BOND BASICS - II

Its relationship to Macaulay's duration (DurMac) can be stated as follows: DurMod=(-DurMac)/(1+(Yield/2)) Effective Margin The coupon rate for a floating-rate security periodically changes based on a predetermined index such as the prime rate or the three-month Treasury bill. Given this uncertainty, the true value of the cash flows cannot be determined, and hence, yield to maturity cannot be calculated.

A security's effective margin measures the potential return for a floating-rate security. It measures the average spread or margin over the underlying index that an investor can earn over the life of the security.

While this measure has its merits, it nevertheless overlooks two important aspects that may affect the potential return from investing in a floating-rate security. First, effective margin assumes that the index will remain constant. Second, this measure does not take into account the cap or floor on the security, if any exists.

First Coupon Date The first coupon date is the date on which the first cash coupon payment will be made. Since most bond issues in the US pay semi-annually, normally their first coupons are paid exactly 6 months after they are issued. Such issues are said to have normal first coupons.

Sometimes, however, the amount of the first coupon is not equal to 1/2 the issue's coupon rate, because for some reason the bonds were issued before or after the date 6 months prior to the first coupon date. Such issues are said to have "short" (first coupon < normal coupon) or "long" (first coupon > normal coupon) first coupon periods.

For example, the U.S. Treasury 7 3/4% due 3/31/96 were originally 5-year notes with a short first coupon. The Federal Reserve would have normally issued the note on 3/31/91. But, since 3/31/91 was a Sunday, the actual issue date was 4/1/91. Therefore, the first coupon was less than the normal 3.875% since the first coupon period was one day less than a normal coupon period.

In order to calculate the odd first coupon correctly, both the issue date and the first coupon date must be specified (the first coupon date may be deduced). However, if the settlement date (or valuation date) is beyond the first coupon date, both the issue date and the first coupon date become irrelevant for analytical purposes, since all remaining coupons will be normal.

IRR The "internal rate of return" is the discount rate which equates the present value of the future cash flows of an investment to the cost

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