In some securities, yield is quoted on an add-on basis, whereas for others it is quoted on a discount basis
Sunil K. Parameswaran
Money markets securities are short-term debt securities, with a maximum maturity of one year at the time of issue. These include Treasury Bills which are issued by the central or federal government; unsecured promissory notes called commercial paper; which are issued by corporations; and negotiable certificates of deposit which are issued by commercial banks. Repurchase agreements or Repos and Bill Discounting are also money market activities. Since the duration is short-term, the market computes returns on a simple interest basis.
In the case of some securities the yield is quoted on an add-on basis, whereas in the case of others it is quoted on a discount basis. The difference may be illustrated as follows. Consider a face value of Rs 100 and a quoted yield of 6% per annum. Assume that the year consists of 360 days, which is the assumption in the US and EU markets, and that the security has 108 days to maturity. The discount is (100 x 0.06 x 108 ÷ 360) = 1.80. Thus, the price will be quoted as Rs 100 – Rs 1.80 = Rs 98.20. The quoted rate is called the discount rate. In the case of other securities, the rate is quoted on an add-on basis. Assume the same numbers. The interest on an investment of Rs 100 is Rs 1.80. Thus, in this case, the investor will invest Rs 100 and receive Rs 101.80.
The difference between the securities is the following. In case of a discount security, while the discount is based on the face value, rate of return will be based on the investment, which will always be lower. Thus, if a discount security is bought and held till maturity, rate of return will always be greater than the quoted yield. In the case of an add-on security, interest is computed on the face value, and the initial investment is also the face value. Consequently, rate of return for an investor who buys at the quoted rate, and holds until maturity, will be equal to the quoted rate.
T-bill returns may at times have to be compared with bond market returns. The yield measure that is computed for comparison, depends on whether the bill has less than or more than 182 days till maturity. The reason is a bond with less than 182 days till maturity, is also a zero coupon security, as there is only one cash flow left. Thus, it can be directly compared with a T-bill. A bill with more than 182 days to maturity, would be compared with a bond with more than 182 days to maturity, which is not a zero coupon security. Thus, the bill must be treated as if it too pays a coupon before maturity. This is purely a technical adjustment. The interest for the first six months is computed on the quoted price, and the compounded value is assumed to earn simple interest for the remaining period. The terminal value is equated to the face value to compute the yield.
(The writer is CEO, Tarheel Consultancy Services)