Fixed Income Securities

1. Bond Characteristics
Coupon, AI, Bond Quote, Call and put
provisions, Indenture, Subordination clause,
debenture trustee, Bond Issue in Primary
market
2. Bond Pricing
YTM, YTC
3. Bond Types
Regular, Zero-coupon, Floating rate , Eurobonds, Convertible, Inverse floater, asset
Backed, Catastrophe, Junk
4. Default Risk
1. CDOs
2. CDS

Bonds_Basics
Bonds are debt. Issuers are borrowers and
holders are creditors.
The indenture is the contract between the
issuer and the bondholder.
The indenture gives the coupon rate,
maturity date, and par value.

Bonds Basics
Face or par value is typically Rs.100; this is
the principal repaid at maturity.
The coupon rate determines the interest
payment.
Interest is usually paid semiannually.
The coupon rate can be zero.
Interest payments are called coupon
payments.

A 5-year maturity bond (F.V.=100) with a coupon rate of

10% paid annually is trading at a yield of 8%.
a) Compute the price of the bond.
b) What is the price if the coupons are paid semiannually.
a) 107.99
b) 108.11

What is the effective annual rate for a coupon bond

selling at par and paying a 10% coupon semiannually?
10.25%

Accrued Interest & Quoted

Bond Price
A 10%, 10-year bond issued on 30th Oct, 2012 is
trading at a price of Rs.99 on 17th July, 2014. What is
the final price at which the bond would be available to
the buyer?
AI=5*(77/180)=2.1389
Price=99+2.1389=101.1389

YTM vs. Current Yield

YTM
The YTM is the bonds
internal rate of return.
YTM is the interest
rate that makes the
present value of a
bonds payments
equal to its price.
YTM assumes that all
bond coupons can be
reinvested at the YTM
rate.

Current Yield
The current yield is the
bonds annual coupon
payment divided by the
bond price.
For bonds selling at a
premium, coupon rate >
current yield>YTM.
For discount bonds,
relationships are
reversed.

10% coupon bond (paying coupon annually) maturing

in 5 years (FV=100). If the investor who subscribed to
the bond at t=0, sells the bond at yield of 11% at the
end of one year then, what has been the return earned
by investor?

10
10 100
Pr ice
...
1
4
(1 11%)
(1 11%)

Pr ice 96.90
10 96.90
100
(1 r )

r 6.90%

Realized Yield versus YTM

Reinvestment Assumptions
Holding Period Return
Changes in rates affect returns
Reinvestment of coupon payments
Change in price of the bond

Given a bond (F.V.=100) coupon rate 10% maturing

after 5 years, to be redeemed at face value.
Lets take the example of two person (A & B), both of
whom purchase the above bond at Rs.100 at the time
of the issue of the bond by the company. What is the
YTM for A and B?
If Person A, puts the interest income in safe-box while
person B re-invests it in a FD giving 8% return. Then
how much interest are they earning over the period of
5
the bond?

100 * (1 r ) 150

r 8.45%

(10 * (1 8%) 4 10) 3.6

(10 * (1 8%) 3 10) 2.6

For B

(10 * (1 8%) 2 10) 1.7

(10 * (1 8%) 10) 0.8

Total interest on interest income=8.7

Earnings of B= 50+8.7+100(Redemption value)

100 * (1 r ) 158.7
5

r 9.68%
In the above cases even when the A and B have
different realized yields their YTM is the same.

Bond Prices and Yields

Prices and yields (required rates of return)
have an inverse relationship
The bond price curve is convex.
The longer the maturity, the more sensitive
the bonds price to changes in market
interest rates.

A 5-year maturity bond (F.V.=100) with a coupon rate of

10% paid annually is trading at a yield of 8%.
a) Compute the price of the bond.
b) If the yield increases by 2% what is the % change in
price of the bond?
c) If yield decreases by 2%, then what is the % change
in price?
What is the conclusion?
a) 107.99

Bond Theorems
1% decrease in YTM produces higher change in price than a 1% increase
Higher coupon bond is more sensitive to yield changes

For a longer maturity bond the price is more sensitive to the

yield

Bond Types

Callable bonds can be repurchased before the

maturity date at the specified call price.
Convertible bonds can be exchanged for shares of
the firms common stock.
Puttable bonds give the bondholder the option to
retire at the specified price.
Floating rate bonds have an adjustable coupon rate

Yield to Call
If interest rates fall, price of straight bond can rise
considerably.
The price of the callable bond is flat over a range
of low interest rates because the risk of
repurchase or call is high.
When interest rates are high, the risk of call is
negligible and the values of the straight and the
callable bond converge.

A 30-year maturity, 8% coupon bond paying coupons

annually is callable in 5 years at a call price of Rs.
1100. The bond currently sells at par.
a) What is the yield to call?
b) What is the yield to maturity?
c) What is the yield to call if the call price is only
Rs.1050
d) What is the yield to call if the call price is Rs.1100
but the bond can be called in 2years instead of 5
years

a) 9.65%
b)8%
c) 8.84%
d)12.70%

Convertible Bonds
Gives the holder the right to exchange the bond for a
given number of shares of stock anytime upto and
including the maturity date of the bond. The bond
specifies the conversion ratio.
You own a callable convertible bond with a conversion
ratio of 35. The stock is currently selling for 40 per
share. The issuer of the bond has announced a call at a
call price of 1100. What are your options? What should
you do?

Factors Used by Rating Companies

Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt

Protection Against Default

Subordination of future debt restrict
additional borrowing
Dividend restrictions force firm to retain
assets rather than paying them out to
shareholders
Collateral a particular asset bondholders
receive if the firm defaults

Credit Default Swaps

A credit default swap (CDS) acts like an insurance
policy on the default risk of a corporate bond or
loan.
CDS buyer pays annual premiums.
CDS issuer agrees to buy the bond in a default or
pay the difference between par and market
values to the CDS buyer.

Credit Default Swaps

Institutional bondholders, e.g. banks, used CDS to
enhance creditworthiness of their loan portfolios,
to manufacture AAA debt.
CDS can also be used to speculate that bond
prices will fall.
This means there can be more CDS outstanding
than there are bonds to insure!

Credit Risk and Collateralized Debt

Obligations (CDOs)
Major mechanism to reallocate credit risk in
the fixed-income markets
Structured Investment Vehicle (SIV) often
used to create the CDO
Loans are pooled together and split into
tranches with different levels of default
risk.
Mortgage-backed CDOs were an
investment disaster in 2007

Q7
Q8
Q10
Q11
Q14
Q21
Q29

Q7: 8.16%
Q8: Lower

a
b
c

Q10:
Q11:

1
463.1935
500.249
543.9337

95

8.536%

100

8.000%

105

7.502%

Q14: 105.24, 104.45

Q21 (a) 6.74%
Q29

2
1134.202
1124.938
1195.457

3
1000
1000
1065.152