4.1.4 Bond Yields and Return Calculations

4. Bond Yields and Return Calculations

4.1. Yield to Maturity

4.1.1 Definition

Yield to maturity is a single discount rate which if applied to all the bond’s cash flows, would make the cash flow’s present value equal to the bond’s market price.

When YTM expressed with semi-annual compounding, the bond’s market price is :

$$P=\frac{c/2}{1+y/2}+\frac{c/2}{(1+y/2{)}^2}+\cdots +\frac{c/2+100}{(1+y/2{)}^{2T}}$$

Suppose that a 2-year, $8\%$ semi-annual coupon bond is priced at $105$. The YTM of the bond is:

$$105=\frac{4}{(1+\frac{YTM}{2})}+\frac{4}{(1+\frac{YTM}{2}{)}^2}+\frac{4}{(1+\frac{YTM}{2}{)}^3}+\frac{104}{(1+\frac{YTM}{2}{)}^4}$$

The calculator solution is:
$N=4$, $PMT=4$, $PV=-105$, $FV=100$ $CPT\to 1/Y=2.6625$, $YTM=2.6625\times 2=5.33\%$

4.1.2 Properties of YTM

The bond price is inversely related(反向相关) to YTM.

• At premium: coupon rate > YTM
• At par: coupon rate = YTM
• At discount: coupon rate < YTM (e.g,.zero coupon bond)
  

“Pull to par” effect(回归面值): If no default and the yield keep constant, bond price approaches par value as its time-to-maturity approaches zero.

4.1.3 The Relationship between Spot Rates and YTM

YTM is a kind of average of all the spot rates.
$$P=\frac{C{F}_1}{(1+YTM)}+\frac{C{F}_2}{(1+YTM{)}^2}+\cdots +\frac{C{F}_n}{(1+YTM{)}^n}$$
$$P=\frac{C{F}_1}{(1+z_1)}+\frac{C{F}_2}{(1+z_2{)}^2}+\cdots +\frac{C{F}_n}{(1+z_n{)}^n}$$

Coupon effect: The fact that correctly priced bonds with same maturity but different coupons have different yield to maturity.

As coupon rises, the average time it takes bondholders to recover their cash flow flows falls. Therefore, the spot rates for the early payment dates is becoming more important in determining the yield to maturity.

• Spot curve is upward-sloping (negative relationship): The higher the coupon rate, the lower the YTM (with the same maturity)

• Spot curve is downward-sloping (positive relationship):The higher the coupon rate, the higher the YTM (with the same maturity)

• Spot curve is flat (equal): YTM = spot rate

Yield Spreads: The market price of a security is recovered by discounting a bond’s cash flows using a appropriate term structure plus a spread.

• G-spread: yield spread over an actual or interpolated government bond.
• Zero volatility spread(Z-spread, static spread): a constant yield spread over a government spot curve.
  $$PV=\frac{PMT}{(1+z_1+Z{)}^1}+\frac{PMT}{(1+z_2+Z{)}^2}+\cdots +\frac{PMT+FV}{(1+z_n+Z{)}^n}$$

Japanese yields: in Japan, yields are quoted on a simple yield basis, which means that there is no compounding in the yield measurement.
A five-year bond has a coupon of $2\%$ and the price of the bond is $99$, the Japanese yield is
$$\text{Japanyield}=\frac{c}{p}+\frac{100-p}{pT}=2.22\%$$

Question 1: Fiona Johnson, FRM, is a risk manager for a fund. She is analyzing a US Treasury bond position in a client’s portfolio. This bond is a straight bond with a face value $$100,000$ and $5$ years maturity. The coupon rate is $6\%$ on a semi-annual basis and yield to maturity is $5\%$. Fiona thinks that US Treasury yield curve will shift and the yield of this bond will decrease $25$ bps. What will the approximate price change of this bond?

$N=10$, $1/Y=2.5$, $PMT=3000$, $FV=100,000$, $\to F{V}_{\text{original}}=104,376$

$N=10$, $1/Y=(5-0.25)/2=2.375$, $PMT=3000$, $FV=100,000$, $\to F{V}_{\text{new}}=105,505.5$

$\text{Price change}=105,505.5-104,376=1129.5$

Question 2: Thomas buys a three-year zero-coupon bond for $87.0$. Based on the information from Yahoo Finance, he notices that the three-year spot rate is $4\%$ (semi-annually compounded). What is the spread of the bond?

$$87=\frac{100}{(1+0.04/2+s/2{)}^6}\to s=0.0070$$

4.2 Conventions for Quotation

Bond dealers usually quote flat price while the full price will be paid, and there can be a difference between them.

Full price = Flat price + Accrued Interest (AI)
Dirty price = Clean price + Accrued Interest (AI)

$$\text{FullPrice}=\left[\frac{PMT}{(1+r{)}^1}+\frac{PMT}{(1+r{)}^2}+\cdots +\frac{PMT}{(1+r{)}^n}\right](1+r{)}^{t/T}$$

Accrued Interest(AI): the proportional share of the next coupon payment.

$$AI=\frac{t}{T}\times PMT$$

Day-count conventions:

• Actual/actual: most commonly for government bonds
• 30/360: most commonly for corporate and municipal bonds.

An investor is considering buying a corporate bond with $8\%$ coupon rate and $$100$ par value. This bond matures on September 1st 2032 with semi-annual coupon payment. The payment is made on March 1st and September 1st every year. Suppose today is May $15^{th}$ 2020 and required yield is $6\%$. How much should the investor pay and what should be the price quoted?

1. 计算AI，注意日期模式
   $AI=74/180\times 4=1.6444$

2. 计算上一个票息支付日的债券价格
   Bond price for previous coupon date (2020/3/1)

   $PMT=4$, $FV=100$, $N=25$, $1/Y=3$, $CPT$ $PV=117.4131$

3. 复利到交割日（脏价）
   Dirty price for 2020/5/15: $117.4131\times (1+3\%{)}^{74/180}=118.8486$

4. 计算净价
   Clean price = dirty price - AI = $118.8486-1.6444=117.2042$

关注日期模式

4.3 Decomposition of P&L

4.3.1 Gross and Net Realized Returns

Gross Realized Return: including capital gain or loss and coupon, and if we want to look at the return over a longer period, we must consider the coupon reinvestment.

$$R_{t,t+1}=\frac{P_{t+1}+c-P_t}{P_t}$$

Suppose there is a 4-year bond with $6\%$ semi-annual coupon rate. The initial price is $104.9$ and turns to be $104$ after one year. The first coupon is reinvested at $5.5\%$. Calculate the gross returns.
$$R_{t,t+1}=\frac{104+3+3\times (1+5.5\%/2)-104.9}{104.9}=4.9\%$$

Net Realized Return: The return after financing costs have been subtracted.

Suppose there is a 4-year bond with $6\%$ semi-annual coupon rate. The initial price is $104.9$ and turns to be $104.32$ after six month. The investor finances the purchase of the bond and a rate of $0.2\%$ would be charged on the amount borrowed. Calculate the net returns.
$$R_{t,t+1}=\frac{104.32+3-104.9}{104.9}-\frac{0.2\%}{2}=2.21\%$$

4.3.2 Decomposition of P&L for a Bond

The bond’s profit and loss consist of both price appreciation/depreciation(capital gain or loss) and cash-carry(cash flows such as coupon payments).

Price appreciation can be decomposed into three components: carry roll-down, rate change and spread change.

The carry roll-down: the return achieved due to the passage of time if there is no change to some aspect of the interest rate environment. The most common assumption when the carry roll-down is calculated is

• Forward rates are realized( the forward rate for a future period remain unchanged as we move through time).
• The interest rate term structure stays unchanged.
• A bond’s yield to maturity remain unchanged.

Rate changes: the return realized when realized rates differ from those assumed in the carry roll-down.

Spread changes: the return realized when a bond’s spread changes.

Consider a bond provides an annual coupon rate of $2\%$. Forward rates are annually compounded and shown below. The investor earns a spread of $50$ bp per years. Calculate the carry roll-down, assuming that forward rates are realized and the spread is unchanged.

Start Period	0-1	1-2	2-3
Forward Rate	3%	4%	5%
Spread	0.5%	0.5%	0.5%

$P=\frac{2}{1.035}+\frac{2}{1.035\times 1.045}+\frac{102}{1.035\times 1.045\times 1.055}=93.1720$

$P_{\text{carry roll-down}}=\frac{2}{1.045}+\frac{102}{1.045\times 1.055}=94.4330$

Suppose now that forward rates are not realized. The forward rates in one year are shown in the table below. If the spread had remained the same, what is the impact of the term structure change?

Start Period	0-1	1-2	2-3
Forward Rate	-	3%	4%
Spread	-	0.5%	0.5%

$P_{\text{rate change}}=\frac{2}{1.035}+\frac{102}{1.035\times 1.045}=96.2392$

Suppose now that the spread increases to $100$ bp, If the forward rates are realized, what is the impact of spread changes?

Start Period	0-1	1-2	2-3
Forward Rate	-	3%	4%
Spread	-	1%	1%

$P_{\text{spread change}}=\frac{2}{1.04}+\frac{102}{1.04\times 1.05}=95.3297$

These results are summarized in the table below:

Initial Price of Bond	$93.1720$
Carry Roll-Down	$94.4330-93.1720+2=3.261$
Rate Changes	$96.2392-94.433=1.8063$
Spread Changes	$95.3297-96.2392=-0.9096$
Final Value of Bond	$95.3297$
Gain	$4.1577=3.261+1.8063-0.9096$