Sources of Return from Investing in a Fixed-Rate Bond
Fixed-rate bond investors have three sources of return:
Par and Forward Rates
Par Rates from Spot Rates An important use of spot rates is determining par rates. A par rate is a yield-to-maturity that makes the present value of a bond’s cash flows equal to par (100% of face value). Par rates derived for hypothetical government bonds with different times-to-maturity are commonly used for term structure analysis because they control for…
Maturity Structure of Interest Rates and Spot Rates
Maturity Structure of Interest Rates Suppose that the yield-to-maturity is higher on one bond compared to another bond. There are several possible reasons for the difference, including credit risk, different currencies, liquidity, tax differences, and the periodicity assumption used in the yield calculation. This factor explaining the differences in yields is called the maturity structure of…
Yield Measures for Money Market Instruments
There are several important differences in yield measures quoted for money market instruments versus bonds: The pricing formula for money market instruments quoted on a discount rate basis. where The unique characteristics of a money market discount rate The pricing formula for money market instruments quoted on an add-on rate basis. where
Yield and Yield Spread Measures for Floating-Rate Notes
Yield and Yield Spread Measures for Floating-Rate Instruments Floating-rate instruments, including floating-rate notes (FRNs or floaters) and most loans, are different from fixed-rate bonds. Rather than fixed coupon payments, they vary from period to period depending on the current level of a reference interest rate. For an FRN, PMT is a function of the MRR and the…
Yield Spread Measures for Fixed-Rate Bonds and Matrix Pricing
In fixed-income security analysis, it is important to understand why bond prices and yields-to-maturity change. To do this, it is useful to decompose a yield-to-maturity into a base rate or benchmark and an issuer-specific spread. The yield spread is the difference between the yield-to-maturity and the benchmark yield. Yield Spreads over the Benchmark Yield Curve The Z-spread over the…
Other Yield Measures, Conventions, and Accounting for Embedded Options
Other Yield Measures and Conventions CYt = Annual coupont / Bond pricet The current yield is a crude measure of return because it focuses solely on interest income, ignoring the frequency of coupon payments, interest on interest (time value of money), and accrued interest. In addition to collecting and reinvesting coupon payments, the investor has a gain…
Periodicity and Annualized Yields
Investors analysing bonds with various cash flow and maturity profiles seek a standardised yield measure to compare across different choices. Yield measures are usually annualised in order to allow a direct comparison. For capital market securities maturing in more than one year, investors want an annualised and compounded yield-to-maturity. An annualised and compounded yield on a fixed-rate bond depends on the assumed number…
Matrix Pricing
Matrix Pricing Process Unlike listed equity securities, most bonds are not actively traded, so there is often no current market price available to calculate yield-to-maturity. Matrix pricing also is used in underwriting new bonds to get an estimate of the required yield spread over the benchmark rate, or the difference in yield-to-maturity between the bond and…