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CHANDLER ASSET MANAGEMENT

Brian Perry, CFA

September 28, 2010

VP, Investment Strategist

CMTA Essentials of Treasury Management

A Discussion of Yield

An introduction to yield

■ Yield refers to the income you receive on your bond

■ There are many different ways of calculating yield

■ Don’t make it more complicated than it needs to be

■ Focus on general concepts

■ There are a lot of formulas - don’t worry about memorizing them

■ There is no test at the end of this presentation!

■ Relax!

2

Understanding yields

■ The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price (or cost) of the investment

■ Calculating yield requires a trial and error process to find the correct interest rate

■ Fortunately financial calculators, computers, or Bloomberg terminals can do this for us

■ Many different types of yields

3

Simple interest

&

Discount securities

4

Simple interest

■ Assumes interest paid once at the end of the period

■ Interest Earned = Par x Rate x Time

■ For a one year CD

■ The current market rate is 4% for one year

■ You invest $1,000 in a one year Certificate of Deposit at 4%

■ Interest Earned = $40 income

5

Simple annual interest

■ What if the period is shorter than a year

■ For instance a 6 month CD

■ The current market rate is 2% for 6 months

■ You invest $1,000 in a six month Certificate of Deposit at 2%

■ Interest Earned = Par x Rate x Time = $1000 x 2% x 6 months = $20 income

■ The simple annual interest rate = yield for period x number of periods in year

■ So the simple annual interest rate on the 6 month CD = 2% x 2 periods = 4%

■ But…simple annual interest is not correct

6

Effective annual interest

■ If the period is less than 1 year, in order to properly annualize the yield we need to calculate the effective annual yield

■ Effective annual yield = (1 + periodic int. rate)*m) - 1

■ From the previous example, the effective annual yield for the 6 month CD

■ ((1 + 2%)*2) - 1

■ 4.04%

■ For large amounts this slight difference can really add up

7

Discount securities

■ Many money market instruments are sold on a discount basis

■ They do not pay interest - the return depends on the difference between the price paid and the face value at maturity

■ Example: purchase a $100,000 Treasury Bill for $99,800 and receive $100,000 at maturity in 3 months

8

Bond equivalent yield

■ Bond equivalent yield (BEY) -

■ Assumes security pays interest two times per year and each interest payment is reinvested at the purchase yield

■ Most common method of comparing yields of different types of securities

■ Yield on money market instrument issued on a discount basis computed so that it is comparable to a yield computed on a coupon security paying semi-annual interest

■ Bond equivalent yield will be greater than discount rate

9

Converting discount rates

■ Convert discount rate to bond equivalent rate

Bond equivalent rate =

365 x discount rate

360 - (discount rate x days to maturity)

■ Convert 3-month T-Bill bought at 3.00 discount rate to a bond equivalent rate

Bond equivalent rate =

365 x discount rate

360 - (discount rate x days to maturity)

365 x .03 = 3.065% BEY

360 - (.03 x 91)

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Yield analysis - “discount” bill

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Source: Bloomberg

Coupon Paying Bonds

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Coupon paying bonds

■ These are “normal” bonds

■ Usually have face value of $1000

■ Usually pay interest semiannually

■ May or may not be callable

■ Several yields to consider for coupon bonds

■ Current yield

■ Yield to maturity

■ Yield to call

■ Yield to worst

13

Current yield

■ A bond’s annual coupon payment divided by the bond price

Current yield =

annual dollar coupon interest

current price

6.00% = .0545 or 5.45%$1,100

■ For a bond selling at a premium, coupon rate (6%) exceeds current yield (5.45%)

■ For a bond selling at a discount, coupon rate is less than current yield

14

Yield to maturity

■ Yield to maturity is the most common yield measure used to determine the expected return of a coupon paying bond

■ Measure of the average rate of return that will be earned on a bond bought now and held to maturity

■ Assumes all coupon payments will be reinvested at the same interest rate as the yield to maturity

■ This is an unrealistic assumption and makes it likely that the actual realized return will differ from the yield to maturity at time of purchase

15

Yield to call

■ Calculates the return on the bond if the bond is called on its first available call date

■ Can be calculated for all call dates

■ Yield to call does not take into account how principal will be reinvested if bond is called

■ Need option-adjusted spread analysis to convert callable bond to an equivalent non-callable “bullet” security

16

Yield to call - price below par

17

Source: Bloomberg

Yield to call - price above par

18

Source: Bloomberg

Yield to worst

■ Calculated for every call date

■ Compared to YTM

■ Yield to worst is lowest of all possible yields

■ Bond Selling at: Relationship

Par coupon rate = YTC = YTM

Discount coupon rate < YTM < YTC

Premium coupon rate > YTM > YTC

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Yield Spreads

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Basic yield spreads

■ Most securities in the bond market are priced on a “spread”

■ The spread represents the additional compensation necessary for holding a risky asset

■ Risky securities are generally compared to Treasuries so the spread is the additional yield over a Treasury with a comparable maturity – this is known as a nominal spread

■ Limitation: the nominal spread only measures one point on the Treasury curve

21

Advanced yield spreads

■ The zero-volatility spread (Z-spread) takes into account the entire yield curve and is more accurate than the nominal spread

■ Option-adjusted spread (OAS) is a model that takes into account the future volatility of interest rates

■ The OAS measure is appropriate for bonds with embedded options such as callable agency bonds or mortgage-backed bonds

■ The OAS can be used to compare the relative merits of a callable and a non-callable bond

■ All spread models are very sensitive to the underlying assumptions of the model and the inputs to the model

22

Yield & Total Return

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Yield and total return

■ Yield measures the coupon payments from a bond

■ Total return includes not only yield but also gains and losses from market movements

■ Yield is a component of total return

24

Total return

■ Total return measurement is the standard in the investment management industry

■ Takes into account realized and unrealized gains and losses

■ It makes sense to measure both yield and total return

■ Total return measures growth rate of an investment

25

Yield and your portfolio

■ There are many different measures of “yield”

■ It is important to compare “apples to apples”

■ If you are uncertain about a yield calculation or a security’s characteristics, it is ok to ask your investment provider for more information

■ It is good to look at both yield and total return

■ Yield is one measure of a security’s attractiveness; it is also important to consider how the security fits in the overall portfolio

26

Important Short Term Rates

&

Investment Options

27

Viewing short-term rates

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Source: Bloomberg

Important short term rates

■ Fed funds rate

■ Discount rate

■ LIBOR - London Interbank Offer Rate

■ Prime rate

■ Swap rate

■ T-bill rate

■ “Risk-free” rate

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Federal Reserve rates

■ Fed funds rate

■ Rate at which banks lend among themselves

■ Target rate set by Federal Reserve

■ Probably most important rate in financial markets

■ Discount rate

■ Rate at which financial institutions can borrow from Fed

■ Rate set by Fed

30

Bank rates

■ LIBOR

■ Very important in international financial markets

■ $10 trillion in adjustable rate loans indexed to LIBOR

■ Prime rate

■ Set by banks usually in response to changes in Fed Funds rate

■ Many credit cards and other consumer debt linked to Prime

■ Swap rate

■ Used for transactions between financial institutions

■ Indicator of level of interest rates and credit risk in markets

31

US Treasury rates

■ T-Bill rate

■ Rate on very short term US Treasury securities

■ Often considered world’s safest and most liquid securities

■ Risk-free rate

■ The rate on an asset without any risk, often the 90 day T-bill

■ Used to calculate the expected or required return on many other financial assets

32

Money market investment options

■ LAIF

■ Treasury bills

■ Agency discount notes

■ Commercial paper

■ Certificates of deposit

■ Money market funds

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Are there any questions or comments?

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Biography

Brian Perry, CFAVice President, Investment Strategist

Brian Perry joined Chandler Asset Management in 2005 and currently serves as the firm’s investment strategist. Mr. Perry analyzes economic developments, conducts research on financial topics, and helps formulate investment strategy. He was also instrumental in creating a new quantitative corporate credit analysis program and in developing the firm’s capital market forecasts and asset allocation models. He serves as the leader of the Interest Rate and Capital Market Expectations Committees.

In addition to his investment responsibilities, Mr. Perry is responsible for Chandler’s client education activities. He edits the monthly Chandler Bond Market Review, has contributed numerous articles to investment industry publications, and is a frequent speaker at investment conferences and charity events. He has appeared on NBC news to discuss the financial markets and is the author of From Piggybank to Portfolio, an investment guidebook scheduled for publication in 2010.

Prior to joining Chandler, Mr. Perry worked as a fixed income trader for an investment bank where he was responsible for trading government, corporate and emerging market securities.

Mr. Perry earned a Bachelor of Science degree in finance from Villanova University, an MBA in international business from National University and an MA in international affairs from The Fletcher School at Tufts University. He is a member of the San Diego Financial Analyst Society and holds the designation of Chartered Financial Analyst.