28‐11‐2018

Interest Rates and Bond Valuation

Financial Management-I; S13&14

Prof. Jijo Lukose P.J.; IIM Kozhikode

 Bloomberg | September 10, 2018 9:07 AM

 Worst still to come for Indian bond market as
risk to inflation rising due to rapid fall in rupee
 The 10-year yield may climb to as high as 8.25
percent by end-September if the government --
which is seeing revenue collections falling behind --
decides to add back the 500 billion rupees ($7 billion)
of borrowing that it had slashed earlier this year.

Interest Rate /Yield (16th Nov 2018)

Call  (%)  6.35
RBI‐LAF Repo Rate  (%)  6.5
RBI‐LAF Reverse Repo Rate   (%)  6.25
Bank rate   (%)  6.75US
1‐yr G‐Sec yield (%)  7.2851 2.65%
10‐yr Benchmark yield (%)  7.7855 3.07%
30‐yr G‐Sec yield (%)  8.0118 3.31%
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Topics
 Introduction
 Bonds and Bond Valuation
 Government and Corporate Bonds
 Bond Markets
 Inflation and Interest Rates
 Determinants of Bond Yields

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Introduction
 A debt security is a contractual obligation by a borrower to
pay certain amounts of cash in future to a lender.
 Markets in which debt securities trade are known as either debt
markets or fixed-income markets.
 In 2010, global stock market capitalization stood at $54 trillion,
the outstanding global debt is $93 trillion
 Source: McKinsey Global Institute’s Mapping Global Capital Markets 2011’
 India, stock market capitalization is above Rs.100 trillion;
where as bond value is around Rs.75 trillion. 75% of the
outstanding debt is issued by government.
 A bond specifies the:
 Par (face) value, Coupon rate, Coupon payment
 Maturity Date

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Livemint, Aug 06 2018. 04 00 AM IST

 India’s capital market regulator has proposed that large

corporations should raise 25% of their borrowings from the
corporate bond market from the next fiscal year.
 A large corporation is one, according to the Securities and
Exchange Board of India (Sebi), which has an outstanding long-
term borrowing of at least ₹ 100 crore. The Reserve Bank of
India (RBI) considers a company large if it has an aggregate
sanctioned credit limit of ₹ 25,000 crore from the banking
system (not how much it has taken) in fiscal year 2018. The
amount is progressively reduced to ₹ 15,000 crore in 2019 and ₹
10,000 crore from 2020.
 Currently, the bond market is dominated by AAA issuers and the
issuances by A-rated entities are a measly 2%.
Financial Management -I, S14 5

Issuer Rural Electrification Corp
Bond type Coupon bonds
Placement method Open subscription
Par amount 1,000 INR
Issuer Name REC‐8.46%‐24‐09‐28‐BOND
Security Code 961776
Face Value 1000
Maturity Date 24‐09‐2028
Next Interest Payment Date 01‐12‐2018
ISIN No INE020B07HP8
Coupon (%) 8.46
Rating AAA
Outstanding FV amount 16,387,809,000 INR
Coupon frequency 1 time(s) per year
NSE , As on Nov 19, 2018 09:54:46 IST
Buy Sell
1,142.00 Pr. Close Open Qty Price Price Qty

0.16 0.01% 1,141.84 1,142.00 20 1,129.99 1,142.00 50

1,000 1,129.50 1,144.50 13
52 week high1,401.00
40 1,120.01 1,144.65 546
52 week low1,060.00 10 1,111.11 1,177.99 50
200 1,050.01 1,178.00 10
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Bond Pricing
 Bonds of similar risk (and maturity) will be priced to yield
about the same return, regardless of the coupon rate.
 Primary Principle:
 Value of financial securities = PV of expected future cash flows
 Interest rates are inversely related to present (i.e., bond)
values.
 𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒; 𝑃 1
 Where C=Coupon rate (c) * Face Value (FV) and y= yield to
maturity
 Bond value is, therefore, determined by the present value of the
coupon payments and par value.
 With SA compounding.
/
 𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒; 𝑃 1
/ / /

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Computing YTM
 The yield to maturity of a bond equals the rate of return
that discounts cash flows (coupon payments and the
principal) back to the bond’s current price.
 𝑃 ∑
 Example 1: Consider a bond with a 10% annual coupon rate,
T=15 years and a par value of $1,000. The current price is
$928.09.
 N = 15; PV = -928.09; FV = 1,000; PMT = 100
 YTM = 11%
 Example 2: Suppose a bond with a 10% coupon rate and
semiannual coupons has a face value of $1,000, 20 years to
maturity, and is selling for $1,197.93.
 N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; yield= 4% (Is this
the YTM?)
 YTM = 4%*2 = 8%

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Current Yield vs. Yield to Maturity

 Current Yield = annual coupon / price
 Yield to maturity = current yield + capital gains yield
 Example: 10% coupon bond, with semi-annual coupons, face value of 1,000,
20 years to maturity, $1,197.93 price
 Current yield = 100 / 1197.93 = .0835 = 8.35%
 Price in one year, assuming no change in YTM = 1,193.68
 Capital gain yield = (1193.68 – 1197.93) / 1197.93 =
-.0035 = -.35%
 YTM = 8.35 - .35 = 8%, which is the same YTM computed earlier
 Bond Pricing with a Spreadsheet
 PRICE (Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)
 YIELD (Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
 Settlement and maturity need to be actual dates
 The redemption and Pr need to given as % of par value
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Zero Coupon Bonds

 Make no periodic interest payments (coupon rate = 0%)
 The entire yield to maturity comes from the difference between the
purchase price and the par value
 Cannot sell for more than par value (?)
 Sometimes called zeroes, deep discount bonds, or original issue
discount bonds (OIDs)
 Treasury Bills and principal-only Treasury strips are good examples
of zeroes
Information needed for valuing pure discount bonds:
 Time to maturity (T) = Maturity date - today’s date
 Face value (F) & Discount rate (YTM)
 Find the value of a 15-year zero-coupon bond with a
$1,000 par value and a YTM of 12%.

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YTM and Bond Value

Bond prices (P) and market interest rates (y) move

in opposite directions.
1300 When c= y, price = par value
When c> y, price > par value (premium bond)
When c< y, price < par value (discount bond)
Bond Price

1200

1100

1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 ytm
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Interest Rate Risk

 Price Risk
 Change in price due to changes in interest rates
 Long-term bonds have more price risk than short-term
bonds
 Low coupon rate bonds have more price risk than high
coupon rate bonds.
 Reinvestment Rate Risk
 Uncertainty concerning rates at which cash flows can be
reinvested
 Short-term bonds have more reinvestment rate risk than long-
term bonds.
 High coupon rate bonds have more reinvestment rate risk than
low coupon rate bonds.

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Bond Pricing Relationships: Maturity

A bond with longer maturity has higher relative (%) price change
than one with shorter maturity when interest rate changes. As
maturity increases, price sensitivity increases at a decreasing rate.
Bond Value

When the interest rate equals the

coupon, both bonds sell for face value
Par

Short Maturity Bond

C Long Maturity Bond Discount Rate
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Bond Pricing Relationships: Coupon Rate

Price sensitivity is inversely related to a bond’s
coupon rate. A lower coupon bond has a higher
relative price change than a higher coupon bond
Bond Value

when YTM changes.

High Coupon Bond

Low Coupon Bond

Discount Rate
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Government Bonds
 Treasury Securities are government debt
 T-bills – pure discount bonds with original maturity less than one year
 T-notes – coupon debt with original maturity between one and ten
years
 T-bonds – coupon debt with original maturity greater than ten years
 State Governments (India) : State Development Loans (SDLs).
 Municipal Securities (US)-Interest received is tax-exempt at the
federal level
 A taxable bond has a yield of 8%, and a municipal bond has a yield
of 6%.
 If you are in a 40% tax bracket, which bond do you prefer?
 8%(1 - .4) = 4.8%
 The after-tax return on the corporate bond is 4.8%, compared to a 6% return
on the municipal
 At what tax rate would you be indifferent between the two bonds?
 8%(1 – T) = 6% >> T = 25%
 You should be willing to accept a lower stated yield on municipals
because you do not have to pay taxes on the interest received
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Corporate Bonds
 Greater default risk relative to government bonds
 The promised yield (YTM) may be higher than the
expected return due to this added default risk
 Bond Ratings – Investment Quality
 High Grade
 Medium Grade
 Low Grade
 Very Low Grade

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Moody's, Standard & Poor's, and Fitch

Ratings
Moody's S&P Fitch description
Aaa AAA Prime

Aa1, Aa2, Aa3 AA+, AA, AA− High grade

A1, A2, A3 A+, A, A− Upper medium grade
Baa1, Baa2, Baa3 BBB+, BBB, BBB− Lower medium grade
Ba1, Ba2, Ba3 BB+, BB, BB−,  Non‐investment grade  speculative
B1, B2, B3 B+, B, B‐ Highly speculative
Caa1,  Caa2, Caa3 CCC+, CCC, CCC‐ Substantial risks
CC Extremely speculative
Ca
C Default imminent
C RD, SD, D DDD,DD,D In default

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India- Ratings Scale and Definitions

CRISIL ICRA’s Long-Term Rating Scale

Symbol Description Symbol Description

AAA Highest Safety LAAA lowest credit risk

AA High Safety LAA low credit risk.
A Adequate Safety LA average credit risk
BBB Moderate Safety LBBB higher than average credit risk
BB Inadequate Safety LBB high credit risk
B High Risk LB very high credit risk
C Substantial Risk LC limited prospects of recovery
D Default LD very low prospects of recovery

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Government Bond Market

List of Government of India Securities outstanding as on November 19, 2018
Sl. Date of Outstanding Stock
ISIN Nomenclature Date of issue
No. maturity (Rs. Crore)
2018-19
1 IN0019980286 12.60% GS 2018 23-Nov-1998 23-Nov-2018 12,631.880

2 IN0020030097 5.64% GS 2019 2-Jan-2004 2-Jan-2019 10,000.000

2027-28
48 IN0020170026 6.79% GS 2027 15-May-2017 15-May-2027 1,21,000.000

49 IN0020070036 8.26% GS 2027 2-Aug-2007 2-Aug-2027 73,427.329

50 IN0020070069 8.28% GS 2027 21-Sep-2007 21-Sep-2027 89,252.240

6.01% GS 2028 (C
51 IN0020020247 8-Aug-2003 25-Mar-2028 15,000.000
Align)
52 IN0020170174 7.17% GS 2028 8-Jan-2018 8-Jan-2028 90,000.000
2055-56
83 7.72% GS 2055 26-Oct-2015 26-Oct-2055 78,000.000
IN0020150077
Total 53,91,929.48

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T Quotations (India) As on Nov 19, 2018 10:14:46 AM IST

07.17 GS 2028

 What is the coupon rate on the bond?

 When does the bond mature?
 What is the bid price? What does this mean?
 What is the ask price? What does this mean?
 How much did the price change from the previous day?
 What is the yield based on the ask price?
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Clean versus Dirty Prices (US)

 8 Nov 28 132:23 132:24 -12 5.14
 In US market, treasury prices are quoted in 32nds
 Clean price: quoted price
 Dirty price: price actually paid = quoted price plus accrued
interest
 Example: Consider T-bond in previous slide, assume today is
July 15, 2012
 Number of days since last coupon = 61
 Number of days in the coupon period = 184
 Accrued interest = (61/184)(.04*1,000) = 13.26
 Prices (based on ask):
 Clean price = 1,327.50
 Dirty price = 1,327.50 + 13.26 = 1,340.76
 So, you would actually pay $1,340.76 for the bond.

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Inflation and Interest Rates

 The ex ante nominal rate of interest includes our desired real rate
of return plus an adjustment for expected inflation.
 (1 + R) = (1 + r)(1 + h), where
 R = nominal rate; r = real rate; h = expected inflation rate
 Approximation: R = r + h
 Inflation-Linked Bonds
 Most government bonds face inflation risk. TIPS (Treasury Inflation-
Protected Securities), however, eliminate this risk by providing promised
payments specified in real, rather than nominal, terms
 The Fisher Effect: Example
 If we require a 10% real return and we expect inflation to be 8%, what is
the nominal rate?
 R = (1.1)(1.08) – 1 = .188 = 18.8%
 Approximation: R = 10% + 8% = 18%
 Because the real return and expected inflation are relatively high, there
is a significant difference between the actual Fisher Effect and the
approximation.
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Bond Yields and Yield Curve

 Term structure is the relationship between time to maturity and
yields, all else equal. It is important to recognize that we pull out
the effect of default risk, different coupons, etc.
 Yield curve – graphical representation of the term structure
 Normal – upward-sloping, long-term yields are higher than short-term
yields
 Inverted – downward-sloping, long-term yields are lower than short-
term yields

Yield Curve
8.10

7.90

7.70

7.50

7.30

7.10

6.90

6.70

6.50
0.0 5.0 10.0 15.0
19‐Nov‐18
20.0
20‐Nov‐18
25.0 www
30.0 ccilindia
35.0 com 40.0

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Factors Affecting Required Return

 Default risk premium – remember bond ratings
 Taxability premium – remember municipal versus taxable
 Liquidity premium – bonds that have more frequent
trading will generally have lower required returns
(remember bid-ask spreads)
 Anything else that affects the risk of the cash flows to the
bondholders will affect the required returns.

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