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Investment Management and Capital Markets

Lecture 4: Yield Curve and Bond Valuation

Yield Curve
Bond Valuation
The term structure

A Bond is an instrument which pays fixed amounts (usually) of interest

(called a coupon) on a regular basis, over its life and is redeemed at par
value (usually) at maturity, by the issuer .

C1 C2 C3 C4 C5 Ct R

0 1 2 3 4 5 t

P t year coupon paying bond

As the cash flows on a fixed coupon paying bond are fixed in time, the
market price (present value) of such an instrument varies according to the
interest rate environment.

Money market securities have a maturity of < 1 year;

Capital market securities have a maturity of > 1 year.

Types of Bonds

The interest payment on bonds is referred to as `coupon’ and is fixed on the face
value of the bond at the time of issue. Coupon payments are semi-annual usually
(though you should assume one annual payment unless otherwise stated in this

The most common type of bonds pay fixed interest and such bonds are called
straights or

Some bonds do not pay any interest at all , and such bonds are called zero coupon
bonds. Zero coupon bonds sell at a deep discount to their par values because all the
benefit from holding the bond is realised at maturity.

Some Bonds link their coupons to market interest rates and such bonds are called
floating rate notes

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Some bonds link their interest payment to the retail price index and such bonds are
called index linked bonds. The return on Index linked bonds is closer to `real interest

Bonds which allow the holder to exercise an option to convert into equity are called
convertible bonds.

Bonds which have no redemption date are called consols, irredeemables or


Debentures are bonds secured against some assets.

Bonds redeemable at the option of the issuer are `callable’ while bonds redeemable at
the option of the holder are `puttable.’

Gilts are Bonds issued by the British Government.

Bonds issued by corporates are corporate bonds.

Eurobonds are bonds sold internationally in the domestic currency of a country.

Strips are securities which result from breaking down a security into various
constituents which are sold off seperately. The usual way in which this is done is to
sell off each future coupon payment and the redemption amount for its present value.

Why are Gilts so much in demand?


The holder of a bond has default risk; ie the risk that the issuer will not honour
payments on the bond. It is also called the credit risk.

The two main credit rating agencies are Moody’s and Standard and Poor’s.
The annexure is a typical extract.

Note the distinction between

`investment grade’: > Baa, Moody’s or > BBB S&P

`non-investment grade’: < Ba , Moody’s or < BB S&P Bonds with lower credit
ratings have a higher default risk and risk premium.

Non-investment grade bonds are also known as junk bonds.

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Definitions of various yields terms

The Spot rate refers to the yield (IRR) of a `pure discount’ or zero coupon bond
of that maturity.

0 1 2 3 4 5 6

P 6 year zero

P = R / (1+ st) t

ie st = t √ ( R/P) - 1

st = spot yield (rate) for period `t’
P = the Market Value of the Bond
R = the redemption amount on the bond (amount at maturity)

The yield curve is a plot of the spot yields of zero coupon bonds of different

In general, a Bond makes regular payments of interest (coupon) to the holder over a
period of time.
C1 C2 C3 C4 C5 Ct

0 1 2 3 4 5 t

P t year coupon paying bond

The Market price of a bond is the present value of various payments made by the
bond and is arrived at by discounting the various payments on the bond by the
related spot rate.

Ie P = C1/(1+ s1) + C2/( 1+ s2) 2 + ….. (Ct + R)/ (1+ st) t

= Σ Cn/ (1+st)t + R / (1+st)t

Ct = the coupon payment at time `t’

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Redemption yield (also called the `yield to maturity’ or `ytm’ or the `gry’
gross redemption yield) of a bond is the IRR on the bond.

It is the `y’ which satisfies the equation:

P = C1/(1+ y) + C2/( 1+ y) 2 + ….. (Ct + R)/ (1+ y) t

= Σ Ct/ (1+y)t + R/ (1+y)t

A strip is a coupon sold on its own. How will it be valued?

The Current Yield or Flat yield of a bond is simply its interest payment divided by
its market price.

CY = Ct / P

The Forward Rate of interest for the period t+1 is the one period
Investment rate between the end of period `t’ and end of period `t+1’.

Forward rates are related as below.

(1+S1) (1+ 1 F2) = ( 1+ S2) 2

(1+S1) (1+ 1 F2)……….( 1+ t-1 Ft ) = ( 1+ St) t

Note alternatively that that the one period forward rate on a bond can be calculated
from the spot yield of two adjacent periods:

( 1 + S t) t
ie t-1 Ft = ---------------- - 1
( 1 + S t -1) t-1

Yield curves

The spot yield curve plots the spot yields (or zero coupon yields) against term to
maturity. The spot yield curve is also called the Term structure of interest rates.

The ytm curve is a plot of the ytms of bonds of the same maturity over time. It is
usually obtained by regression. ( You will notice in the tutorial how bonds of the same
maturity but different coupons have slightly different ytms based on their cash flows.)

Finally, the forward yield curve plots one period forward rates against term to

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Valuing Bonds.

(a) a redeemable bond

Q A company has issued bonds redeemable at the end of three years from now,
with a coupon of 6.0 % payable annually and redeemable at par. (The par value of a
bond is £ 100 unless mentioned otherwise.). The one year, two year and three year
spot rates are 6%, 8% and 10% respectively.

(i) What will be the market price of this bond?

(ii) Calculate the ytm of the bond.


(i) The market value of the bond is the present value of all its payments:

Present Value of first Coupon: 6/ (1.06) = £ 5.66

“” second “ : 6/ (1.08)2 = £ 5.14
“” third “ : 6/ (1. 10)3 = £ 4.51

Present value of redemption amount = 100/ (1.10)3 = 75.13

Total £ 90.44

(ii) ytm of the bond is the IRR of the bond:

Locate the two rates between which the NPV changes sign and interpolate.

|At 9%: annuity of £6 for three years = 6 x 2.531 = 15.186

Redemption amount = 100 x 0.772 = 77.200
Total Value = 92.386

PV = 92.386 - 90.44= 1.946

At 10% annuity of £6 for three years = 6 x 2.487 = 14.922

Redemption amount = 100 x 0.751 = 75.100
Total Value = 90.022

PV = 90.022– 90.44 = - 0.418

By interpolation, the IRR is 9 + ( 1.946/2.364) = 9.823 %

(b) irredeemable bonds

If you have an irredeemable bond with a 6.0% coupon, and the ytm is 9.823% what
will be its value?

Value, as a perpetuity = C/y = 6.0/ 0.09823 = £ 61.08.

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Theories of the term structure

The term structure of interest rates shows the relationship between short term
and long term spot rates.

According to the expectations hypothesis, the market’s expectations of future

interest rates is based on bond yields. Thus the forward interest rate between any
periods can be computed from the spot yields of two adjacent periods and the
spot yield for the period 0-t could be thought of as constructed from one period
forward rates as below:

(1+ S 2 ) 2 = ( 1+ S1 )( 1+ 1 F 2 ) ;

In general:

(1+ S t ) t = ( 1+o F1 )( 1+ 1 F 2 ) ( 1+ 2 F 3) ..... ( 1+ t-1 F t );

St = Spot yield for period 0-t ;

t-1 F t = one period forward rate between (t-1) and t.

This implies that if a contract is made to roll over one period investments, it is the
same as if an investment had been made for the entire period: ie there are no excess
profits to be made by following either strategy: ` perfect substitutability’. The theory
also states that forward rates are the best indicators of expected future
spot rates.

The Liquidity preference hypothesis states that investors have a preference for
liquidity and therefore they will prefer short term investments as compared to longer
term investments. Therefore they are prepared to accept lower rates of interest for the
short term. Conversely, borrowers have to pay a premium for longer term investors.

Here then a premium term, depending upon the maturity, has to be incorporated to
equate the `t’ period spot yield with the yield constructed from one period forward

According to the theory the liquidity premium increases with time.


(1+ S t ) n = ( 1+o F1 )( 1+ 1 F 2 ) ( 1+ 2 F 3) ..... ( 1+ t-1 F t ) + Tn

where `Tn’ is a premium term which increases with the term to maturity.

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The Market Segmentation or preferred habitat theory states that the market is
segmented by different participants who have a preference for different maturities:
banks at the short end and pension funds at the long end. Supply and demand
conditions thus determine the shape of the term structure. This theory explains a
`hump’ noticed often in the yield curve, as there is often not much 09demand for n
medium term maturities.

The effects of inflation could also be kept in mind. A rising yield curve thus implies
higher expectations of inflation in the future (also called the Fisher effect).

Empirical evidence favours the former two theories: the expectations hypothesis
remains the basis of determining what interest rates could be expected to be
while liquidity premiums have been noticed from time to time.

Yield curves of different shapes:

Y axis - `interest rates’

X axis - `term to maturity’

What are the implications for projects ?

- discount rates
- sourcing finance

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