Yield Basis
The yield basis is a technique that determines the price of a security that has a fixed income, for example, a bond, which is expressed not in dollars, but as a percentage of a yield. The method of yield basis simplifies the process of comparing bonds with certain characteristics. The yield basis is found by dividing the coupon amount by the price at which the bond was purchased.
Yield Basis explained
Bonds are predominantly quoted on a yield basis, while, for example, stocks are traded in dollars. As an example, the par value of the bond is $1,000, but it is currently trading at $950. The bond has maturity of 10 years from the date of issue and a coupon rate of 6.5%.
The yield basis can be calculated taking into account the current yield as follows:
Coupon / Purchase price,
1. 6.5% x $1,000 = $65.00, to determine the coupon paid annually.
2. $65.00 / $950 = 0.0684, or 6.84%, it is necessary to find the yield basis.
As a result, this bond will be quoted with a yield basis equal to 6.84%. This yield basis information is useful for the trader, because it gives him a signal that this bond is trading at a discount now, since the coupon rate (6.5%) is below the bond’s yield basis.
In the opposite situation, when the yield basis is below the coupon rate, this means that the bond is trading at a premium, because as the coupon rate increases, the bond value in the markets also increases. In addition, then, a bond buyer may compare the bond's current yield basis with that of other bonds in a particular industry.
Yield Basis and bank discount yield
The bank discount yield expression can be applied in the calculation of the yield basis of a pure discount instrument: r = (Discount / Par Value) x (360/t). In this formula, “r” is annualized yield. The “discount” is formed by subtracting the buying price from the par value. The banks adopted an agreement on the number of days in a year equal to 360, and the time left to maturity is “t”.
The bank discount yield is expressed in terms of the par value, not the current price of the bond, that is, its difference from the current yield. Given calculating technique of the yield basis uses only simple interest. For example, Treasury bills are quoted on the basis of a bank discount.
If a Treasury bill with a face value of $1,000 sells at the price of $950 and the time to maturity equal to 90 days, the yield basis will be: r = [($1,000 - $950)/$1,000] x (360/90) = ($50/$1,000) x 4 = 0.2 or 20%.
In the event that the bond is held to maturity, its owner will receive an income equal to the discount in the form of US dollars, which is due to the fact that the coupon payment on treasury bills is not made.
More about Yield Basis
An investor should be aware that there is a difference between the yield basis and the net yield basis and consider this fact when buying bonds.
When buying bonds through a broker/dealer on the secondary market, a fixed commission may be charged for this service, but there are also situations in which a broker may sell bonds based on net yield basis instead of a commission.
Net yield basis implies that the profit of the broker on the trade is also included in the yield. This is a type of the broker's markup, which is the difference between the amount paid by the broker for the bonds and the amount for which he sells these assets. When making an offer to a client to purchase bonds based on a net yield basis, the broker automatically adds his markup to it.
For example, if a client plans to buy a bond from a broker with a yield to maturity (YTM) of 5%, then the broker's profit will be embedded in the price of this bond, and, accordingly, there will be no separately allocated commission.
When making a comparative analysis of various bonds for the purpose of further purchase, bond traders should ask their broker if there is a commission for the transaction or if the settlement was made on a net yield basis. Besides, brokers may charge other fees for various assistance rendered to the client in the course of the transaction. It is also possible to include accrued interest, i.e. interest accrued on the bond between the last payment made and the settlement date, in the total value of the transaction.