Yield and Yield Spread Measures for Fixed-Rate Bonds
Overview
Earlier lessons demonstrated the relationship between bond prices and yields-to-maturity (YTMs), as well as other features, such as coupon rate and time-to-maturity. Two important considerations for interpreting and determining yields-to-maturity and other yield measures are the assumed frequency of compounding interest and the presence of embedded options that could affect cash flow amounts or timing. This module explores these considerations and extends the analysis of yields by introducing spread measures, which compare yields to benchmark rates to ascertain how much an investor would be compensated for taking certain risks.
Most of the examples and exhibits used throughout the reading can be downloaded as a Microsoft Excel workbook. Each worksheet in the workbook is labeled with the corresponding example or exhibit number in the text.
- Yields-to-maturity allow analysts to use a single measure to compare bonds with varying maturities and coupons. An important factor in yield determination and interpretation is the frequency of compounding, known as periodicity.
- All else equal, more frequent compounding results in greater future values or returns. Therefore, compounding more frequently at a lower rate can be equivalent to compounding less frequently at a higher rate; the more frequent compounding makes up for the lower rate.
- Prices and yields of bonds with embedded options require adjustments to reflect the value of the option. The option-adjusted yield spread and yield-to-worst are measures that reflect option values.
- Yield measures for a bond, as well as changes in them, can be decomposed into a benchmark rate and a spread over the benchmark rate. Benchmark rates reflect macroeconomic, “top-down” conditions that affect all bonds in a market, while spreads capture issuer-specific, “bottom-up” factors, such as credit risk, liquidity, and taxation.
- Similar to how a yield curve graphically depicts the relationship between yields-to-maturity and times-to-maturity for securities with the same risk profile, benchmark rates and spreads can be graphed by time-to-maturity as well, to show the term structure of credit spreads.
Learning outcomes
The candidate should be able to:
- calculate annual yield on a bond for varying compounding periods in a year;
- compare, calculate, and interpret yield and yield spread measures for fixed-rate bonds.
1 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.