Investment Yield Formulas and Yield Case Studies

School of Government: Cash Management & Investment of Public Funds

Investment Yield Formulas and Yield Case Studies

Presented by : Gary Porter, C.F.A. Vice President Capital Management of the Carolinas, LLC distributors of the North Carolina Capital Management Trust Email: gporter@

School of Government: Cash Management & Investment of Public Funds

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School of Government: Cash Management & Investment of Public Funds

What is Yield?

n The annual return on an investment

n Yield on a bond is based on:

n Purchase Price of the bond n Interest or coupon received

n Coupon payments are generally fixed n Price of the bond after purchase fluctuates

n Bond prices change due to changing interest rates n Supply & demand, time to maturity, credit quality

School of Government: Cash Management & Investment of Public Funds

Computing Bond Yields

Yield Measure

Purpose

Nominal Yield

Measures the coupon rate

Current Yield

Measures current income rate

Yield to Maturity*

Measures expected rate of return for bond held to maturity

Yield to Call

Measures expected rate of return for bond held to a call date

* Probably the most widely used

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School of Government: Cash Management & Investment of Public Funds

Determinants of Interest Rates

where:

i = RFR + I + RP

RFR = real risk-free rate of interest I = expected rate of inflation

RP = risk premium

School of Government: Cash Management & Investment of Public Funds

Bond Pricing

n Bond prices move inversely to interest rates

Interest Rates go

Bond Prices go

Interest Rates go

Bond Prices go

If you learn nothing else about bond prices, learn this!

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School of Government: Cash Management & Investment of Public Funds

Bond Pricing

Ex: - Bond purchased at par (price = 100%) 2 year maturity, 5% coupon bond Cost = Principal Amt x Price ($1,000 x 100% = $1,000) Interest rate moves to 4% New Price = 101.9039% New Market Value = $1,019.04 Interest rate moves to 6% New Price = 98.1415% New Market Value = $ 981.42

School of Government: Cash Management & Investment of Public Funds

n Bond Pricing

n Bond Prices move inversely to interest rates n The longer the maturity of the bond, the more

sensitive (variable) its price is to changes in rates (10 yr. security price will move more than 2 yr.) n The lower the coupon of the bond, the greater the price sensitivity

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Yield (%)

School of Government: Cash Management & Investment of Public Funds

Treasury Rates Example o f Dramatic Rise i n Longer Term R ates

4.0

3.5

3.0

2.50% 2.5

2.0

1.41%

1.5

1.67%

1.0

4/30/ 2013

6/30/ 2013

0.5

.65%

0.0

0

2

5

10

30

Years

School of Government: Cash Management & Investment of Public Funds

* Modified Duration is used to approximate the percent change in bond value for a given percent change in yield, using the following formula: Percent change in bond value = (-DM * change in yield)

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