Schweser is confusing me. Page 57, Book 3 says (referring to Yield/Spread Pickup Trades) that “A bond portfolio manager holding [a high-rated issue] could consider the quality difference [between the high-rated issue and the low-rated issue] meaningless” and prefer the lower-rated issue because it has a higher yield. SO HERE, YIELD IS WHAT YOU WANT TO BE HIGH IN A BOND. But the next paragraph down says, “This does not recognize the limitations of yield measures based on a total return framework” and that the spread on the above-mentioned higher-rated bond could potentially narrow and provide a higher price, making the high-rated bond better. SO HERE, PRICE IS WHAT YOU WANT TO BE HIGH IN A BOND. Bottom line: I thought you want a bond with the highest yield/lowest price, because you earn a higher return. Now it says that yes, you get a higher yield, but, say little boy, wouldn’t you rather have your bond have a high price/lower yield? When you invest, do you want your bond yields to be high or your prices to be high when you sell? -Richard
I think you’re reading too much into this. All they’re saying is that you shouldn’t invest solely on yield, as it doesn’t take into account factors such as increased risk. It then says that anyway, you can still buy a higher-rated bond with a lower yield and achieve the same return as a lower-rated bond with a higher yield if the spread narrows and the higher-rated bond increases in price.
There are two aspects contributing to total return: 1) Coupon income - higher for high yield securities. So if you are looking to buy a security, the one with the highest yield (i.e. highest coupon or highest discount to FV for a zero coupon bond) is attractive 2) Capital Price Appreciation - For a lower yield bond (read: higher rating), if the spread narrows (after you have purchased the bond) on account of the higher credit quality of the bond, the price goes up making your purchase a wise decision. As newsuper said, yield is not the only factor to consider while evaluating a bond purchase. Potential change in spread due to credit quality (which will be the differentiator wrt other bonds, since interest rate movements will affect ALL bonds) is also a consideration.
Bond A has a 5% coupon and is priced to yield 6%. Bond B has a 5% coupon and is priced to yield 6.5%. You’re a portfolio manager, you’re looking at two bonds and decide that there is little difference in credit quality. You purchase security B because you want the ‘highest yield/lowest price, because you earn a higher return.’ But 3 months later the spread on Bond A has narrowed and is now yielding 4%. Had you purchased Bond A you would have had price appreciation in addition to the coupon income. The bottom line is that you want to think in terms of total return. On the exam, you definitely want to look at yield but if a question mentions that a credit spread might narrow you should factor the potential price appreciation into your purchase decision as well.
Bankin’ Wrote: ------------------------------------------------------- > Bond A has a 5% coupon and is priced to yield 6%. > Bond B has a 5% coupon and is priced to yield > 6.5%. > > You’re a portfolio manager, you’re looking at two > bonds and decide that there is little difference > in credit quality. You purchase security B > because you want the ‘highest yield/lowest price, > because you earn a higher return.’ > > But 3 months later the spread on Bond A has > narrowed and is now yielding 4%. Had you > purchased Bond A you would have had price > appreciation in addition to the coupon income. > > The bottom line is that you want to think in terms > of total return. On the exam, you definitely want > to look at yield but if a question mentions that a > credit spread might narrow you should factor the > potential price appreciation into your purchase > decision as well. Well said…+1
Bankin’ Wrote: ------------------------------------------------------- > Bond A has a 5% coupon and is priced to yield 6%. > Bond B has a 5% coupon and is priced to yield > 6.5%. > > You’re a portfolio manager, you’re looking at two > bonds and decide that there is little difference > in credit quality. You purchase security B > because you want the ‘highest yield/lowest price, > because you earn a higher return.’ > > But 3 months later the spread on Bond A has > narrowed and is now yielding 4%. Had you > purchased Bond A you would have had price > appreciation in addition to the coupon income. > > The bottom line is that you want to think in terms > of total return. On the exam, you definitely want > to look at yield but if a question mentions that a > credit spread might narrow you should factor the > potential price appreciation into your purchase > decision as well. +1
Bankin’ said it well. One other thing that might be tripping you up is the time-persective from which they are referencing the bonds. Pre-purchase they are looking at yields, but then they are discussing tightening credit spreads and decreased yield in the higher quality bonds as if they already owned them. Meaning once you own the bonds you want the yield to go down (yield down, price up). Just a thought
popov13 Wrote: ------------------------------------------------------- > Bankin’ said it well. > > One other thing that might be tripping you up is > the time-persective from which they are > referencing the bonds. Pre-purchase they are > looking at yields, but then they are discussing > tightening credit spreads and decreased yield in > the higher quality bonds as if they already owned > them. Meaning once you own the bonds you want the > yield to go down (yield down, price up). > Meaning once you own the bonds you want the yield to go down (yield down, price up). ??? Sorry- FI is my achilees heel and its so confusing to me… When people refer to yield, they dont mean the actual coupon right ? If I buy a bond for 6% coupon, regalrdless of what happens to interest rates and the change in bond price I will get the 6% coupon right ? Popov13, when you say “once you own the bonds you want yield to go down” you are not referring to the actual coupon right but in fact coupon/price % goes down given that coupon is the same but the higher price of the bond in the denominator goes up to give the smaller yield % Confirm its not the actual coupon going up? Because if I was a Pension fund FI manager who had to ALM liabilities with future cash flows, I wouldnt want my coupon changing on me
IH8FSA Wrote: ------------------------------------------------------- > Meaning once you own the bonds you want the > yield to go down (yield down, price up). > ??? Don’t think about it in terms of yield, think about it in terms of price. When you’re long an investment what do you want said investment’s market value to do? Of course you want it to go up. > > Sorry- FI is my achilees heel and its so confusing > to me… When people refer to yield, they dont > mean the actual coupon right ? If I buy a bond > for 6% coupon, regalrdless of what happens to > interest rates and the change in bond price I will > get the 6% coupon right ? Most of the time the coupon on the FIXED income is fixed. There are Variable CMOs and other FI investments with coupons that move, but unless otherwise noted on the exam assume the coupon is fixed. There are a number of issues that can muddy the waters (optionality, accrued interest, etc.) but thinking about the investment you’re holding in terms of price and realizing the coupon is usually fixed are fundamentals.
Bankin. THANK you very much for that confirmation above , very helpful. I have a quick question, So what is YTM ? And is this affected by interest rates ?
YTM (yield to maturity) is the single discount rate that is used to discount future cash flows that will make the present value of these future cash flows equal to the current price. Price = \sum_{i = 1}^n C/(1 + y)^i + F/(1+y)^n C = Coupon F = Face Value y = YTM Price is the current price. If you know Price, C and F then compute y using non-linear equation solution techniques. Your financial calculator can do this for you. For example, consider a 10 year, 5 percent annual pay bond with a face value of 1000. If the current price of this instrument is 900 what is the yield to maturity? hp12c f-clx 10 n 50 pmt 1000 fv 900 chs pv i i is ytm = 6.3835%.
kombinatorics ^ thank you for the above calculation. But I was searching for a more qualitative answer. For example if im a first time fixed income investor and Im quoted a Yield and Yield to maturity how would I explain them? so: COUPON: Fixed amount of money the investor will receive as long as they hold the security??? YIELD %: Coupon/bond price - Since coupon stays the same, its the denominator that changes, so e.g when interest rates rise, bond prices fall and the yield % rises ??? YTM: Is what you will earn from the time you earn the bond to the time the bond matures and this % figure includes income and capital appreciation.??? Questions: 1) For yield, why wouldnt we always want a high yileding bond ? Think about it, if the bond is high yielding, the price is already low ( coupon/price) so theres more of a chance of price appreciation if the interest go down? But you might say “well how about if rates rise”, well sure, but would I want to buy a bond that is lower priced (higher yiled) since it will experience LESS of a price decline when interest rates rise? 2) YTM- what happens if you pay a premium for a bond above Par value? this would e.g $1100 for a $1000 bond> does this mean that YTM is neagtive? Can YTM be negative ?
IH8FSA Wrote: ------------------------------------------------------- > COUPON: Fixed amount of money the investor will > receive as long as they hold the security??? Yes. There may be other cash flows resulting from a security’s optionality, but the coupon is typically fixed and based on a percentage of the security’s face value > YIELD %: Coupon/bond price- Since coupon stays > the same, its the denominator that changes, so e.g > when interest rates rise, bond prices fall and the > yield % rises ??? In it’s most basic form, the yield is the rate of return you’ll earn on the security. Using your formula above, how would you handle a a zero coupon bond? Using your formula the yield would be zero, wouldn’t it? > > > YTM: Is what you will earn from the time you earn > the bond to the time the bond matures and this % > figure includes income and capital > appreciation.??? Without getting into the nitty gritty, the yield to maturity is the rate of return you’ll earn if the security is held to maturity. There is also a yield to call and yield to worst. > > Questions: > > > > 1) For yield, why wouldnt we always want a high > yileding bond ? If we’re not talking about the risk side of the equation, cash flow needs, what bond price movements mean the economy is doing and how the rest of your portfolio is probably doing, or anything like that you would definitely prefer BUYING higher yielding bonds. But, after purchase you would like to see the PRICE rise and the yield fall. Think about it, if the bond is > high yielding, the price is already low ( > coupon/price) so theres more of a chance of price > appreciation if the interest go down? But you > might say “well how about if rates rise”, well > sure, but would I want to buy a bond that is lower > priced (higher yiled) since it will experience > LESS of a price decline when interest rates rise? I’m not going to get into all of this, but we would prefer buying at a low price and after we’re holding it, in this simple example, we would like the price to rise (yield to fall). > > 2) YTM- what happens if you pay a premium for a > bond above Par value? this would e.g $1100 for a > $1000 bond> does this mean that YTM is neagtive? > Can YTM be negative ? If you pay $1100 for a bond with a $1000 par value then the $100 premium is amortized over the life of the bond. This does not mean the yield is negative. Type the following into your BA II Plus N = 10 PV=-1100 Pmt=50 FV=1000 Cpt -> I I (hopefully) = 3.78% The difference between the 3.78% and the 5% yield you’d be receiving if the security were purchased at par is the premium that is being amortized off. The second part of your question is actually kind of funny. A few years ago I would have said that the YTM would never be negative because people would not accept a negative return, but that has (strangely) happened to the short end of the treasury curve a few times since the crash in 2008. But, under normal circumstances the YTM will not go negative. However the your YIELD, as opposed to YTM, can be negative if you paid a premium and there are a lot prepayments.
Let me go qualitative on you, technical math geeks, go easy on me if I make some mistakes, I am going for conceptual explanations here and how I think about it. 
IH8FSA Wrote: ------------------------------------------------------- > kombinatorics ^ thank you for the above > calculation. > > But I was searching for a more qualitative answer. > For example if im a first time fixed income > investor and Im quoted a Yield and Yield to > maturity how would I explain them? > > so: > > COUPON: Fixed amount of money the investor will > receive as long as they hold the security??? Yes, assuming no defaults and assuming the coupon is a fixed payment and not floating, which is like 99% of the time (I made that 99% up, but you get the idea) > YIELD %: Coupon/bond price - Since coupon stays > the same, its the denominator that changes, so e.g > when interest rates rise, bond prices fall and the > yield % rises ??? Yields don’t neccessarily rise here. Lets take a bond priced at par with a coupon payment of 4% and YTM of 4%. If interest rates rise to 6% then a bond paying 4% is less desireable, since you can get a newly issued bond paying 6%. So the price on your 4% bond will fall until its YTM (given the lower price) is equal to approx 6%. Think of this as a new equilibrium price. > YTM: Is what you will earn from the time you earn > the bond to the time the bond matures and this % > figure includes income and capital > appreciation.??? Yes, but assumes you can reinvest all coupon payments at the YTM, think of this as an IRR for the bond. > Questions: > > > > 1) For yield, why wouldnt we always want a high > yileding bond ? Think about it, if the bond is > high yielding, the price is already low ( > coupon/price) so theres more of a chance of price > appreciation if the interest go down? But you > might say “well how about if rates rise”, well > sure, but would I want to buy a bond that is lower > priced (higher yiled) since it will experience > LESS of a price decline when interest rates rise? > For the buyer, a high yielding bond, relative to others in the market, is good yeah, but that assumes it actually pays out. Keep in mind that the yield is high (which means price is low) for a reason. The market thinks the risk of default is high, so not willing to pay the same price it would for a more highly rated bond, i.e. market demands a risk premium in the form of higher yield. > 2) YTM- what happens if you pay a premium for a > bond above Par value? this would e.g $1100 for a > $1000 bond> does this mean that YTM is neagtive? > Can YTM be negative ? Lets say you own a AAA rated bond that has a coupon of 6%. Market rates have now fallen to 4% and newly issued AAA bonds pay 4% coupons and YTM is 4%. Your bond, paying 6% is now more desireable, so investors are willing to pay a premium. Well this premium, paid by the buyer, starts eating into that 6% coupon payment, which will reduce its yield. This will be done until the YTM is approximately equal to newly issued 4% bond market rates. Now, you could just hold the bond to maturity and collect your 6% coupons (but probably reinvest at a lower rate now that rates are down to 4%). Or you could sell it at the higher market price and realize your capital appreciation.
I didn’t see Bankin’s post before I posted, so any discrepancies, he is probably right.