Characteristics of Bonds Various types of Bonds.

Yield Curve

Debt Security
A Debt Security is a claim on a specified

periodic stream of income. They are also called Fixed Income Securities. Payment cash flows are determined in advance, so easy to value.

Bonds and their Characteristics

A Bond is an instrument which obligates the issuer to

make specified payments to the bondholder. Bonds can be described through the below 3 values
Par Value This is also the Face Value of the Bond. It

represents the amount which the issuer promises to pay at maturity. Maturity Date - This is the date when the principle amount is payable to the Bond Holder. Coupon Rate This is the interest rate payable to the Bond Holder at regular intervals.

Types of Bonds
Government Bonds Government of India

periodically issues Bonds called G-Secs or Gilt Edged Securities. Interest paid semi annually. Mostly medium to long term bonds.
Corporate Bonds These are bonds issued by

companies in order to borrow money. A secured corporate debt is called Corporate Bond whereas an unsecured corporate debt is known as Corporate Debentures.

Another Differentiation of Bonds

Type of Bond Straight Bonds Charecteristics Plain Vanilla Bond. Pays a fixed coupon over its life and returns the principle on maturity. Does not carry any interest payment. Issued at a discount over its face value and redeemed at Par on maturity

Zero Coupon Bonds

Floating Rate Bonds

Interest rate is linked to a benchmark rate such as the Treasury Bill interest rate.
These are bonds which give special rights to the investors: -Convertible Bonds Bond Holder can convert them into equity at maturity -Callable Bonds Issuer has the right to redeem the bond prematurely - Puttable Bonds Investor has the right to sell them prematurely back to the issuer

Bonds with Embedded Options

Bond Pricing
PB C t t t 1 ( 1 r )
T

ParValueT T (1 r )

PB
Ct T

= Price of the Bond (Present Value) = Interest Amount or Coupon Payments (pmt) = Number of Periods (nper) = Discount Rate/ Yield to Maturity

* Yield to maturity is the prevailing interest rate for an instrument of similar maturity.

Relationship between Bond Price and Yield

What should be the price of a 10 year , 8% coupon Bond,

with a par value of 1000? Interest paid semi-annually.

What happens to the value of the Bond if the interest rate

goes down to 7% per annum?

What happens to the value of the Bond if the interest rate

increases to 9%.
Can you explain the relationship between the Bond Pricing

and the Yield (interest rate)?

Bond Prices and Yield

Bond Prices and Yields (required rates of return) have

an inverse relationship. When yields get very high, the intrinsic value of the bond would be very low, since the bond becomes less attractive. When yields approach Zero, the value of the bond approaches the sum of the total cash flows.

Yield Curve A relationship between Price and Yield

Price

Yield

Yield To Maturity
It is the rate at which the present value of the Bonds

Payments is equal to its price.

It is the total yield that an investor would get, given

the discounted price (present value) of a bond and future cash inflows in a bond.
What should be the YTM of an 8% bond, issued for 30

years, with a par value of 1000? The price quoted for the bond is 1276.76.

Yield to Maturity - Formula T ParValue T C t PB T t (1 r ) t 1 (1 r )

Example Find the Yield to Maturity of a 10 year

bond, with a coupon rate of 7%. The price quoted is 950 and the par value is 1000.

35 1000 950 T t (1 r ) t 1 (1 r )
20

Expected and Stated YTM

Stated Yield to Maturity The Yield to Maturity

achieved at by discounting the stated information in the bond.

Expected Yield to Maturity The Yield to Maturity

(YTM) achieved at by considering the chances of default in the stated information.

The stated YTM is the maximum possible YTM on a

bond, while the Expected YTM is a realistic YTM which is usually lower than the Stated YTM.

Expected and Stated YTM

Example : Beta company issued a 12% coupon bond 10 years ago at par value of Rs 1000. The bond now has 5 years left to maturity. However, Beta is facing some financial problems, due to which it assumes that it would be able to pay only 80% of the par value at maturity.
Inputs Coupon Payments Number of Semiannual periods Final Payment Price Expected YTM Stated YTM Rs 60 Rs 60 10 800 850 10 1000 850

YTM

7%

8%

Are Bonds Risk Free ??

Main Risks Associated with Bonds..

Interest Rate Risk Increase in interest rate make the

Bond less attractive and vice versa.

Default Risk/ Credit Risk The issuer of a bond might

default in the payment of the coupon amount or the final amount at maturity.
Inflation Risk Inflation rate also impacts bond prices

directly by increasing or decreasing the bond prices.

Main Risks Associated with Bonds..

Liquidity Risk A Bond might not be able to be

liquidated when the need arises.

Tax Attributes Tax implications, post the purchase of

the bond, might make the same less attractive.

Solve
A Rs 100 par value bond bearing a coupon rate of 12%

will mature after five years. What is the value of the bond, if the discount rate is 15%? The Market Price of a Rs 1000 par value bond carrying a coupon rate of 14% and maturing after 5 years is 1050. What is the yield to maturity of this bond? A Rs 100 par value bond bears a coupon rate of 14% and matures after five years. Interest is payable semiannually. Compute the value of the bond if the required rate of return is 16%.

Rating of Bonds
Debt Ratings Debt Ratings reflect the probability of

timely payments of interest and principle by a borrower. Debt Ratings are not recommendations for purchase, but a grading of debt instruments on the basis of their investment quality. Main Rating Agencies
International Moodys, Standard and Poors, Austrailian

Ratings etc. Indian Crisil, ICRA etc.

All Debt instruments need to be necessarily rated

accordingly

Functions of Debt Ratings

Debt ratings rate Debt instruments only on the basis of their Credit Risk.
Main functions of credit ratings: Provide superior information. Low cost information. Basis for proper Risk-Return trade off. Healthy Discipline on Corporate Borrowwers. Greater credence to Financial and Other Representations Formulation of Public Policy guidelines on Institutional Investments.

Crisil Debt Rating Symbols

Crisil The largest Credit Rating Agency in India. There are 3 kinds of rating symbols given by Crisil 1. High Investment Grades
1. 2.

AAA - represents a very highly rated investment, issued by an institution which is fundamentally very strong. AA These investments are assumed to offer high safety of timely payments of interest and principle. A - Adequate safety of timely payments, but changes in circumstances, might affect their ability to payback. BBB Sufficient Safety of timely payments, but any changes, would weaken and reduce their ability to make payments.

2.
1.

Investment Grades

2.

Crisil Debt Rating Symbols

3. Speculative Grades
1. 2.

3.

4.

BB Inadequate Safety of timely payments, however less susceptible to default in the near future. B Currently managing to make timely payments, however, any changes would lead to a lack of ability or willingness to payback. C Timely payments will continue only till the time, the circumstances are favorable. Highly susceptible to defaults. D There is a high expectation of default on maturity. Probably other instruments issued by the same organization are already in default or arrears.

Yield Curve A relationship between YTM and Maturity

Shows the relationship between the Yield

to Maturity and Years to Maturity

Information on expected future short term

interest rates can be implied from the yield curve

Expected One Year Rates in coming years

Expected One-Year Rates in Coming Years Year 0 (today) 1 2 3 Interest Rate 8% 10% 11% 11%

Pricing of Bonds using Expected Rates

ParValue PVn (1 r1 )(1 r2 )...(1 rn )
A Zero Coupon Bond, paying Rs 1000 after 1 year would

sell today at Rs 925.93. A Zero Coupon Bond, paying Rs 1000 after 2 years would sell today at Rs 841.75.
r1 = One-year rate for period 1 r2 = One-year rate for period 2 rn = One-year rate for period n

Bond Prices using Expected Rates

Time to Maturity Price of Zero* 1 2 3 4 925.93 841.75 758.33 683.18 Yield to Maturity 8.00% 8.995 9.660 9.993

* Rs 1,000 Par value zero coupon Bond

Pricing of Bonds Using Spot Rates

A Maturity 4 years Coupon Rate 6% Par Value 1,000 Cash Flow in 1-3 60 Cash Flow in 4 1,060 Assuming Annual compounding B 4 years 8% 1,000 80 1,080

Price of Bonds using Spot Rates Bond A

Period 1 2 3 4 Total Spot Rate .05 .0575 .063 .067 Cash Flow 60 60 60 1,060 PV of Flow 57.14 53.65 49.95 817.80 978.54

* Since spot rates are different for each year, we would have to calculate the PV of each year separately

Price of Bonds using Spot Rates Bond B

Period 1 2 3 4 Total Spot Rate .05 .0575 .063 .067 Cash Flow 80 80 80 1080 PV of Flow 76.19 71.54 66.60 833.23 1047.56

* Since spot rates are different for each year, we would have to calculate the PV of each year separately

Solving for Yield To Maturity

Bond A Bond Price YTM Bond B Price YTM

978.54 6.63%

1,047.56 6.61%

Bond Pricing Relationships

Inverse relationship between price and yield. An increase in a bonds yield to maturity results in a smaller price decline than the gain

associated with a decrease in yield.

Long-term bonds tend to be more price

sensitive than short-term bonds.

Bond Pricing Relationships

As maturity increases, price sensitivity increases at

a decreasing rate.
Price sensitivity is inversely related to a bonds

coupon rate.
Price sensitivity is inversely related to the yield to

maturity at which the bond is selling.

Duration
A measure of the effective maturity of a bond. The weighted average of the times until each

payment is received, with the weights proportional to the present value of the payment.
Duration is shorter than maturity for all bonds

except zero coupon bonds.

Duration is equal to maturity for zero coupon

bonds.

Duration Calculation
wt CF t (1 y )
D t wt
t 1 T

Price

CFt Cash Flow for period t

Duration Calculation - Spreadsheet

8% Bond Time years .5 1 1.5 Payment 40 40 40 PV of CF (10%) 38.095 36.281 34.553 Weight .0395 .0376 .0358 C1 X C4 .0197 .0376 .0537

2.0

1040
sum

855.611
964.540

.8871
1.000

1.7742
1.8852

Duration/Price Relationship
Price change is proportional to duration and not to maturity. P/P = -D x [(1+y) / (1+y)

D* = modified duration
D* = D / (1+y) P/P = - D* x y

Rules for Duration

Rule 1 The duration of a zero-coupon bond equals its time to maturity.
Rule 2 Holding maturity constant, a bonds duration is higher when the coupon rate is lower. Rule 3 Holding the coupon rate constant, a bonds duration generally increases with its time to maturity.

Rule 4 Holding other factors constant, the duration of a coupon bond is higher when the bonds yield to maturity is lower.

Rules for Duration

Rules 5 The duration of a level perpetuity is equal to:
(1 y ) y

Rule 6 The duration of a level annuity is equal to:

1 y T y (1 y ) T 1