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Chapter Outline
Bond Definition Typical Issuers of Bonds Types of Bonds as to Place and Currency of Issue Traditional Types of Bonds (as to Timing of Cash Flows, Optionality, and Convertibility) Bond Payment Structures Elements of a Bond Bond Price vs. Yield-to-Maturity General Bond Pricing Formula Bond Formula Adjustments Price Distinctions Holding Period Return
Bonds
Are capital market instruments
have a maturity of more than 1 year
Multilateral Organizations
e.g. World Bank, Asian Development Bank, etc.
Is a contract of an institution which binds the institution that issued the bond to pay certain amounts of money to the owner of the bond on certain dates.
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Domestic Bonds
Issued by a borrower resident in the country and denominated in the local currency Example: Singapore Airlines issues bonds denominated in Singapore Dollars in Singapore.
Foreign Bonds
Issued by a borrower which is nonresident in the country in which the bond is being issued Example: General Electric USA issues a 10-year bond in Singapore Dollars and sells this in Singapore.
Eurobonds
A Eurobond is any bond with a payment currency which differs from the currency of the country in which the bond is issued. Eurobond markets developed as a means of escaping domestic regulations, especially (withholding) tax, and now rival the size of domestic markets. Euro is used in the same sense as Eurodollars. Example: PLDT issues USD-denominated bond in Europe.
Amortizing
Amortizing principal repayment means that some of the principal is paid prior to maturity.
Callable Bonds
Normally a fixed rate bond with a call option embedded by the issuer This call option involves a price higher than the face/maturity value and a call date which is significantly ahead of its maturity date.
Elements of a Bond
Bonds are a claim to a set or stream of future cash flows. They have two primary cash flow components:
Face/Par/Redemption/Maturity Value (Principal) Component Periodic Coupon (Interest) Payment Component
The face value (principal) of a bond is the amount that the issuer agrees to repay the bondholder at the maturity date. The periodic amount of interest payment to bondholders during the life of the bond is called the coupon.
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Elements of a Bond
The coupon payments represent the interest on the bond and are made at regular intervals. Final interest payment and principal are paid at specific date of maturity (terminal value; final cash flows). The coupon amount divided by the face value is the coupon rate. A bonds price and coupon rate are often expressed as a percentage of the face value.
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Bonds
Which would you buy?
FXTN with 5 years to go till maturity earning a semi-annual coupon of 8.50% and trading at 99.05 per 100 face FXTN with 9 years to go till maturity earning a semi-annual coupon of 8.25% and trading at 95.44 per 100 face Both FXTNs have the same issuer (Philippine government) and are denominated in PHP.
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(1 + YTM )N
(1 + YTM )
n =1
Where: FV YTM N
= = =
Where: C = = YTM = n =
future coupon amount FV x coupon rate yield to maturity nth cash flow until maturity (N)
In notation form:
2 3
P=
n =1
(1 + YTM )n (1 + YTM )N
5 5 5 4.7619 100 4.5351 4.3192
FV
4 Total
105
Future Values
86.3838
Present Values
105 5 5 5
105
Future Values
Future Values
4.7170 96.5349
4.4500
4.1981
83.1698
Present Values
4.8077 103.6299
4.6228
4.4450
89.7544
Present Values
Summary of Examples
From the previous slides: Price of the Bond Yield to Maturity 100.0000 5% 96.5349 6% 103.6299 4%
P=
n =1
(1 + YTM )
FV (1 + YTM )N
Expected Return
If an investor buys a 5% five-year annual coupon bond yielding 6%, the investor expects to earn a 6% return. Yield is forward looking. Return is backward looking. The return is the single interest rate that equates the final investment proceeds to the future value of the bonds purchase price.
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Discounting the FV: 128.1854648/(1.06)^5 = 95.78763 or Compounding the PV: 95.78763 x (1.06)^5 = 128.185464 Yield to Maturity is like a bank deposit rate it is the implied reinvestment rate of all cash-flows.
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Using the bank account, we have replicated the cash flows of the bond: YTM is the equivalent rate to depositing the cash price of the bond in a bank account.
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Withholding Tax
In the Philippines, all government securities are subject to a 20% final withholding tax on interest income. How is withholding tax reflected in the general bond pricing formula?
Both the coupon rate and the YTM must be expressed net of final withholding tax of 20%
C p
n
YTM Adjustment
YTM 1 + p
Where: p =
Withholding Tax
Coupon Rate Adjustment
C p (0.8)
YTM Adjustment
(YTM )(0 . 8 ) 1 + p
n
(YTM )(0 .8 ) 1 + p
Where: YTM p N DSC E = = = = =
N 1 +
DSC E
yield to maturity coupon payment frequency nth cash flow until maturity (N) number of days from settlement date to next coupon date number of days in coupon period
Day-Count Conventions
Valuation of most bonds in the Philippines uses the 30/360 day-count convention.
This simply means that, when counting the DSC, each month is assumed to have 30 days while each year is assumed to have 360 days.
Accrued Interest
Accrued interest, by definition, is the amount of interest that has accrued from the issue/last coupon date up to the settlement date.
Coupon Frequency Annual (p=1) Semi-annual (p=2) Quarterly (p=4) Monthly (p=12)
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E 360 180 90 30
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Accrued Interest
C p (0.8)( A) AccruedInterest = t
Accrued Interest
The price of a fixed rate bond after adjusting for accrued interest may be obtained through the following: Present Value of the Coupons + Present Value of the Face Value Accrued Interest
Where: C = = p = A = t =
future coupon amount FV x coupon rate coupon payment frequency accrued number of days number of days in a coupon period (same as E)
Price Distinctions
Clean Price
Also known as the Flat Price or Acquisition Cost of the bond Is equal to the Net Present Value (NPV) of all the bonds expected future cash flows less Accrued Interest Is the basis for the marking-to-market of bonds
+
n =1
C p (0.8)( A) t
Price Distinctions
Dirty Price
Is the total amount that is to be paid (received) by a buyer (seller) of a bond to (from) the bonds seller (buyer) Is equal to the Net Present Value (NPV) of all the bonds expected future cash flows May be arrived at by adding the Clean Price of the bond to Accrued Interest
Is the basis for secondary market quotations (bid and offer) of bonds
(DP
HPR =
sale
DPpurchase ) + DPpurchase
n n = purchase
sale
Reinvestment Income
Interest earned from reinvesting interim cash flows (interest and/or principal)
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Problem 1
What is the price of a 3-year, 11% semiannual bond with face value of PHP500,000.00 if the YTM is 10.75%? Assume that the bond was issued free from transaction costs. Was the bond sold at par, at a premium, or at a discount?
Problem 2
A bank has given you its bid and ask for a 2-year, 11.00% semi-annual bond with a par value of PHP1,000,000.00. Its bid for the bond is 11.25% while its offer is 10.75%. Assuming that the bond is subject to 20% final withholding tax on interest income, what is the price per hundred (PPH) equivalent of its bid and offer quotation for the bond?
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Problem 3
What is the price of a 2-year, 10% semiannual bond with par value of PHP750,000.00 if the YTM is 10.50%? If it is sold 1 year later at a YTM of 10.25%, what is the price at sale? Did the investor make money from the sale? What is the investors holding period return (HPR)? For this problem, assume that the bond is subject to 20% final withholding tax on interest income.
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Problem 4
On May 30, 2006, an investor purchases a PHP10,000,000.00 par value worth of a Fixed Rate Treasury Note (FXTN) with a coupon rate of 8.50% p.a. and a maturity date of March 3, 2011 at a YTM of 8.75%. Provide the following information: a) Dirty Price of the FXTN; b) Accrued Interest; c) Clean Price of the FXTN.
References
Treasury Certification Program (TCP) Money Market Module Ateneo-BAP Institute of Banking Fixed Income Seminar Notes Fund Managers Association of the Philippines (FMAP) and UBS Investment Bank Lecture Notes Treasury Operations (FIN538M) Lecture Notes Fixed Income Securities Special Topics in Financial Engineering (FIN570M)
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