Bonds
A bond is a contract that requires the borrower to
pay the interest income to the lender.
This specific rate of interest is known as coupon rate.
Generally stocks are considered risky but bonds are
not.
But this is not fully correct.
Bonds do have risk.
But the nature & types of risks may be different.
So we can discuss the nature of bonds with respect to
risk.
SANDEEP KAPOOR
MIET, MEERUT
BONDS NATURE
1. Interest Rate Risk:
• Variability in the return from the debt instrument to investor is
caused by the changes in the market interest rate.
• It is due to the relationship between coupon rate & market rate.
2. Default Risk:
• The failure to pay the agreed value of the debt instrument by the
issuer.
3. Marketability Risk:
• Variation in return causes difficulty in selling the bonds quickly
without having any substantial reason for price concession.
4. Call-ability Risk:
• There is always an uncertainty regarding the maturity period, because
issuer can call the bond any time by redeeming it.
SANDEEP KAPOOR
MIET, MEERUT
Bond Basics
Two basic yield measures for a bond are
its coupon rate and its current yield.
Annual Coupon
Coupon Rate =
Par Value
Annual Coupon
Current Yield =
Bond Price
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MIET, MEERUT
The Bond Pricing Formula
Recall: The price of a bond is found by adding together
two components
1. The present value of the bond’s coupon payments and
2. The present value of the bond’s face value.
The formula is:
C 1- 1 + FV
Bond Price = (1+YTM/2) 2M
(1+YTM/2) 2M
YTM
Where,
C represents the annual coupon payments (in Rs),
FV is the face value of the bond (in Rs), and
M is the maturity of the bond, measured in years.
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Example:
What is the price of a straight bond with:
Rs.1,000 face value, coupon rate of 5%, YTM
of 6%, and a maturity of 10 years?
C 1 FV
Bond Price = YTM 1- +
(1+YTM/2)2M (1+YTM/2)2M
50 1 1000
= 1- +
0.06 (1+0.06/2)2X10 (1+0.06/2)2X10
= (833.33 X 0.44632) + 553.68
= Rs.925.61
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Premium and Discount Bonds
Bonds are given names according to the
relationship between the bond’s selling price and
its par value.
Premium bonds: price > par value
YTM < coupon rate
Discount bonds:price < par value
YTM > coupon rate
Par bonds: price = par value
YTM = coupon rate
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MIET, MEERUT
Calculating Yield to Maturity
It is a single discount factor that makes present
value of future cash flows from a bond equal to the
current price of the bond.
or
YTM is the rate of return, which an investor can
expect to earn if the bond is held till maturity.
To find out YTM the present value technique is
adopted i.e.
Coupon1 Coupon2 Couponn + M.V.
Present value = + +
(1+y)1
(1+y)2
(1+y)n
Where,
y=YTM SANDEEP KAPOOR
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Example
A 10 years bond with 4.5% coupon rate & maturity
value Rs. 1000/- selling at Rs.900/-. What is its
YTM?
Solution Using Alternative formula:
Annual coupon interest rate + (Discount/Years to maturity)
YTM = (current price + par price)/2
= 45+(100/10)
(900+1000)/2
45+(100/10) 45+10 55
= = = = 5.79%
(900+1000)/2 950 950
SANDEEP KAPOOR
MIET, MEERUT
Calculating Yield to Maturity
Suppose we know the current price of a bond, its
coupon rate, and its time to maturity. How do we
calculate the YTM?
We can use the straight bond formula, trying
different yields until we come across the one that
produces the current price of the bond.
90 1 1000
YTM 1- +
1083.17=
(1+YTM/2)2X5 (1+YTM/2)2X5
This is tedious. So, to speed up the calculation,
financial calculators and spreadsheets are often
used. SANDEEP KAPOOR
MIET, MEERUT
Yield to Call
Yield to call (YTC) is a yield measure that
assumes a bond will be called at its earliest
possible call date.
The formula to price a callable bond is:
C 1- 1 + CP
Callable Bond Price=
YTC (1+YTC/2)2T (1+YTC/2)2T
Where,
C is the annual coupon (in Rs),
CP is the call price of the bond,
T is the time (in years) to the earliest possible call date,
YTC is the yield to call, with semi-annual coupons.
SANDEEP KAPOOR
MIET, MEERUT
Calculating the Price of a Coupon Bond
A Bond traded on 1 March 2008 matures in 20 years on 1
March 2028. Assuming an 8 percent coupon rate and 7% yield
to maturity. What is the price of this Bond?
Solution using excel function PRICE
=PRICE("3/1/2008", "3/1/2028",0.08,0.07,100,2,3)
Answer = 110.6775
For a bond with Rs.1000 face value multiply the price by 10 to get
Rs.1106.78
This function uses the following:
=PRICE (Now, Maturity, Coupon, YTM,100,2,3)
Where,
100 indicates the redemption value as a percentage of face value
2 indicates semi annual coupons.
3 specifies an actual day count with 365 days
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Calculating Yield to maturity of a Bond
A Bond traded on 1 March 2008 matures in 8 years on 1
March 2016. Assuming an 8 percent coupon rate and a
price of Rs.110. What is the yield to maturity of this Bond?
Solution using excel function YIELD
=YIELD(“3/1/2008",“3/1/2016",0.08,110,100,2,3)
Answer = 6.38%
This function uses the following:
=yield(Now, Maturity, Coupon, Price,100,2,3)
Where,
Price is entered as a percentage of face value
100 indicates the redemption value as a percentage of face
value
2 indicates semi annual coupons.
3 specifies an actual day count with 365 days per year.
SANDEEP KAPOOR
MIET, MEERUT
Calculating Yield to call of a Bond
A Bond traded on 1 March 2008 matures in 15 years on 1 March
2023. And may be called any time after 1 March 2013 at a call
price of Rs.105. The Bond pays an 8.5% coupon and currently
trades at par. What are the yield to maturity & yield to call for
this bond?
Yield to maturity is based on 2023 maturity and current price of
Rs.100
=YIELD(“3/1/2008",“3/1/2023",0.085,100,100,2,3)
Answer = 8.5%
Yield to call is based on 2013 maturity and current price of
Rs.100
=YIELD(“3/1/2008",“3/1/2013",0.085,100,105,2,3)
Answer = 9.308%
SANDEEP KAPOOR
MIET, MEERUT
Bond Theorems
Theorem 1:
If the market price of the bond increases, the
yield would decline and vice versa
Example Bond A Bond B
Par Value Rs.1000 Rs.1000
Coupon rate 10% 10%
Maturity period 2 Years 2 Years
Market Price Rs.874.75 Rs.1035.66
Yield 18% 8%
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Theorem 2:
If bond’s yield remains the same over its life, the
discount or premium depends on the maturity period.
Example Bond A Bond B
Par Value Rs.1000 Rs.1000
Coupon rate 10% 10%
Yield 15% 15%
Maturity period 2 Years 3 Years
Market Price Rs.918.71 Rs.885.86
Discount Rs.81.29 Rs.114.14
Thus the Bond’s with short term to maturity sells at a
lower discount than the bond with a long term to
maturity. SANDEEP KAPOOR
MIET, MEERUT
Theorem 3:
If bond’s yield remains constant over its
life.
The discount or premium decrease at an
increasing rate as its life gets shorter.
It happens due to the concept of time
value of money.
For example:
If Investor get a rupee at T+5 period it
would value lesser if he get he get it at T
period
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MIET, MEERUT
Theorem 4:
A rise in the bond’s price for a decline in the bond’s
yield is greater than the fall in the bond’s price for a
raise in the yield.
For Example:
A bond of 10% coupon rate, maturity period of five years
with face value of Rs.1000.
IF the yield declines by 2%, that is to 8% then the bond
price will be Rs.1079.87. (using bond pricing formula,
slide-2)
If the yield increases by 2% the, the bond price will be
Rs.927.88. (using bond pricing formula, slide-2)
Now fall in yield has resulted in raise of Rs.79.87 but raise
in the yield caused a variation of Rs.72.22 in the price.
SANDEEP KAPOOR
MIET, MEERUT
Theorem 5:
The change in the price will be lesser for a percentage
change in bond’s yield if its coupon rate is higher.
Example Bond A Bond B
Coupon Rate 10% 8%
Yield 8% 8%
Maturity period 3 Years 3 Years
Price Rs.105.15 Rs.100
Face Value Rs.100 Rs.100
Yield Raise (YR) 1% 1%
Price after YR Rs.102.53 Rs.97.47
% change in Price 2.4% 2.53%
SANDEEP KAPOOR
MIET, MEERUT
Term Structure of Interest Rate
The relationship between the yield and time
is called term structure.
It is also known as yield curve.
In analyzing the effect of maturity on yield
all other influences are held constant.
The maturity dates for bonds are different.
But the risks, tax liabilities & redemption
possibilities are similar.
There are some theories that explains the
term structure of interest rates.
SANDEEP KAPOOR
MIET, MEERUT
Theories of term structure of Interest Rates
1. Expectation Theory
2. Liquidity Preference Theory
3. Segmentation Theory
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Expectation Theory
This theory is based on the expectations of
the investors.
Under this theory the shape of yield curve is
studied.
As it gives an idea of future interest rate
change & economic activity.
There are three main types of yield curve
shapes i.e.
Normal
Flat
Inverted SANDEEP KAPOOR
MIET, MEERUT
Normal Yield Curve
If investor expects that there would be a
continuous rise in market interest rates.
Then the bond’s price will decrease.
Thus the yield will increase.
Graphical presentation
Yield to maturity
Years to Maturity SANDEEP KAPOOR
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Flat Yield Curve
If investor expects that there would be no
change market interest rates.
Then the bond’s price will remain constant.
Thus the yield will also remain constant.
Graphical presentation
Yield to maturity
Years to Maturity SANDEEP KAPOOR
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Inverted/Falling yield Curve
If investor expects that there would be a
decline in market interest rates.
Then the bond’s price will increase.
Thus the yield will decrease.
Graphical presentation
Yield to maturity
SANDEEP KAPOOR Years to Maturity
MIET, MEERUT
Conclusion of Expectation Theory
There are only three types
of returns i.e.
1. Normal
2. Flat
Yield to maturity
3. Inverted
As indicated by the graph
Years to Maturity
SANDEEP KAPOOR
MIET, MEERUT
Liquidity Preference Theory
According to this theory Investor prefers the
liquidity.
So, he prefers short term bonds over long term
bonds due to liquidity.
If no premium exists for holding the long term bond
Investor would prefer to hold short term bonds.
Thus they must be motivated to buy the long term
bond by some sort of premium.
As the forward rates are actually higher than the
projected interest rate.
SANDEEP KAPOOR
MIET, MEERUT
Segmentation Theory
According to this theory liquidity can not be the main
consideration for all classes of investors.
For example
Insurance companies
Pension Funds
Retired Persons
All of above prefer the long term rather than short term
securities to avoid the possible fluctuations in the interest rate.
On the other hand there are corporate who prefers liquidity.
They prefer short term bonds
Supply and demand for fund are segmented in sub-markets
because of the preferred habitats of the individuals.
Thus yield is determined by the demand and supply of the funds.
SANDEEP KAPOOR
MIET, MEERUT
Duration
The term duration has a special meaning
in the context of bonds.
It is a measurement of how long (in
years), it takes for the price of a bond to
be repaid by its internal cash flow.
It is important to consider
Asbonds with higher durations carry more risk
and have higher price volatility than bonds
with lower duration.
SANDEEP KAPOOR
MIET, MEERUT
Types of Bonds w.r.t. Duration
For each of the two basic types of bonds
the duration is following:
Zero coupon Bond:-
Duration is equal to its time to maturity
Vanilla Bond:-
Duration will always be less than its time
to maturity.
SANDEEP KAPOOR
MIET, MEERUT
Types Duration
There are four main types of duration
calculations.
Each of which differ in the way they
account for factors such as
Interestrate changes
Bonds redemption feature
The four types of durations are:
1. Macaulay duration
2. Modified duration
3. Effective duration
4. Key rate duration SANDEEP KAPOOR
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Macaulay Duration
The formula of Macaulay duration was
created by Frederick Macaulay in 1938.
It is calculated by adding the results of
multiplying the present value of each cash
flow by the time it is received and dividing
by the total price of security.
SANDEEP KAPOOR
MIET, MEERUT
Macaulay Duration
Ƹ tXC nXM
t=1 (1+i)t + (1+i)n
Macaulay Duration=
Price of the Bond
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MIET, MEERUT
Recall
Bond price
C 1- 1 + FV
Bond price = (1+YTM/2) 2M
(1+YTM/2) 2M
YTM
SANDEEP KAPOOR
MIET, MEERUT
Thus Macaulay Duration (MD)
Ƹ tXC +
nXM
t=1 (1+i)t (1+i)n
MD=
C 1 + FV
YTM (1+YTM/2)2M (1+YTM/2)2M
SANDEEP KAPOOR
MIET, MEERUT
For Example
Mr. B holds a five year bond with a par
value of Rs. 1000 and coupon rate of 5%.
For simplicity, let’s assume that the coupon
is paid annually and that interest rates are
5%. What is the Macaulay Duration of the
Bond.
The above formula is very complex.
Alternatively we can use the following table
to find out Macaulay Duration.
SANDEEP KAPOOR
MIET, MEERUT
Solution
Price of the
P.V. of Bond
Years (t) Inflow Inflow (t) PVF @5% inflow (t) (column 2 X4)
1 50 50 0.953 47.6 47.6
2 50 100 0.907 90.7 45.35
3 50 150 0.863 129.45 43.15
4 50 200 0.822 164.4 41.1
5 1050 5250 0.784 4116 823.2
4569.15 1000
Duration =
P.V. of inflow (t)
Price of the Bond
4569.15 =4.56 Years
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Modified Duration
It is a modified version of the Macaulay
model that accounts for changing interest
rates.
As interest rate affect the yield.
The fluctuating interest rates will affect
duration.
This modified formula shows that:
How much the duration changes for each
percentage change in the yield.
So there is an inverse relationship between
modified duration and change in yield.
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Formula
Modified Duration = Macaulay Duration
1+
Yield to Maturity
Number of coupon periods per Year
Modified Duration = Macaulay Duration
1+
YTM
n
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MIET, MEERUT
Example
Let’s consider the example of Mr. B’s bond and run through
the calculation of his modified duration.
Currently his bond is selling at Rs.1000/- or par
Which translates to yield to maturity of 5%.
Recall, we calculated a Macaulay duration of 4.56
Modified Duration =
4.56
1+
0.05
=4.33 years 1
Modified duration will always be lower than Macaulay Duration.
SANDEEP KAPOOR
MIET, MEERUT
Effective Duration
Modified duration assumes that the expected cash
flows will remain constant even if prevailing
interest rates change. Such as:
Option free fixed income bonds
Effective duration is used when expected cash
flows also changes with a change in interest rates.
Effective duration requires the use of binomial
trees to calculate the option adjusted spread (OAS)
There are entire courses build around just those
two topics.
So calculations involved for effective duration are
beyond the scope of our syllabus
SANDEEP KAPOOR
MIET, MEERUT
Key Rate Duration
It is used for portfolios which consists of fixed income
securities with differing maturities.
It allows the duration of a portfolio to be calculated for
one basis point change in interest rates.
It calculates the spot durations of each of 11 key
maturities i.e.
3 months, 1, 2, 3, 5, 7, 10, 15, 20, 25, and 30 years
The formula for key rate duration is as follows:
Price of security after 1% decrease in yield - Price of security after 1% increase in yield
2 X (Initial price of security) 1%
The sum of the key rate duration is equal to the
effective duration.
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MIET, MEERUT
