Lesson 10 of 18
For some debt products such as mortgage-backed securities, we calculate cash flow yield instead of yield to maturity. This is because investors in mortgage-backed securities receive their cash flow from the cash flow of the underlying collateral pool and this cash flow is not fixed. In the underlying collateral pool, the home owners make the payments for the loans they have taken which acts as the cash flow to mortgage-backed securities. However, the homeowners can prepay their loans based on the changing interest rate conditions. This will affect the principal and interest payments to the MBS. Since the cash flow is uncertain, typically an assumption is made about the prepayment rate, and based on that cash flows are estimated. This cash flow is then used to calculate the cash flow yield.
The procedure to calculate cash flow yield will be the same as for YTM, i.e., the interest rate that will make the present value of all cash flows equal to the current price of the MBS.
Just like for semi-annual bonds, here also we need to convert the cash flow yield to bond-equivalent yield.
The cash flows to MBS are paid monthly. So, the cash flow yield we calculate will also be monthly yield. Bond equivalent yield calculation is a two-step process. Let’s say the monthly yield is 1%.
Step 1: Calculate Effective Semi-annual Yield
The first step is to convert the monthly yield into effective semi-annual yield.
Effective semi-annual yield = (1+ym)^6 – 1
Effective semi-annual yield = (1.01)^6 – 1 = 6.152%
Step 2: Calculate Bond Equivalent Yield (BEY)
We calculate BEY by simply doubling the effective semi-annual yield
BEY = 2*6.152 = 12.304%
As you can see, BEY is calculated as per the convention in the market.