion of Yield
CMTA Essentials of Treasury Management
September 28, 2010
Brian Perry, CFA
VP, Investment Strategist
6225 Lusk Boulevard
|
San Diego, CA 92121
|
Phone 800.317.4747
|
Fax 858.546.3741
|
www.chandlerasset.com
An introduction to yield
■ Yield refers to the income you receive on your bond
■ There are many different ways of calculating yield
■ Don’t make it more complicated than it needs to be
■ Focus on general concepts
■ There are a lot of formulas - don’t worry about memorizing them
■ There is no test at the end of this presentation!
■ Relax!
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Understanding yields
■ The yield on any investment is the interest rate that will make the present
value of the cash flows from the investment equal to the price (or cost) of
the investment
■ Calculating yield requires a trial and error process to find the correct interest
rate
■ Fortunately financial calculators, computers, or Bloomberg terminals can do
this for us
■ Many different types of yields
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Simple interest
&
Discount securities
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Simple interest
■ Assumes interest paid once at the end of the period
■ Interest Earned = Par x Rate x Time
■ For a one year CD
■ The current market rate is 4% for one year
■ You invest $1,000 in a one year Certificate of Deposit at 4%
■ Interest Earned = $40 income
4
Simple annual interest
■ What if the period is shorter than a year
■ For instance a 6 month CD
■ The current market rate is 2% for 6 months
■ You invest $1,000 in a six month Certificate of Deposit at 2%
■ Interest Earned = Par x Rate x Time = $1000 x 2% x 6 months = $20 income
■ The simple annual interest rate = yield for period x number of periods in year
■ So the simple annual interest rate on the 6 month CD = 2% x 2 periods = 4%
■ But…simple annual interest is not correct
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Effective annual interest
■ If the period is less than 1 year, in order to properly annualize the yield we
need to calculate the effective annual yield
■ Effective annual yield = (1 + periodic int. rate)*m) - 1
■ From the previous example, the effective annual yield for the 6 month CD
■ ((1 + 2%)*2) - 1
■ 4.04%
■ For large amounts this slight difference can really add up
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Discount securities
■ Many money market instruments are sold on a discount basis
■ They do not pay interest - the return depends on the difference between the
price paid and the face value at maturity
■ Example: purchase a $100,000 Treasury Bill for $99,800 and receive
$100,000 at maturity in 3 months
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Bond equivalent yield
■ Bond equivalent yield (BEY) ■ Assumes security pays interest two times per year and each interest payment is
reinvested at the purchase yield
■ Most common method of comparing yields of different types of securities
■ Yield on money market instrument issued on a discount basis computed so
that it is comparable to a yield computed on a coupon security paying semiannual interest
■ Bond equivalent yield will be greater than discount rate
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Converting discount rates
■ Convert discount rate to bond equivalent rate
Bond equivalent rate =
365
x
discount rate
360 - (discount rate x days to maturity)
■ Convert 3-month T-Bill bought at 3.00 discount rate to a bond equivalent
rate
Bond equivalent rate =
365
x
discount rate
360 - (discount rate x days to maturity)
365 x .03
= 3.065% BEY
360 - (.03 x 91)
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Yield analysis - “discount” bill
Source: Bloomberg
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Coupon Paying Bonds
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Coupon paying bonds
■ These are “normal” bonds
■ Usually have face value of $1000
■ Usually pay interest semiannually
■ May or may not be callable
■ Several yields to consider for coupon bonds
■ Current yield
■ Yield to maturity
■ Yield to call
■ Yield to worst
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Current yield
■ A bond’s annual coupon payment divided by the bond price
Current yield =
annual dollar coupon interest
current price
6.00%
$1,100
= .0545 or 5.45%
■ For a bond selling at a premium, coupon rate (6%) exceeds current yield
(5.45%)
■ For a bond selling at a discount, coupon rate is less than current yield
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Yield to maturity
■ Yield to maturity is the most common yield measure used to determine the
expected return of a coupon paying bond
■ Measure of the average rate of return that will be earned on a bond bought
now and held to maturity
■ Assumes all coupon payments will be reinvested at the same interest rate
as the yield to maturity
■ This is an unrealistic assumption and makes it likely that the actual realized
return will differ from the yield to maturity at time of purchase
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Yield to call
■ Calculates the return on the bond if the bond is called on its first available
call date
■ Can be calculated for all call dates
■ Yield to call does not take into account how principal will be reinvested if
bond is called
■ Need option-adjusted spread analysis to convert callable bond to an
equivalent non-callable “bullet” security
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Yield to call - price below par
Source: Bloomberg
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Yield to call - price above par
Source: Bloomberg
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Yield to worst
■ Calculated for every call date
■ Compared to YTM
■ Yield to worst is lowest of all possible yields
■ Bond Selling at:
Relationship
Par
coupon rate = YTC = YTM
Discount
coupon rate < YTM < YTC
Premium
coupon rate > YTM > YTC
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Yield Spreads
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Basic yield spreads
■ Most securities in the bond market are priced on a “spread”
■ The spread represents the additional compensation necessary for holding a
risky asset
■ Risky securities are generally compared to Treasuries so the spread is the
additional yield over a Treasury with a comparable maturity – this is known
as a nominal spread
■ Limitation: the nominal spread only measures one point on the Treasury
curve
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Advanced yield spreads
■ The zero-volatility spread (Z-spread) takes into account the entire yield
curve and is more accurate than the nominal spread
■ Option-adjusted spread (OAS) is a model that takes into account the future
volatility of interest rates
■ The OAS measure is appropriate for bonds with embedded options such as
callable agency bonds or mortgage-backed bonds
■ The OAS can be used to compare the relative merits of a callable and a
non-callable bond
■ All spread models are very sensitive to the underlying assumptions of the
model and the inputs to the model
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Yield & Total Return
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Yield and total return
■ Yield measures the coupon payments from a bond
■ Total return includes not only yield but also gains and losses from market
movements
■ Yield is a component of total return
23
Total return
■ Total return measurement is the standard in the investment management
industry
■ Takes into account realized and unrealized gains and losses
■ It makes sense to measure both yield and total return
■ Total return measures growth rate of an investment
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Yield and your portfolio
■ There are many different measures of “yield”
■ It is important to compare “apples to apples”
■ If you are uncertain about a yield calculation or a security’s characteristics, it
is ok to ask your investment provider for more information
■ It is good to look at both yield and total return
■ Yield is one measure of a security’s attractiveness; it is also important to
consider how the security fits in the overall portfolio
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Important Short Term
Rates
&
Investment Options
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Viewing short-term rates
Source: Bloomberg
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Important short term rates
■ Fed funds rate
■ Discount rate
■ LIBOR - London Interbank Offer Rate
■ Prime rate
■ Swap rate
■ T-bill rate
■ “Risk-free” rate
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Federal Reserve rates
■ Fed funds rate
■ Rate at which banks lend among themselves
■ Target rate set by Federal Reserve
■ Probably most important rate in financial markets
■ Discount rate
■ Rate at which financial institutions can borrow from Fed
■ Rate set by Fed
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Bank rates
■ LIBOR
■ Very important in international financial markets
■ $10 trillion in adjustable rate loans indexed to LIBOR
■ Prime rate
■ Set by banks usually in response to changes in Fed Funds rate
■ Many credit cards and other consumer debt linked to Prime
■ Swap rate
■ Used for transactions between financial institutions
■ Indicator of level of interest rates and credit risk in markets
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US Treasury rates
■ T-Bill rate
■ Rate on very short term US Treasury securities
■ Often considered world’s safest and most liquid securities
■ Risk-free rate
■ The rate on an asset without any risk, often the 90 day T-bill
■ Used to calculate the expected or required return on many other financial assets
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Money market investment options
■ LAIF
■ Treasury bills
■ Agency discount notes
■ Commercial paper
■ Certificates of deposit
■ Money market funds
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Are there any questions or comments?
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Biography
Brian Perry, CFA
Vice President, Investment Strategist
Brian Perry joined Chandler Asset Management in 2005 and currently serves as the firm’s investment strategist.
Mr. Perry analyzes economic developments, conducts research on financial topics, and helps formulate investment
strategy. He was also instrumental in creating a new quantitative corporate credit analysis program and in
developing the firm’s capital market forecasts and asset allocation models. He serves as the leader of the Interest
Rate and Capital Market Expectations Committees.
In addition to his investment responsibilities, Mr. Perry is responsible for Chandler’s client education activities. He
edits the monthly Chandler Bond Market Review, has contributed numerous articles to investment industry
publications, and is a frequent speaker at investment conferences and charity events. He has appeared on NBC
news to discuss the financial markets and is the author of From Piggybank to Portfolio, an investment guidebook
scheduled for publication in 2010.
Prior to joining Chandler, Mr. Perry worked as a fixed income trader for an investment bank where he was
responsible for trading government, corporate and emerging market securities.
Mr. Perry earned a Bachelor of Science degree in finance from Villanova University, an MBA in international
business from National University and an MA in international affairs from The Fletcher School at Tufts University.
He is a member of the San Diego Financial Analyst Society and holds the designation of Chartered Financial
Analyst.
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