Understanding the Yield Token Design Mechanism of DeFi Principal and Interest Separation Fixed Income Products in One Article

Author: Kenton Prescott, Founder of Sense Finance, Former Integration Engineer at MakerDAO

Compiled by: Perry Wang

DeFi is a hub for a range of yield-generating activities, such as lending, collateralization, and protocol dividends. Due to the composability of Ethereum, users can transition from one profit-generating activity to another as easily as swapping between tokens. These yield-generating assets represent a part of the yield-generating activities, each carrying unique, real-time redeemable floating cash flows, typically measured in Annual Percentage Yield (APY). Typical examples include cTokens from Compound and Uniswap LP shares.

Earning variable interest rates is straightforward, but the returns are limited. Currently, users looking to hedge against interest rate fluctuations to manage risk or profit from interest rate changes are not adequately served.

Many projects are actively working to fill this gap—these fixed income protocols, or those supporting fixed rates and trading future yields, can be broadly categorized into three camps:

• Structured/Tranche Products (BarnBridge, Saffron, 88mph)
• Zero-Coupon Bond Lending Protocols (Notional, Yield, Hifi, UMA)
• Principal-Interest Separation Protocols (Pendle, Element, Swivel)

We will focus on Principal-Interest Separation Protocols—these protocols decompose yield-generating assets into their principal and yield components, packaging the principal and yield into fixed income assets with defined maturity dates.

Similar to tokenized equity, these assets are used separately to repay principal and yield in the future. Various teams have experimented with different naming conventions, but in this article, we will use the following terms to describe them:

• Target: Fixed income asset
• Principal Token (Zero): Tokenized equity of the principal portion of the target
• Yield Token (YT): Tokenized equity of the yield portion of the target

As the prices of Principal Tokens (Zero) and Yield Tokens (YT) are functionally related to the APY of the target, fixed income futures trading can thus become a reality. Holders of Principal Tokens will benefit from a decline in the target's APY, while holders of Yield Tokens will benefit from an increase.

Principal Tokens are akin to zero-coupon bonds, delivering a single cash flow at maturity. They are simple and easy to evaluate. On the other hand, Yield Tokens resemble floating rate bonds, providing unknown cash flows at future dates. They are more complex and harder to value, but they provide fertile ground for financial innovation. This is why we see various Yield Token design mechanisms in the market.

In this article, we will discuss different methods for creating future yield claims. We have explored the trade-offs involved and hope to share our findings as they become more prevalent.

Below is a quick categorization of the Yield Token design space, where we analyze existing solutions and propose a simple framework for thinking about Yield Token design.

Introduction to Yield Tokens

Yield Tokens (YT) are tokenized claims on future on-chain cash flows of specific assets. Let’s illustrate this with a direct example.

Example

Taking Compound Dai (cDAI) as an example:

An issuer deposits cDAI tokens worth 100 DAI into a Principal-Interest Separation Protocol, committing to lock it for 2 months.

The Principal-Interest Separation Protocol generates:

• 100 Principal Tokens: to be repaid with 100 DAI worth of cDAI principal in 2 months
• 100 YT: to pay the floating rate cash flows generated by cDAI in 2 months
• The pricing of Principal Tokens is discounted relative to the market price of 100 DAI (assumed at $99.58), while YT is priced based on the expected future interest payments discounted (assumed at $0.42).

At the time of YT minting, cash flows may be unknown, similar to variable rate fixed income instruments, but the underlying cash flow source is always known, which is sufficient to unlock valuable use cases. For example, if the source is a money market loan, YT can enable loan rate hedging and supply rate trading. In the later sections of this article, we will introduce different YT designs, analyze their properties, and discuss their various use cases.

Design Space

Upon closer inspection, YT can be further broken down into two parts:

• PY (Past Yield): realized cash flows
• FY (Future Yield): expected future cash flows

Note that assuming market expectations are static, PY does not decrease once generated, but FY declines over time.

This is an interactive tool that displays PY and FY as functions of the target's APY and time.

The core of YT construction is the management of PY. We introduce three designs:

• Maturity Dividend (Drag) --- PY is paid out at maturity
• Periodic Dividend (Collect) --- PY is paid out before maturity
• Dividend Reinvestment (Recycle) --- PY is reinvested before maturity

Drag

Overview --- The PY of these YTs is paid out only at maturity.

Drag YTs retain PY until maturity, with YT holders receiving full repayment on or shortly after the maturity date. PY and FY are discounted based on the maturity date as of today. They are similar to Principal Tokens with a floating redemption value.

Projects that adopt the Drag YT design mechanism include:

• Element
• APWine
• Tempus

Collect

Overview --- Holders of Collect YT can redeem PY before maturity.

Collect YT distributes PY during the yield accumulation period, meaning YT holders receive PY before maturity. PY is calculated at today’s market value, while FY is calculated based on the discount factor related to its maturity date today. They are similar to coupon bonds but lack principal cash flows and have nearly continuous coupon flows.

Currently, there are two types of Collect YT positions:

• Passive positions --- PY remains unchanged, exhibiting market trends similar to Drag YT. However, the value of Collect YT may fluctuate as they can access cash more quickly.
• Active positions --- Holders actively reinvest their PY into more YT, resembling Recycle YT.

Projects that adopt the Collect YT design mechanism include:

• Pendle
• Swivel

Recycle

Overview --- This type of YT reinvests its PY into more YT.

Recycle YT extracts PY and purchases YT at market prices (YT / underlying asset of the target). The newly acquired YT is then distributed to existing holders—this adds more principal to existing YT positions, thereby amplifying their FY portion. The reinvestment mechanism is similar to active traders reinvesting coupon dividends back into their positions.

Market Trend Characteristics

To explore the market trend characteristics of these design mechanisms, we constructed two sensitivity measures:

• Time Sensitivity --- Percentage change in YT price after one day
• Interest Rate (IR) Sensitivity --- Percentage change in YT price resulting from a 1% change in the expected interest rate of the target

Similar to theta and delta in option pricing, these measures help us understand the factors influencing YT prices.

Our analysis results are as follows. While the market prices of these tokenized claims may differ significantly from our model values, relative valuations, i.e., the return values of one set of inputs compared to another, are in the correct proportion. Therefore, for our purposes of comparing percentage changes, this is sufficient. Let’s look at the analysis results and then discuss some key insights.

Results

• We define the price as the value of the entire YT position. For example, a Collect YT position consists of two balances in the holder's wallet: the growing PY balance in the target and the static YT balance.
• Collect YT is held by passive users who keep PY unchanged.
• We propose a basic valuation framework. It assumes the current target interest rate is the nominal rate, compounded continuously, and remains stable until maturity. These assumptions create unique PV equations for each YT design.

Model Values

Here are the results of our valuation analysis, which are updated in real-time in this notebook.

Sensitivity

Our sensitivity analysis results (from this notebook, which we strongly encourage you to experiment with).

Time Sensitivity

While this notebook shows the relationship between time sensitivity and time, we provide a more intuitive chart displaying the cumulative price changes over time.

Interest Rate Sensitivity

Key Insights

When the YT series is initialized, no YT exists with PY, so all YT designs have equal IR sensitivity. However, as time passes, PY accumulates and sensitivities begin to diverge.

Drag YT --- Its value does not decrease over time, but as the maturity date approaches, their prices decrease in proportion to FY, and their IR sensitivity diminishes.

Collect YT --- The way users dispose of PY defines the type of Collect YT position. Passive Collect YT holders allow their PY to accumulate, thus holding positions similar to Drag YT. On the other hand, active YT holders manually reinvest their PY, thus holding positions similar to Recycle YT.

Recycle YT --- Resets its IR sensitivity after each reinvestment event to maintain its value as best as possible; however, inefficiencies in reinvestment can lead to price declines. This structure is well-suited for passive traders who wish to maintain IR sensitivity in their balances and do not want to take on the task of constantly seeking reinvestment opportunities for their capital.

As mentioned, there are differences in market trend characteristics across the entire YT token design space. We hope to see the following types of users:

Traders: They buy YT hoping to profit (fully) from an increase in the target's APY. There may be two types of trading preferences:

• Optimized for risk reduction to ensure returns (Drag, passive Collect).
• Optimized for holding risk to ensure returns (active Collect, Recycle).

Hedgers: They buy YT hoping to partially hedge against loan rates denominated in the target asset (Drag, Collect).

In short—Recycle YT can passively achieve the same effect as actively managing Collect YT.

Conclusion

In summary, we discussed three different approaches to tokenizing future yields: Drag, Collect, and Recycle. Each design mechanism differs in how it handles PY (past yield), which affects its market trend characteristics. Specifically, it influences YT's sensitivity to time and interest rates.

However, to delve deeper into these assets, we must also recognize that they are part of a broader category of investments (fixed income products), and the discussions above are just the tip of the iceberg. Further exploration will reveal yield curves, measures of investor sentiment, and a new market that helps us understand discount rates.