Understanding Bonds

U
Prof Ninad M Mondkar?
Prof.
Mondkar CFPCM,RFC
RFC
Chief Learning Officer
Financial Planning Academy

B d are IOU
Bonds
IOU (I
( I owe Y
You))
What is a
Bond?

Th
They are a security
it issued
i d in
i
connection with a borrowing
arrangement
rr
t
A
An obligation
bligati for
f r the
th issuer
i r to
t make
ak
specified payments (interest &
principal) to the Bondholder
Bondholder

What are the

Ch
Characteristics?
i i ?

Characteristics: Par Value: Value stated on the face of the

bond Amount the issuer promises
bond.
to pay at the time of Maturity.
C
Coupon
R
Rate:
Interest rate payable to the
Bondholder
Maturityy Date: Date when the principal amount
is payable to the Bondholder

An
Example
Exampl
Please

Example: A issuer
An
i
sells
ll a Bond
B d with
ith a par
value of 1,000, a coupon rate of 8%
(
(payable
bl semi-annually)
i
ll ) & a
maturity period of 12 years.
Ans:Th buyer
The
b r off suchh bond
b d would
w ld receive
r iv
an interest of 40 every six months
for 12 years & a principal amount of
1,000 at the end of 12 years.

Two types: What are the

different
types of Bonds ?

1. Government Bonds
2. Corporate Bonds
g Bonds
a. Straight
b. Zero Coupon Bonds
c. Floatingg Rate Bonds
d. Bonds with Embedded Options
e. Commodity Linked Bonds

Issued By:- RBI (on behalf of the GOI,

state governments)
Government
Bond ?

Also called as: - Gilt edged securities (Gsecs)

Period:- Medium to longg term
Interest Payments:- Semi-annually
(typically)
A number
b r off government
r
t agencies
i also
l
issue bonds that are guaranteed by the
Central or the State government.

Issued
Issued By:
By:- Companies
Corporate
Bond ?

Also called as: - Corporate

Debenture
Period:- Medium to long term
Interest Payments:y
Semiannually (typically)

Straight
B d?
Bond

Straight Bonds: Most popular bonds

Also called as Vanilla Bonds
Pays fixed periodic coupon
(usually semi-annually) over its
life
f & returns the principal
p
p on the
date of maturity.

Zero
Coupon
Bond ?

Zero Coupon Bonds: Does not carry any regular

interest payments
Al called
Also
ll d as Zero
Z
Issued at a steep discount over
its fface value & redeemed at face
f
value on maturity
Contd

An
xampl
example
please!

IDBI issued deep

discount bonds in 1996
which have a face value
off 200,000 & a
maturity period of 25
yyears. The bonds were
issued at 5,300.

Floating
Rate
Rat
Bond ?

Floating Rate Bonds: They pay an interest rate that is

linked to the benchmark rate such
as Treasury bill interest rate.
Example: In 1993 the SBI came out with
the ffirst ever issue off floating
f
g
interest rate bonds in India.

Bonds with
Embedded
Option?

Bonds with Embedded Option:

Option:Bonds may have options
embedded in them giving certain
rights to investors and/or issuers.
Common types of such bonds are: -

(a) Convertible bonds

((b)) Callable bonds
(c) Puttable bonds

Commodity
Linked
Bonds?

Commodity Linked Bonds: Th payoff

The
ff from
f
a commodity
di
linked bond depends to a certain
extent to the price of a certain
commodity.
y

Bond Valuation

How are
Bonds valued ?

Valuation of a bond (or for that

that matters any asset, real or
financial) = PV (Cash Flows
expected from it)
= PV off iinterest payments + PV
of principal repayment

How are
Bonds valued ?

Therefore to value a bond we

require: (a) An estimate of expected cash
flows
(b) An
A estimate
i
off required
i d
return

Assumptions
If any?

While valuingg a bond we layy down a

few assumptions:(a) Coupon interest rate is fixed for
the term off the bond.
(b) The coupon payments are made
y & theyy next
x coupon
p
everyy year
payments is receivable exactly a
yyear from
f
now.
(c) The bond will be redeemed at par
on maturity.
y

Terminology:
gy - (CMPD Function))
Terminology

N = number off year

y to maturityy
i% = required (or expected) rate of
return ((also called as
expected yield)
PV = Present Value off the bond
(also called as Market Price)
Pmt = Coupon payments received
(Face Value x Interest Rate)
FV = Future Value or Face Value or
M i proceeds
Maturity
d or Par Value
V l

An
xampl
example
please!

Compute
p the value off
bond having 10 year,
12% coupon withh a par
value of 1,000
1 000 having
a required
q
yield
y off 13%

Answer ?

Answer: N = 10
i% = 13
PV = ? (-945.737)
P t = 1000 x 12% = 120
Pmt
FV = 1000

Bond Value
with
semii annuall
interest

Most of the bonds pay interest

semi annually. To value such a
bond we make the following
modifications
- pmt / 2
(semi annual interest payment)
- nx2
((number off halff yearly
y y periods)
p
)
-i/2
(discount rate as per half yearly
periods)

Bond
Yields

Why yields?
Bonds are generally traded
on the basis off prices
p
but
they are generally compared
I terms
In
t
off their
th i yields
i ld as
there are significant
g f
variations in cash flow
patterns.

Common type
of

Bond Yields

Common type of yield: Current yield = The

annual coupon
p interest to
the market price.
Yield
Yi ld to
t maturity
t it =
NPV = 0,, i.e. YTM = IRR
RR
Yield to call =
V l off the
Value
h bond
b d till
ill the
h
call (buy back) by the issuer

Current
Yield

Current Yield: = Annual Interest

Market
k Price
E.g.: Th currentt yield
The
i ld off a 10 yr,
12% coupon
p bond with a
par value of 1,000 &
selling
lli price
i for
f
950 is
i
(1000 12%)/950
= (1000*12%)/950
= 12.63%

E.g.: YTM

Consider a `11,000
000 par value
bond, carrying a coupon rate of
9% & maturing
i after
f 8 years. The
Th
current selling price of the bond is
`800. What is the YTM on this
bond?
Ans: N = 8 ; i% = ? (13.20%)
(13 20%) ;
PV = - 800 ;
Pmt = (1000*9%) = 90 ;
FV = 1000.

Calculation of YTC
(CMPD Mode)
YTC

N= no
no. of years to the assumed
call date
i% = expectedd rate off return
(required yield)
PV = Market Price ; Selling price
Pmt = ((Face value*Coupon
p rate))
FV = Par Value, Future Value,
Maturity Value