Bond Analytics

MANISH BANSAL Jeetay Investment Pvt. Ltd.

Email: manish.bansal@jeetay.com
Phone: +91 98924 86751

Important terms linked to debt instruments

Face value/ Par value Issue price (at face value or at premium/discount to the face value)

Redemption value (at face value or at premium/discount to the face value)

Rate of interest (Coupon) and frequency Maturity of the instrument Terms of redemption
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Risks in Bonds

Interest rate risk - Does not exist, if instrument is held till maturity. Reinvestment risk - Does not exist in zeros. Call risk Credit risk Liquidity risk Event risk

Risks in international \Cross Border Bonds

Currency risk Political risk

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Price of a Bonds

In finance, price of any financial

instrument is present value of all future

cash flows

Hence, we need following to value bonds:

Stream of cash flows and their timings Discount rate

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Time Value of Money

One Rupee received today is worth more than one Rupee received tomorrow

The reasons for this phenomenon are

Opportunity cost Loss in purchasing power or Inflation Risk of lending the money
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Concept of Compounding

Compounding means that the interest received on a sum of money is reinvested at the same rate and this interest also earns interest Let us compare two situations

Bank A pays interest @10% compounded annually

Bank B pays interest @10% compounded semi-annually

Which of the two offers better return???
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Concept of Compounding

Suppose an investor invests Rs.100 in both the banks After 1 year, Bank A pays back Rs.110 being the sum of principal (Rs.100) and interest (Rs.10) And, Bank B pays Rs. 110.25 being the sum of:

Principal (Rs.100) Interest for two six month periods (Rs.5+5 = 10) Interest for six months on the first interest of Rs.5 (Rs.5 X 0.05= 0.25)

Hence, Bank B offers better return. This happens because in compounding, interest also starts earning interest
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Concept of Compounding

Compounding frequency means the number of times interest is deemed to be paid out in a year Higher the compounding frequency, higher the return for same nominal rate since, the interest is paid out faster and starts earning interest earlier Nominal rate (i.e., the qouted rate) along with compounding frequency determines the effective rate of return on an instrument
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Conversion from Nominal to Effective rate

Nominal rates are quoted in the market along with their compounding frequency, e.g., 10% quarterly To convert nominal rate in to effective annualized rate, we use the following formula:

re= (1+rn/k*100)^k - 1 where re = Effective annualized yield rn = Nominal yield k = Compounding frequency For example: 12% quarterly is 12.55% annualised 12% semi-annual is 12.36% annualised
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Effective rate computation

Formulae for various frequencies Semi - Annual Compounding r effective = (1 + r/(2 * 100))^2 - 1 Monthly Compounding r effective = (1 + r/(12 * 100))^12 - 1 Daily Compounding r effective = (1 + r/(365 * 100))^365 - 1 Continuos Compounding r effective = exp(r/100) - 1 where r = nominal annual rate of interest
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Difference between Compounded and payable

10% compounded quarterly is not equal to 10% payable quarterly. Compounding assumes that the interest payable is reinvested at the same rate for remaining life of the bond.

But, in case of payable, interest or coupon is actually paid out and this may or may not be invested at the same rate because interest rates at the time of payment could be different from original rate.
Hence, we can not definitely calculate the total return in case of payable, whereas, in case of compounding, we can find the exact total return promised. 11

Calculating Present Value

Present Value (Single or Bullet Cash Flow) Present value is the amount that must be invested today in order to a get a given amount at a future date. Computation of Present Value Cash Flow (at time t) = Ct Rate (per period) = r No. of periods =t Present value = Ct /(1+r)^t
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Calculating Present Value

Present Value (Multiple Cash Flows) Present value of multiple cash flows is the sum of present values of individual cash flows calculated as explained earlier.

Computation of Present Value Cash flow at time t) = Ct Rate of interest (per period) = r No. of preriods = n Present value = Ct /(1+ r)^(t) (t = 0 to n) (Please note that the term 1/(1+r)^t is also called the discount factor or PV factor for maturity t)

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Calculating Present Value

Period (years)Cash Flow
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 0 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 107.5 Total Present Value =

Discount Factor Present Value

1.0000 0.9434 0.8900 0.8396 0.7921 0.7473 0.7050 0.6651 0.6274 0.5919 0.5584 0.00 7.08 6.67 6.30 5.94 5.60 5.29 4.99 4.71 4.44 60.03 111.04

Coupon= Yield =

15% 12%

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Calculating Future Value

Future Value (Single or Bullet Cash Flow) Future value of a sum of money is the amount an investor would get on investing the sum for a fixed period of time at a fixed rate. Computation of Future Value Principal (Cash flow at time=0) =P Rate of interest (per period) = r No. of periods = n Future value = P(1+r)^n 15

Calculating Future Value

An investor invests a sum of Rs. 100,000 in a financial instrument that promises to pay 15% per year for 5 years. Interest is compounded semiannually. The future value of the investment would be:

FV = 100,000*(1+0.075)^(5*2) = 206,103.2
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Calculating Future Value

Future Value (Multiple Cash Flows) Future value of multiple cash flows is the sum of future values of individual cash flows calculated as explained earlier. Computation of Future Value Cash flow at time t) = Ct Rate of interest (per period) = r No. of periods = n Future value = Ct (1+ r)^(n-t) (t = 0 to n) (the future value factor is raised to power (n-t) since a cash flow after t years will be invested for the remaining (n-t) years.)
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Calculating Future Value

Period (years)
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

Cash Flow

Future Value Factor

1.7908 1.6895 1.5938 1.5036 1.4185 1.3382 1.2625 1.1910 1.1236 1.0600 1.0000

Future Value at the end of 5 years

0.00 12.67 11.95 11.28 10.64 10.04 9.47 8.93 8.43 7.95 107.50 198.86

0 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 107.5 Total Future Value =

Coupon= Yield =

15% 12%

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Calculating Bond Price

Price of a bond is equal to the present value of expected cash flows. Therefore, to price a bond, we need: bearing bond would be periodic coupon and redemption value

1. Periodic cash flows - Cash flows for a typical coupon

2. Yield (discount rate) Required yield depends on the yield offered on comparable securities in the market. Instruments are compared on the basis of maturity and credit risk.
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Calculating Bond Price

Compute the price of a 16 % coupon bond, interest payable semi-annually, with 3 years to maturity and a par value of Rs. 1,000. Applicable discount rate for a bond of similar credit rating is 16.5% payable semiannually. If this Bond is issued at an upfront discount of 5%, would you buy?
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Calculating Bond Price

No. of periods Maturity Cash flows PV factor PV

1 2
3 4 5 6

0.5 1
1.5 2 2.5 3

80 80
80 80 80 1080

0.92379 0.85338
0.78834 0.72826 0.67276 0.62149

73.90 68.27
63.07 58.26 53.82 671.21

Price

988.53
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Relationship Between Coupon, Yield and price

From pricing methodology, we can infer the relationship between Coupon Rate, Required Yield and Price: Keeping the coupon rate constant, an increase in yield will lead to a decrease in the price and vice versa Keeping the required yield constant, an increase in coupon rate will lead to an increase in the price and vice versa
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Relative Value Analysis

Various yield measures are used to compare different bonds. These are:

Current Yield: The current yield relates to the annual coupon interest to the market price of financial instrument.
Current yield = Annual rupee coupon interest / Market price

Yield-to-Maturity: Yield-to-maturity is the interest rate (internal rate of return) that will make present value of cash flows equal to price of the financial instrument. 23

Relative Value Analysis

Yield for a Portfolio: Yield for a portfolio of bonds is computed by determining the cash flows for the portfolio and interest that will make the present value of cash flows equal to the market value of portfolio.

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Calculation of Yield to maturity (YTM)

YTM

on any investment is computed by determining the interest rate that will make present value of the cash flows from the investment equal to the price of investment.
Yield

to maturity on a bond is also called the Internal Rate of Return (IRR)

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Calculation of Yield to maturity

Solving for the yield (y) using the bond pricing formula requires a trial and error procedure. The objective is to find interest rate that will make the present value of cash flows equal to the price. The following illustration will demonstrate the procedure.

Illustration
A financial instrument offers Rs. 2,000 in the first 2 years, Rs. 2,500 in the third year and Rs. 4,000 in the fourth year. The price of the instrument is Rs. 7,702. What is the yield (Internal Rate of Return) offered by this instrument ?
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Calculation of Yield to maturity

Years Cash Flow Discounting Factor 1/(1+ r)^ n 0.8772 0.7695 0.6750 0.5921 Present Value at 14% Yield 1,754.39 1,538.94 1,687.43 2,368.32 7,349.07

1 2 3 4

2,000 2,000 2,500 4,000

Total Present Value

Present value of the bond computed here is less than given price of the bond, hence the YTM should be lesser than 14%. So, we try YTM = 12%
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Calculation of Yield to maturity

Years Cash Flow Discounting Factor 1/(1+ r)^ n 0.8929 0.7972 0.7118 0.6355 Present Value at 12% Yield 1,785.71 1,594.39 1,779.45 2,542.07 7,701.62

1 2 3 4

2,000 2,000 2,500 4,000

Total Present Value

Present value computed here is very close to given price of the bond, hence the YTM is slightly lesser than 12%. We can get the exact value by more trials.
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Coupon, YTM and Current Yield

For a par bond, coupon rate, YTM and Current yield are equal. For a premium bond Coupon > Current yield > YTM

For a discount bond Coupon < Current Yield <YTM

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Shortcomings of Yield-toMaturity

Yield-to-Maturity (YTM) is not a good

effective return measure for an investor because it assumes:

Intermediate cash flows to the investor are reinvested at a rate equal to

the yield-to-maturity, and

Investor holds the bond till maturity.

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Shortcomings of Yield-toMaturity
As a result of the above shortfalls, investor is exposed to the following risks:

Interest Rate Risk : If investor does not hold bond till maturity, an increase in future interest rates could lead to a capital loss when the bond is sold in the secondary market. Reinvestment Risk : Assumption of the intermediate cashflows being reinvested at the yield-to-maturity, exposes investor to the risk that the future reinvestment rates would be less than the yield-to-maturity.
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Problems with YTM

YTM is a convenient summary. However,

You can only calculate it after you know a bond's price. It only applies to a single bond.

Ideally, one should not use yield to maturity to value coupon paying bonds.
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Correct Way to Value Bonds

Dont use YTM Use Zero Coupon Spot Rate for each cash flow Spot Rate for a maturity is defined as the interest on a zero coupon bond of that maturity Gives a correct picture of the value of each cash flow by eliminating intermediate cash flows and hence eliminating the interest rate and reinvestment risk How do we calculate Zero Coupon Spot Rates?
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Volatility in Prices of Bonds

A fundamental property of a bond is that the price of the bond changes inversely to the change in the yield of the bond. The graph of the price yield relationship for a typical bond is given below.

Price Yield
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Volatility in Prices of Bonds

We study the volatility in bond prices to understand their behavior with changes in yield. This is very important for the risk management of bond portfolio. We need to measure by how much the price of a bond will change for a given change in yield. We have already seen that the risk of investing in coupon paying bonds can be divided as the reinvestment risk and the interest rate risk.

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Volatility in Prices of Bonds

To

study the bond price volatility characteristics, consider the following illustration.

Consider the following four bonds (face value 100) where the yield is 15%: Coupon Maturity Price Zero 5 years 49.72 Zero 25 years 3.04 15% 5 years 100.00 15% 25 years 100.00
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Volatility in Prices of Bonds (Contd.) It shows Look at the following data carefully.
the change on prices of bonds with changes in yield
Yield 14.00% 14.99% 15.01% 16.00% 0%-5 yr 4.46% 0.04% -0.04% -4.24% 0%-25 yr 24.40% 0.22% -0.22% -19.46% 15%-5 yr 3.43% 0.03% -0.03% -3.27% 15%-25 yr 6.87% 0.06% -0.06% -6.10%

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Volatility in Prices of Bonds (Contd.)

From the data it can be seen that: Longer the maturity, higher the moves Lower the coupon, higher the moves (note that lower coupon means higher average maturity since lesser proportion of present value is paid out before maturity) For small change in interest rate, increase and decrease in price are of almost same magnitude but for large change in interest rate, increase in price is more than decrease in price.
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Pull to Par Effect

Change in the price of a bond with time

For any bond, selling at premium or at discount the price moves toward the par value as the bond approaches maturity date.
The explanation for Pull to Par Effect derives from the bond pricing formula. The difference in the prices of two bonds having equal face value arises due to the difference in the coupon rates. As the bonds move toward maturity, the present value of the coupon payments forms a lesser proportion of bond price.

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Pull to Par Effect

As the bonds move toward maturity, the present value of the face value forms a greater proportion of the bond price. Hence, the discount or premium bonds will converge to par value at maturity as shown below:

Premium Bond Maturity

Par
Time Price Discount Bond
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Macaulay Duration

The weighted average time to maturity of a Bond is called Macaulay Duration.

The weights are the present value of the cashflows

Larger cash flows get more weight than smaller cash flows. Since their present value is lower, distant cash flows get less weight than more immediate cash flows.

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Macaulay Duration

Macaulay duration is defined for a bond with annual cashflow Ct, yield to maturity y, and maturity T as :

Dmac ={ t*PV(Ct)}/{ PV(Ct)}

Note that the denominator is simply the sum of present value of all future cash flows of the bond and hence is equal to the price (inclusive of the accrued interest).

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Macaulay Duration - An Example

Consider a 2 year, 15% s.a. bond selling at par. The duration is calculated as follows:
Cash Flow 7.5 7.5 7.5 107.5 Discounting Factor 0.9302 0.8653 0.8050 0.7488 Duration PV/Price (PV/Price)* Time 0.0698 0.0698 0.0649 0.1298 0.0604 0.1811 0.8050 3.2198 (in half 3.6005 years)
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Time 1 2 3 4

Macaulay Duration - Zero Coupon Bond

Consider a zero coupon bond paying $1 at time T. Its Macaulay duration is

T/(1 + y)^T Dmac = ---------------1/(1 + y)^T = T

Macaulay duration equals maturity for a zero coupon bond.

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Modified Duration

Macaulays Duration (Dmac) can be modified slightly to give a better risk measure called Modified Duration (MD)
Modified Duration (MD) = Dmac/(1+y/k)*k where k = frequency of compounding y = yield to maturity of the bond MD directly gives the percentage change in price with a unit change in yield.

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Factors Affecting Duration

Time to maturity Higher the time to maturity higher the duration and hence higher the interest rate risk of the bond Coupon rate Lower the coupon rate higher the duration and hence higher the interest rate risk of the bond Current level of interest rates (yield) Lower the yield higher is the duration and hence higher the interest rate risk of the bond Thus, Modified Duration is a very convenient interest rate risk measure for bonds. Higher the duration higher the interest rate risk of the bond
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Modified Duration as Interest Rate Sensitivity

Let the initial price of a bond be P0 If the yield moves by (y-y0), the new price P1 is approximately given by P1 ~ P0 + (-MD)*P*(y-y0) Using the formula for MD as derived earlier. (~ means approximately equal to)
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Example

At a yield of 10%, a 5 year 5% annual coupon bond has a value of 81.05 and a Modified Duration of 4.08 year. Assume the bond's yield increases from 10% to 10.01%. Use its duration to calculate the bond's change in value. Calculate the new value longhand, using the new yield.
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Example

Using the duration

DP

= =

(-MD) x P x D y - 4.08 x 81.05 x 0.0001

= - 0.033 Thus the changed price is = 81.05 - 0.033 = 81.017

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Dollar Duration

Modified Duration can also be expressed as the change in dollar value of the bond for a unit change in yield. This is called Dollar duration. Dollar duration is defined by

$D

= -(dP/dy) = -MD*P

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Dollar Duration

From its definition, the change in price of a bond due to a change in yield dy is given by
dP ~ - $ D x dy

Dollar duration gives the dollar change in value for a 100 basis point change in interest rates.

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Price Value of a Basis Point

The Price Value of a Basis Point (PVBP) is the price change of a security for a one basis point change in yield. It is equal to Dollar Duration divided by 100. PVBP = $D/100 For example, the 5 year bond we looked at earlier, has Dollar duration of 3.31 PVBP of 3.31 / 100 = 0.0331
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Duration and Immunisation

Duration of a 5 year, 9% coupon bond, at a yield of 9%, is 4.24 years.

Suppose we are an insurance company with a fixed commitment in 4.24 years, for which we receive 100 today. By investing the 100 in the coupon bond, we can immunise our returns over the next 4.24 years against shifts in interest rates.

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Using Modified Duration for Hedging

We can use Modified Duration for minimising the price risk of bonds. This can be done by matching the duration of a bond portfolio with the duration of the liabilities funding that portfolio. If duration of the assets and liabilities are matched the portfolio is immunised against small changes in the yield because the change in value of assets is exactly offset by the change in the value of liabilities. The process of matching the duration of a bond portfolio (asset) with the liabilites that fund it, is known as Immunisation. 54

Using Modified Duration for Hedging

If we were to invest the money in a bond with a shorter duration than the liability, we would be subject to reinvestment risk. If we invested in a bond with a longer duration, we would be subject to price risk. Investing in a duration matched asset balances reinvestment risk and price risk.

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Drawbacks of Using Duration for Hedging

The duration of a bond keeps changing as the interest rates change. the time passes. Hence, if a portfolio is duration matched or immunised at particular time, there is no guarantee that it will remain immunised as time passes. Thus immunisation has to be done on a continuous basis which involves large transaction costs
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Drawbacks of Using Duration for Hedging

Duration is an accurate measure only for small yield changes. Duration estimates the changes in price assuming a linear relationship between the price of the bond and the yield. But the actual relationship is non-linear. Hence, for large changes in yield the change in price calculated using duration is not correct. This is illustrated in the diagram on next slide. For a small change in yield to y1, the actual price is very close to the predicted price. But for a large change in yield to y2, the actual price is much higher than the predicted price. 57

Drawbacks of Using Duration for Hedging

Price
Price Predicted by Duration

Actual Price

Y0 Y1

Y2

Yield

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Drawbacks of Using Duration for Hedging

Duration calculates the change in the value of a portfolio assuming a parallel shift in yield curve, i.e., all the yields shift up or down by the same amount. This means that duration hedged portfolios will not be immunised against non-parallel shifts in the yield curve and could still lose value due to non-parallel shifts in the yield curve. Parallel and non-parallel shifts in the yield curve are illustrated on the next slide.
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Illustration: Shifts in Yield Curve

Non-Parallel Shift : Steepening Non-Parallel Shift : Flattening

Yield Downward parallel Shift Original Yield Curve

Maturity
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Convexity

Duration is an accurate measure only for small yield changes.

Can we come up with a measure that (combined with duration) allows us to do better approximation of price than using duration alone?

The answer is YES. The measure is called convexity.

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Convexity

Duration is a measure of how price changes with interest rates. It is the first derivative of price with respect to yield.

Convexity measures how duration changes with interest rates. It is the second derivative of price with respect to yield.
1 d2P C = --- --------P dy2
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Calculating Convexity

Convexity of a bond paying cashflow Ct in period t (discounted cash flow) can be obtained by the following formula 1 ct C = --------- t(t+1) ---------------k^2*(1+y/k)^2 P/(1+y)^2 (k = compounding frequency)

Convexity of a 5 year bond with coupon 5% and yield 10% is C = 2103 / 81.05 / 1.1^2 = 21.4465

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Calculating Convexity
Time Cash Flow 1 2 3 4 5 5 5 5 5 105 4.5455 4.1322 3.7566 3.4151 65.1967 SUM Price Hence, C = 2103 / 81.05 / (1 + 10%) ^ 2 = 21.4465 Disc. Factor 0.9091 0.8264 0.7513 0.6830 0.6209 DCF t(t+1)* DCF 9.09 24.79 45.08 68.30 1955.90 2103.17 81.05

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Convexity of a Zero Coupon Bond

The convexity of a zero-coupon bond can be easily calculated from the formula :
T(T + 1) C(zero coupon) = ----------(1 + y)^2

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Change in Price Due to Convexity

Consider a bond with price P and convexity C. If the yield on the bond changes by dy, the change in the price of the bond will be given by dP (due to convexity) = (1/2)*C*P*(dy)^2

It can be seen that the change in price due to the property of convexity is always positive. Hence, convexity is a desirable property in a bond. Because of convexity the bond price rises at a faster rate and falls at lower rate with changes in the yield.
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Total Change in Price of a Bond with Yield

The total change in the price of a bond due to a change in yield is the sum of two components Change in price due to duration dP = (-MD)*P*(dy)

Change in price due to convexity dP = (1/2)*C*(dy)^2

Thus total change in price is given by dP = (-MD)*P*(dy) + (1/2)*C*(dy)^2 This is also called the Taylors Rule of Expansion

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Estimating Price Movements with Duration and Convexity

Suppose, the price of the bond was P0 before the yield change. The new price P1 will be

P1 = P0 + (-MD)*P*(y-y0) + (1/2)*C*(dy)^2

The first term is the change in price due to the duration or first derivative of price with respect to yield. The second term is the change in price due to the convexity or second derivative of price with respect to yield.

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Estimating Price Movements with Duration and Convexity

Using duration alone allows us to estimate price movements when yield changes are small. Using convexity as well as duration allows us to improve our estimates when yield movements are larger.

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Example

Consider a 5 year, 5% (annual) coupon bond, with price 81.046 and yield 10 %. Now the yield decreases to 8%. Calculate the new price. Price change due to duration: The bond's modified duration is 4.08, dP = - 4.08 x (-.02) x 81.046 = 6.613 Price change due to convexity: The bond's convexity is 21.447, dP = 1/2 x 21.447 x (-.02)^2 = 0.348 Total Change = 6.961 The bond's value increases from 81.046 to 88.007
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Factors Affecting Convexity

Time to maturity as time to maturity increases the convexity increases Coupon rate convexity decreases with increase in the coupon rate Current level of interest rates (yield) convexity decreases with increase in yield For a given duration, the more spread out the cash flows, the higher the convexity

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Duration Vs. Convexity

Increasing the duration of a position increases its exposure to the direction of interest rates. This is because the change in value of position due to duration depends on the direction of interest rate change.
Increasing convexity increases a position's exposure to large movements (i.e. volatility). The direction is unimportant. This is because the change in value of position due to convexity depends on the square of interest rate change.
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Yield Curve

Represents the plot of yield to maturity against varying terms to maturity of bonds. YTMs of traded bonds of varying maturities is computed and plotted as a scatter plot. The yield curve is drawn through these points, representing the average YTMs across terms in the market

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