Mastering CFA Level 1 Fixed Income: Calculating Horizon Return & Horizon Yield

19 Apr 24

Published by Chalk & Board

Level 1 with Nathan Ronen, CFA

Greetings, CFA candidates! Nathan Ronen, CFA here with an exclusive fixed income update tailored primarily for CFA® Level I (“Level 1”) candidates. While Level 2 and Level 3 candidates may find this insightful, our focus today is on delving into fixed income concepts that are crucial for CFA Level 1 preparation. Stick around as we explore a hypothetical example, calculating Horizon Return and Horizon Yield, and unravel the intricacies that often challenge candidates during the exam.

Understanding the Scenario:

Let's dive into a hypothetical scenario featuring Maria Suarez, who recently purchased a 5% annual coupon-paying bond with a 30-year maturity at a current price of 86.2458099. Maria plans to hold the bond for 11 years, and there's a twist – the day after her purchase, yields increased by 1%. The goal is to calculate the Horizon Return over this 11-year holding period.

Key Steps in Problem Solving:

Step 1: Calculate Yield to Maturity (YTM) at Issuance

Begin by calculating the YTM at the time of issuance. Using your financial calculator, input the bond details – a 30-year term, 5% coupon rate, current price of 86.2458099, and a future value of 100. This yields a YTM of 6%. Given the 1% increase in yields post-purchase, the effective YTM becomes 7%.

Step 2: Calculate Future Value of Reinvested Coupons

For the 11-year holding period, Maria will receive annual coupons of 5% of par ($100). Assuming reinvestment at a rate 1% higher than the YTM at issuance (7%), calculate the future value of these reinvested coupons. The result is $7,892.

Step 3: Calculate Present Value of Bond at Horizon Date

Next, determine the present value of the bond at the 11th year, considering 19 years remaining until maturity. Utilize the 7% discount rate, the 5% coupon payments, and the future value of $100. The present value at year 11 is $7,933.

Step 4: Determine Horizon Return

Combine the initial investment with the future value of reinvested coupons and the present value of the bond at year 11. The resulting total value is $15,825. Calculate the Horizon Return by taking the 11th root of this value, subtracting one, and converting the result to a percentage. In this case, the Horizon Return is 5.67%.

Conclusion and Exam Strategy:

Mastering these types of calculations is vital for CFA Level 1 success, but it's also crucial to understand that the detailed problem-solving illustrated here might not be presented in its entirety during the exam. While they may ask components like YTM or future value, attempting to solve the entire scenario within the time constraints may be impractical. Stay focused, skip if needed, and prioritize answering questions efficiently.

Best of luck with your preparation!

Nathan Ronen, CFA