Fixed Income Securities

Lecture 03:
Prof. Jerchern Lin Yield to Maturity

Yield to Maturity

Readings:
TUCKMAN Chapter 3
MARTELLINI Chapters 2, and 4

1
 Questions/Summary
What is the yield to maturity? Is it defined for zero or coupon bonds?
Can you easily compute it?
What it means for the price if c=y? If c>y? If c<y? If c=0?

Why do we have Yields?

Do Higher Yields mean better Investment Opportunities?
Do they measure Value?
What do they measure?

What is the coupon effect?

What is the par rate? How do we compute it?

2
 Outline
Bond pricing basics

A. The discount function

B. Valuing fixed cash flows
C. Yields
D. Forward rates
E. Term structure theories

3
Key Concepts and Buzzwords

Concepts Buzzwords
Yield to maturity internal rate of return,
redemption yield, yield curve,
Coupon Effect term structure of interest rates
Par Rate
Rate of Return

4
 YTM: Definition
Definition: the yield-to-maturity of a bond is defined as
the discount rate that makes the market price of the
bond equal to the discounted value of its future cash
flows.

The yield-to-maturity is often called the internal rate of

return, or the redemption yield.

5
 General Formulation
Suppose a bond (or portfolio of bonds) has price P and
fixed cash flows K1, K2,...,Kn at times t1, t2,..., tn.
Its yield to maturity is the single rate y that solves:

Note that the higher the price, the lower the yield.
6
 Examplecontd
Recall the 1.5-year, 8.5%-coupon bond we priced in the
last class.
Using the zero rates 5.54%, 5.45%, and 5.47%, the bond
price is 1.043066 per dollar par value.
That implies a yield of 5.4704%:

7
 Yield of a Bond on a coupon date
For an ordinary semi-annual coupon bond on a coupon date, the
yield formula is

2
1
= +
2 1+ 2
=1 2 1+ 2

where c is the coupon rate and T is the maturity of the bond in years.

8
 Price-Yield Relations
Applying the annuity formula to the value of the coupon stream, with
r=y/2 and n=2T:

The closed-form expression simplifies computation.

Note that if c=y, P=1 (the bond is priced at par).
If c>y, P>1 (the bond is priced at a premium to par).
If c<y, P<1 (the bond is priced at a discount).
The yield on a zero is the zero rate: c=0 ; y=rT

9
 Examplecontd
Recall that the 1.5-year 8.5%-coupon bond was priced at
1.043066 per dollar par value.
In other words, the bond is priced at a premium.
That implies that the coupon rate must be higher than
the yield.
Indeed, c= 8.50% > y= 5.4704%.

10
UNDERSTANDING YIELDS

11
 Questions

Why do we have Yields?

Do Higher Yields mean better Investment Opportunities?

Do they measure Value?

What do they measure?

12
 Lesson 1

Yields through Zeros,

Coupon Effect

13
 Yields through Zeros
Strips/Zero market Bond market

Prices of Zeros Prices of Coupon

Bonds

Zero Rates Bond Yields

14
 Bond Yields and Zero Rates
Recall that we can construct coupon bonds from
portfolios of zeroes, and we can construct zeroes from
portfolios of coupon bonds.

This means that, in the absence of arbitrage, the prices

of zeroes imply prices for coupon bonds and the prices
of coupon bonds imply prices for zeroes.

Equivalently, yields on zeroes imply yields on coupon

bonds and yields on coupon bonds imply yields on
zeroes.
15
 Review: Valuation Formulas
We have expressions for the value of a portfolio of fixed
cash flows in terms of
discount factors (by no arbitrage)
discount rates (by the definition of the discount rates)
yield (by the definition of yield).

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 Yield and Zero Rates
Compare the formula with zero rates and the formula with yield:

Notice that the yield is a blend or a kind of average of the different

zero rates associated with the cash flows. In other words, the yield
must be between the highest and lowest zero rates.

17
 Examplecontd
Compare the two formulas for the 1.5-year 8.5%-coupon
bond:

The yield of 5.4704% is a kind of average of the discount

rates 5.54%, 5.45%, and 5.47%.

18
 The Coupon Effect
Consider two bonds with the same maturity but
different coupon rates.

Their yields are "averages" of the zero rates associated

with their cash flows.

Because they have the same maturity, the two bonds

have cash flows at the same times, so their yields are
averages of the same set of zero rates,

But the bond with the higher coupon rate places more
weight on the shorter-term rates.
19
Example of the Coupon Effect

Recall that the 6-month and 1-year STRIPS rates were

5.54% and 5.45%. The yield curve is downward sloping
over this range.

Consider two one year coupon bonds with coupon rates

6% and 10%.

Which must have a higher yield?

20
Example of the Coupon Effect

Par Coupon Maturity Price Yield

100 0 0.5 97.30 5.540%

100 0 1.0 94.76 5.450%
100 6% 1.0 100.53 5.451%
100 10% 1.0 104.37 5.452%

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 The Coupon Effect
If the zero yield curve is upward sloping, then the bond
with the higher coupon will have a lower yield.

Conversely, if the yield curve is downward sloping then

the higher coupon bond will have a higher yield.

This "coupon effect" is just a mathematical relationship

that results from pricing all bonds from the same set of
zeroes rates, which is necessary for no arbitrage.

22
 Illustration of the Coupon Effect
with Yield Curves

The next few slides sketch yield curves for bonds with
different coupon rates.

In each slide, a single discount function determines three

yield curves:
zero rates across different maturities
yields on bonds with a constant low coupon with different
maturities
yields on bonds with a constant high coupon with different
maturities

23
 YTM: Interpretation
Yield to maturity is just a complex, nonlinear average
of spot rates of interest.

Because most of the bonds cash flow arrives at maturity (the

principal), the T-year spot rate gets the most weight in the yield-
to-maturity calculation.

High coupon bonds pay a larger percentage of their face value

as coupons than low coupon bonds; thus, their yields-to-maturity
give more weight to earlier spot rates.

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 YTM: Interpretation

The yield of a portfolio of fixed cash flows depends on

the size and timing of those cash flows.

The yield is more heavily influenced by cash flows that

are
larger in size (in present value terms)
later in time (for a given present value)

25
 Upward Sloping Yield Curve
Yield Zero curve

Low coupon
High coupon

Maturity 26
Downward Sloping Yield Curve
Yield

High coupon

Low coupon

Zero curve

Maturity 27
Hump Shaped Yield Curve
Yield

high
low
zero

Maturity
28
Yield Curves for Zeros, Bonds, and
Annuities

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 Lesson 2

Yields vs Value

30
 Are Yields a good measure of
Value?

Can you compare two 2-year bonds, one yielding 6%

and the other one yielding 8%?

Which one is a better investment?

31
Yields as a Measure of Value
If one portfolio has a higher yield than another, is it a
better value?

Zeroes with different maturities have different yields (the yield

curve is not flat). Are higher yielding zeroes a better value?

No arbitrage implies that if zeroes of different maturity have

different yields, then coupon bonds of different maturity will have
different yields. And bonds with the same maturity but with
different coupon rates will also have different yields. Is the bond
with the highest yield the best buy?

32
How do we compare investment
opportunities?

33
 Rate of Return
The rate of return on an investment from time 0 to time T
tells the payoff per dollar invested. In un-annualized
terms, this is

34
 Rate of Return
The annualized, semi-annually compounded rate of
return, R, is defined by

Note that at time 0, VT may be unknown--i.e, VT can be

a random variable. That means R can be a random
variable.

35
 Rate of Return to Maturity for a
Zero-Coupon Bond
The one and only case in which the rate of return is not
random is the rate of return on a zero from the day it is
purchased until the day it matures.
R is known with certainty at the date of investment.
R is equal to the zero rate and also equal to the zero's yield.

36
Rate of Return for Any Other Asset
The future value of the asset is unknown (random).

The rate of return on a zero over a horizon shorter than its

maturity date depends on the future price of the zero some time
before maturity. (INVESTMENT HORIZON MATTERS)

If the asset pays intermediate cash flows, such as a bond paying

coupons, the future value depends on future reinvestment rates
(future bond prices). (REINVESTMENT RISK MATTERS)

37
 Yield vs Rate of Return
Yield and rate of return are simply different concepts.

Yield is the single discount rate that sets the present

value of a bond's cash flows equal to a given price.

Yield can only be computed when the asset's cash flows are
fixed (non random)
Given cash flows, yield and price are equivalent information.
Computing yield requires only current information.

38
 Yield vs Rate of Return

Rate of return is a concept that is meaningful for any

asset, not just an asset with fixed cash flows.

The notion of rate of return requires a specification of a

horizon.

At the time the investment is made, the rate of return is

generally unknown--a random number.

39
Yield is a Poor Measure of Value
In the special case of two assets with identical fixed cash
flows, the higher yielding one is a better value, because
its price is lower.

Otherwise, yield contains little information about value.

In assessing the value of a bond, the investor needs to

consider the possible return over the investment horizon:
What is the expected return?
What is the variance of that return (risk)?
Does the return serve to hedge other risks in the portfolio
(diversification by way of co-variance)?

40
Yield is a Poor Measure of Value
What if the zero curve is flat?

What would it mean if there were 2 different bonds with

the same maturity one yielding 6% and the other one
8%?

41
 Yield: Final Comment

If a bonds yield remains unchanged over a certain period,

THEN the total return over the period equals the yield

But if there is any shift in the term structure, this is no longer

true: in general there is reinvestment risk

42
Last Concept for Today

Par Rates

43
 Par Rates

The par rate for a given maturity T is the coupon rate

that makes a T-year coupon bond sell for par.

Of course, the yield on the bond will also be the par rate.

Since coupon bonds are usually issued at par, par rates

are yields on newly issued bonds.

44
 Par Rate Formula
For each maturity T, the par rate cT is the coupon rate
that sets the bond price equal to par.

implies

45
 Examplecontd
To solve for the 1.5-year par rate, use the discount
factors for time 0.5, 1.0, 1.5:

46
Yield Curves for Zeroes and Par
Bonds

47
 Questions/Summary
What is the yield to maturity? Is it defined for zero or coupon bonds?
Can you easily compute it?
What it means for the price if c=y? If c>y? If c<y? If c=0?

Why do we have Yields?

Do Higher Yields mean better Investment Opportunities?
Do they measure Value?
What do they measure?

What is the coupon effect?

What is the par rate? How do we compute it?

2