The concept of yield basis is fundamental for investors in fixed-income securities, such as bonds. It provides a method to assess the value of bonds in a manner that facilitates easy comparison between various securities, helping investors make informed decisions. This article explores the yield basis method, its calculation, and its implications for investors.
What Is Yield Basis?
Yield basis is a way to express the price of fixed-income securities as a yield percentage rather than a dollar value. This method enables investors to easily compare bonds with different characteristics, such as coupon rates, maturities, and market prices. Instead of focusing solely on price, yield basis emphasizes the return on investment that the bond will generate.
Key Features of Yield Basis
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Quoting as Yield Percentage: Bonds are communicated as yield percentages. This standard allows for straightforward comparisons across different bonds.
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Discount or Premium Indicator: The yield quote signifies whether a bond is trading at a discount (yield basis greater than coupon rate) or premium (yield basis less than coupon rate) compared to its face value.
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Costs Included: When purchasing bonds on a net yield basis, it includes the broker's profit alongside the yield, ensuring the investor understands the total acquisition cost.
How to Calculate Yield Basis
The yield basis is calculated using the following formula:
[ \text{Yield Basis} = \frac{\text{Coupon Amount}}{\text{Bond Purchase Price}} ]
Example Calculation
Consider a bond with a 6.75% coupon rate, a $1,000 par value, and a current market price of $940.
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Determine the annual coupon payment:
[ \text{Coupon Payment} = 6.75\% \times \$1,000 = \$67.50 ] -
Calculate the yield basis:
[ \text{Yield Basis} = \frac{67.50}{940} = 0.0718 \text{ or } 7.18\% ]
In this example, since the yield basis (7.18%) exceeds the coupon rate (6.75%), it indicates that the bond is trading at a discount.
Understanding Bank Discount Yield
For certain instruments, particularly pure discount securities like Treasury bills, the yield basis is calculated using the bank discount yield formula:
[ r = \left(\frac{\text{Discount}}{\text{Par Value}}\right) \times \left(\frac{360}{t}\right) ]
where:
- r = Annualized yield
- Discount = Par value minus purchase price
- t = Time left to maturity (in days)
Example of Bank Discount Yield Calculation
Suppose a Treasury bill has a $1,000 face value that is selling for $970 with 180 days until maturity:
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Calculate the discount:
[ \text{Discount} = \$1,000 - \$970 = \$30 ] -
Substitute values into the formula:
[ r = \left(\frac{30}{1000}\right) \times \left(\frac{360}{180}\right) = 0.06 \text{ or } 6\% ]
This calculation signifies that holders of the Treasury bill will earn a dollar return equal to the discount if the security is held until maturity.
Special Considerations for Investors
Difference Between Yield Basis and Net Yield Basis
Investors should be aware of the distinctions between yield basis and net yield basis. When bonds are sold through brokers, they may charge a commission for their service or incorporate their profit directly into the net yield.
- Net Yield Basis: This includes the broker's markup or profit in the yield quoted to investors, meaning that when they evaluate the yield, they should consider these additional costs.
Additional Fees
When purchasing bonds, other fees might also apply, such as:
- Broker-Assisted Transactions: Additional fees for transactions not executed online.
- Accrued Interest: The interest that accrues on the bond between the last coupon payment and the settlement date, which is typically included in the total cost of acquisition.
Conclusion
Understanding yield basis is crucial for bond investors who wish to make informed decisions about their investments. By appreciating how yield is calculated and what various yield metrics imply, investors can effectively navigate the bond market. Whether considering investing in corporate bonds or government securities, being well-versed in yield basis helps optimize investment strategies, thereby facilitating sound financial planning in the realm of fixed-income investing.