Part 08

Part-08
Prices & Yields:

Advanced Perspectives
1
Valuation in between
Coupon Dates
 While valuing a bond we assumed
that we were standing on a coupon
payment date.
 This is a significant assumption
because it implies that the next
coupon is exactly one period away.
 What should be the procedure if
the valuation date is in between
two coupon payment dates?
2
The Procedure
for Treasury Bonds
 Calculate the actual number of
days between the date of valuation
and the next coupon date.
 Include the next coupon date.
 But do not include the starting
date.
 Let us call this interval N1.
3
Treasury Bonds (Cont…)
 Calculate the actual number of
days between the coupon date
preceding the valuation date and
the following coupon date.
 Once again include the ending
date but exclude the starting date.
 Let us call this time interval as N2.
4
 The next coupon is then k periods
away where
5
Illustration
 There is a Treasury bond with a
face value of $1,000.
 The coupon rate is 8% per annum,
paid on a semi-annual basis.
 The coupon dates are 15 July and
15 January.
 The maturity date is 15 January
2022.
 Today is 15 September 2002.
6
No. of Days Till the
Next Coupon Date
Month No. of Days
September 15
October 31
November 30
December 31
January 15
TOTAL 122
7
No. of Days between
Coupon Dates
Month No. of Days
July 16
August 31
September 30
October 31
November 30
December 31
January 15
TOTAL 184 8
 K = 122/184 = .6630
 This method is called the
Actual/Actual method and is often
pronounced as the Ack/Ack
method.
 It is the method used for Treasury
bonds in the U.S.
9
The Valuation Equation
 Wall Street professionals will then
price the bond using the following
equation.
10
Valuation
 In our example
11
The Treasury Method
 There is a difference between the
Wall Street approach and the
approach used by the Treasury to
value T-bonds.
 The difference is that the Treasury
uses a simple interest approach for
the fractional first period.
12
The Treasury Method
(Cont…)
 The Treasury will thus use the
following equation.
13
The Treasury Method
(Cont…)
 The Treasury approach will always
give a lower price because for a
fractional period the simple
interest approach will always give
a larger discount factor than the
compound interest approach.
14
The 30/360 PSA Approach
 The Actual/Actual method is applicable
for Treasury bonds in the U.S.
 For corporate bonds in the U.S. we use
what is called the 30/360 PSA method.
 In this method the number of days
between successive coupon dates is
always taken to be 180.
 That is each month is considered to be
of 30 days.
15
The 30/360 Approach
(Cont…)
 The number of days from the date
of valuation till the next coupon
date is calculated as follows.
 The start date is defined as
 D1 = (month1, day1,year1)
 The ending date is defined as
 D2 = (month2,day2,year2)
16
The 30/360 Approach
(Cont…)
 The number of days is then
calculated as
 360(year2 – year1) + 30(month2 –
month1) + (day2 – day1)
17
Additional Rules
 If day1 = 31 then set day1 = 30
 If day1 is the last day of February,
then set day1 = 30
 If day1 = 30 or has been set equal
to 30, then if day2 = 31, set day2 =
30
18
Examples of Calculations
Start End Date Actual Days
Date Days Based on
Jan-01-86 Feb-01-86 31 30/360
30
Jan-15-86 Feb-01-86 17 16
Feb-15-86 Apr-01-86 45 46
Jul-15-86 Sep-15-86 62 60
Nov-01-86 Mar-01-87 120 120
Dec-15-86 Dec-31-86 16 16
Dec-31-86 Feb-01-87 31 31
Feb-01-88 Mar-01-88 29 30
19
Pricing of A Corporate
Bond
 Let us assume that the bond
considered earlier was a corporate
bond rather than a Treasury bond.
20
Pricing (Cont…)
21
30/360 ISDA
 The difference between 30/360
PSA and 30/360 ISDA is that the
additional rule pertaining to the
last day of February is not
applicable.
22
30/360 SIA
 The additional rules for this
convention are the following.
 If day1 = 31, then set day1 = 30.
 If day1 is the last day of February and
the bond pays a coupon on the last
day of February then set day1 = 30.
 If day1 = 30 or has been set equal to
30, then if day2 = 31, set day2 = 30.
23
30/360 European
Convention
 In this convention, if day2 = 31,
then it is always set equal to 30.
 So the additional rules are:
24
Examples of Calculations
Start End Date Actual Days
Date Days Based on
30/360E
Mar-31- Dec-31- 275 270
86 86
Dec-15- Dec-31- 16 15
86 86
25
Actual/365 Convention
 The difference between this and
the Actual/Actual method is that
the denominator in this convention
will consist of 365 even in leap
years.
26
Actual/365 Japanese
 This is used for Japanese
Government Bonds (JGBs)
 It is similar to the Actual/365
method.
 The only difference is that in this
case, the extra day in February is
ignored in leap years, while
calculating both the numerator and
the denominator. 27
Actual/365 ISDA
 This day count convention is identical to the
Actual/365 convention for a coupon period that
does not include days falling within a leap
year.
 However for a coupon period that includes
days falling within a leap year, the day count is
given by:
#of days falling within the leap year
______________________________ +
366
#of days not falling within the leap year
_________________________________
365
28
Actual/360 Convention
 This is a simple variant of
Actual/365.
 This is the convention used for
money market instruments in most
countries.
29
Global Conventions
Country Security Convention
Japan T-bills Act/365 Japanese
Japan JGBs Act/365 Japanese
Japan Other Bonds Act/365 Japanese
UK Fixed rate gilts Act/Act
UK Index linked gilts Act/Act
UK Strips Act/Act
US T-bills Act/360
US T-notes and T- Act/Act
US bonds
Other bonds 30/360 PSA
India Government 30E/360
India bonds
Corporate bonds Act/365 30
Accrued Interest
 The price of a bond is the present value
of all the cash flows that the buyer will
receive when he buys the bond.
 Thus the seller is compensated for all
the cash flows that he is parting with.
 This compensation includes the amount
due for the fact that the seller is parting
with the entire next coupon, although
he has held it for a part of the current
coupon period.
31
Accrued Interest (Cont…)
 This compensation is called
Accrued Interest.
 Let us denote the sale date by t;
the previous coupon date by t1;
and the following coupon date by
t2
 The accrued interest is given by
32
Accrued Interest (Cont…)
 Both the numerator and the
denominator are calculated
according to the conventions
discussed above.
 That is for U.S. Treasury bonds the
Actual/Actual method is used,
whereas for U.S. corporate bonds
the 30/360 method is used.
33
Why Accrued Interest?
 Why should we calculate the
accrued interest if it is already
included in the price calculation?
 The answer is that the quoted
bond price does not include
accrued interest.
 That is, quoted prices are net of
accrued interest.
34
(Cont…)
 The rationale is as follows.
 On July 15 the price of the
Treasury bond using a YTM of 10%
is $829.83.
 On September 15 the price using a
yield of 10% is $843.5906.
 Since the required yield on both
the days is the same, the increase
in price is entirely due to the
accrued interest. 35
Why Accrued Interest
(Cont…)
 On July 15 the accrued interest is
zero.
 This is true because on a coupon
payment date, the accrued interest
has to be zero.
 On September 15 the accrued
interest is
36
(Cont…)
 The price net of accrued interest is
 $843.5906 - $13.4783 = $830.1123$,
which is very close to the price of
$829.83 that was observed on July 15.
 We know that as the required yield
changes, so will the price.
 If the accrued interest is not subtracted
from the price before being quoted,
then we would be unsure as to whether
the observed price change is due to a
change in the market yield or is entirely37
(Cont…)
 However if prices are reported net
of accrued interest, then in the
short run, observed price changes
will be entirely due to changes in
the market yield.
 Consequently bond prices are
always reported after subtracting
the accrued interest.
38
Clean versus Dirty Prices
 Quoted bond prices are called
clean or add-interest prices.
 When a bond is purchased in
addition to the quoted price, the
accrued interest has also to be
paid.
 The total price that is paid is called
the dirty price or the full price.
39
Negative Accrued Interest
 One logical question is
 Can the accrued interest be negative?
 That is, can there be cases where the seller
of the bond has to pay accrued interest to
the buyer.
 The answer is yes.
 In markets where bonds trade ex-dividend
the dirty price will fall by the present value
of the next coupon on the ex-dividend date
and the dirty price will be less than the
clean price.
40
Example
 Take a T-bond that matures on 15
July 2021.
 It pays a 9% coupon semi-annually
on 15 January and 15 July every
year.
 The face value is 1000 and the
YTM is 8%.
 Assume that we are on 5 January
2002 which is the ex-dividend
date. 41
Example (Cont…)
 Using the Actual/Actual convention we
can calculate k to be 0.0543.
42
Example (Cont…)
 The moment the bond goes ex-
dividend the dirty price will fall by
the present value of the
forthcoming coupon, because the
buyer will be no longer entitled to
it.
43
Example (Cont…)
 Thus the ex-dividend dirty price is
44
Example (Cont…)
 This is the amount payable by the
person who buys the bond an
instant after it goes ex-dividend.
 The accrued interest an instant
before the bond goes ex-dividend
is:
0.09x1000 174
________ x ____ = $ 42.5543
2 184
45
Example (Cont…)
 Thus the clean price at the time of the
bond going ex-dividend is
1140.4910 – 42.5543 = $1097.9367
 The clean price is therefore greater than
the ex-dividend dirty price.
 This represents the fact that the seller has
to compensate the buyer because while the
buyer is entitled to his share of the next
coupon the entire amount will be received
by the seller.
46
Example (Cont…)
 The fraction of the next coupon
that is payable to the buyer is
0.09x1000 10
_________ x ____ = $2.4457
2 184
 Hence the buyer has to pay
1097.9367 – 2.4457 = $1095.4910
which is the ex-dividend dirty
price. 47
Yield Measures
 The yield or the rate of return from
a bond can and is computed in
various ways.
 We will discuss various yield
measures and their relative merits
and demerits.
48
The Current Yield
 This is very commonly reported.
 Although it is technically very
unsatisfactory.
 It relates the annual coupon
payment to the current market
price.
49
Example of the Current
Yield
 A 15 year 15% coupon bond is
currently selling for $800.
 The current yield is given by
50
Current Yield (Cont…)
 If you buy this bond for $800 and
hold it for one year you will earn
an interest income of $150.
 So your interest yield is 18.75%
 However, if you sell it after one
year you will either make a Capital
Gain or a Capital Loss.
51
 What is a Capital Gain?
 If the price at the time of sale is
higher than the price at which the
bond was bought, the profit is
termed as a Capital Gain.
 Else if there is a loss, it is termed a
Capital Loss.
 The current yield does not take
such gains and losses into account.
52
 One question is:
 Should the current yield be based on the dirty price
or the clean price
 The advantage of using the clean price is that
the current yield will stay constant till the yield
changes.
 However if the dirty price is used the current yield
will be higher in the period between the ex-dividend
date and the coupon date when the dirty price is less
than the clean price and will be lower between the
coupon date and the subsequent ex-dividend date
when the dirty price will be more than the clean
price.
 This gives rise to a sawtooth pattern.
53
 The current yield is used to
estimate the cost of or profit from
holding the bond.
 If short-term rates are higher than
the current yield, the bond is said
to involve a running cost.
 This is known as negative carry or
negative funding.
54
Simple YTM
 This yield measure attempts to
rectify the shortcomings of the
current yield by taking into
account capital gains and losses.
 The assumption made is that
capital gains and losses accrue
evenly over the life of the bond.
55
Simple YTM (Cont…)
 The formula is:
Simple YTM = C M-P
__ + ____
P PXN/2
56
 For the 15 year bond that we
considered earlier
Simple YTM = 150 1000-800
_____+_________ = 20.42%
800 15 x 800
57
 The problem with the simple YTM
is that it does not take into
account the compound interest
that can be earned by reinvesting
the coupons.
 This will obviously increase the
overall return from the bond.
58
Yield to Maturity (YTM)
 The YTM is the interest rate that
equates the present value of the
cash flows from the bond
(assuming that the bond is held to
maturity), to the price of the bond.
 It is exactly analogous to the
concept of the Internal Rate of
Return (IRR) used in project
valuation. 59
YTM (Cont…)
 Consider a bond that makes an
annual coupon of C on a semi-
annual basis.
 The face value is M, the price is P,
and the number of coupons
remaining is N.
60
YTM (Cont…)
 The YTM is the value of y that
satisfies the following equation.
61
YTM (Cont…)
 The YTM is a solution to a non-linear
equation.
 We generally require a financial
calculator or a computer to calculate it.
 However it is fairly simple to compute
the YTM in the case of a coupon paying
bond with exactly two periods to
maturity.
 In such a case it is simply a solution to a
quadratic equation. 62
YTM for a Zero Coupon
Bond
 The YTM is easy to compute in the
case of zero coupon bonds.
 Consider a ZCB with a face value
of $1,000, maturing after 5 years.
 The current price is $500.
 The YTM is the solution to
63
Features of YTM
 The YTM calculation takes into
account all the coupon payments,
as well as any capital gains/losses
that accrue to an investor who
buys and holds a bond to maturity.
64
Sources of Returns From a
Bond
 A bondholder can expect to
receive income from the following
sources.
 Firstly there are coupon payments
which are typically paid every six
months.
 There will be a capital gain/loss
when a bond matures or is called
before maturity or is sold before 65
Returns From a Bond
(Cont…)
 The YTM calculation assumes that the
bond is held to maturity.
 Finally when a coupon is received it will
have to be reinvested till the time the
bond eventually matures or is sold or is
called.
 Once again the YTM calculation
assumes that the bond is held till
maturity.
 The reinvestment income is nothing but
interest on interest. 66
YTM
 A satisfactory measure of the yield
should take into account all the
three sources of income.
 The current yield measure
considers only the coupon for the
first year.
 All the other factors are totally
ignored.
67
YTM (Cont…)
 The YTM calculation takes into
account all the three sources of
income.
 However it makes two key
assumptions.
 Firstly it assumes that the bond is
held till maturity.
 Secondly it assumes that all
intermediate coupons are 68
YTM (Cont…)
 The latter assumption is built in to
the mathematics of the YTM
calculation.
 The YTM is called a Promised Yield.
 It is Promised because in order to
realize it you have to satisfy both
the above conditions.
 If either of the two conditions is
violated you may not get what was
promised. 69
The Re-investment
Assumption
 Consider a bond that pays a semi-
annual coupon of $C/2.
 Let r be the annual rate of interest
at which these coupons can be re-
invested.
 r would be dependent on the
market rate of interest that is
prevailing when the coupon is
received, and need not be equal to
y, the YTM, or c, the coupon rate. 70
Reinvestment (Cont…)
 For ease of exposition we will
assume that r is a constant for the
life of the bond.
 However, in practice, it is likely
that each coupon may have to be
reinvested at a different rate of
interest.
 Thus each coupon can be re-
invested at a rate of r/2 per six 71
 The coupon stream is an annuity.
 The final payoff from re-investment
is the future value of this annuity.
 The future value is
72
 The future value represents the
sum of all the coupons which are
reinvested (which in this case is
the principal), plus the interest
from re-investment.
 The total value of coupons that are
reinvested is
73
Re-investment (Cont…)
 The interest on interest is
therefore
The YTM Calculation assumes that r/2 = y/2.

74
Reinvestment in Action
 Consider an L&T bond with 10
years to maturity.
 The face value is Rs 1,000.
 It pay a semi-annual coupon at the
rate of 10% per annum.
 The YTM is 12% per annum.
 Price can be calculated to be
Rs 885.295.
75
(Cont…)
 Assume that the semi-annual
interest payments can be
reinvested at a six monthly rate of
6%, which corresponds to a
nominal annual rate of 12%.
 The total coupon income = 50 x 20
= 1000
76
(Cont…)
 Interest on interest gotten by
reinvesting the coupons
77
(Cont…)
 Finally in the end you will get back
the face value of Rs 1,000.
 So the total cash flow at the end
= 1000 + 839.3 + 1000 = 2839.3

 To get this income, the bondholder
has to make an initial investment

of 885.295.
78
(Cont…)
 So what is the effective rate of
return?
 It is the value of i that satisfies the
following equation
79
(Cont…)
 So the rate of return is 6% on a
semi-annual basis or 12% on a
nominal annual basis, which is
exactly the same as the YTM.
 So how was this return achieved?
 Only by being able to reinvest all
the coupons at a nominal annual
rate of 12%, compounded on a
semi-annual basis. 80
The Significance of the
Reinvestment Rate
 The reinvestment rate affects only
the interest on interest income.
 The other two sources are
unaffected.
 If r > y, that is if the reinvestment
rate were to be higher than the
YTM, then the investor’s interest
on interest income would be
higher, and the return on
investment, i, would be greater 81
The Reinvestment Rate
(Cont…)
 On the contrary, if r < y, that is, the
reinvestment rate is less than the YTM,
then the interest on interest income
would be lower, and the rate of return, i,
would be less than the YTM, y.
 So if you buy a bond by paying a price
which corresponds to a given YTM, you
will realize that YTM only if
 You hold the bond till maturity
 You are able to reinvest all the
intermediate coupons at the YTM. 82
Reinvestment Risk
 One of the risks faced by an
investor is that the future
reinvestment rates may be less
than the YTM which was in effect
at the time the bond was
purchased.
 This risk is called Reinvestment
Risk.
 The degree of reinvestment risk
depends on the time to maturity as
83
Reinvestment Risk
(Cont…)
 For a bond with a given YTM, and a
coupon rate, the greater the time
to maturity, the more dependent is
the total return from the bond on
the reinvestment income.
 Thus everything else remaining
constant, the longer the term to
maturity, the greater is the
reinvestment risk. 84
Reinvestment Risk
(Cont…)
 For a bond with a given maturity
and YTM, the greater the quantum
of the coupon, or in other words,
the higher the coupon rate, the
more dependent is the total return
on the reinvestment income.
 Thus everything else remaining the
same, the larger the coupon rate,
the greater is the reinvestment 85
Reinvestment Risk
(Cont…)
 Thus premium bonds will be more
vulnerable to such risks than
bonds selling at par.
 Correspondingly, discount bonds
will be less vulnerable than bonds
selling at par.
86
Zero Coupon Bonds
and Reinvestment Risk
 If a zero coupon bond is held to
maturity, there will be no reinvestment
risk, because there are no coupons to
reinvest.
 Thus if a ZCB is held to maturity, the
actual rate of return will be equal to the
promised YTM.
 If the risk is lower or absent, the return
should also be less.
 Thus a ZCB will command a higher price
than an otherwise similar Plain Vanilla 87
The Realized Compound
Yield
 We will continue with the assumption
that the bond is held till maturity.
 But we will make an explicit assumption
about the rate at which the coupons can
be reinvested.
 That is, unlike in the case of the YTM,
we will no longer take it for granted that
intermediate cash flows can be
reinvested at the YTM.
88
Illustration
 Let us reconsider the L&T bond.
 Assume that intermediate coupons
can be reinvested at 7% for six
months, or at a nominal annual
rate of 14%.
 The total coupon income and the
final face value payment will
remain the same, but the
reinvestment income will change. 89
Illustration (Cont…)
 The interest on interest
90
 So the final amount received
= 1000 + 1049.75 + 1000 =
3049.75
 The initial investment is once
again 885.295
 Therefore, the rate of return is
given by
91
 This is the rate of return for six
months.
 The nominal annual return is 6.38
x 2 = 12.76%, which is greater
than the YTM of 12%.
 The RCY is greater than the YTM,
because we assumed that the
reinvestment rate was greater
than the YTM. 92
 Had we assumed the reinvestment
rate to be less than the YTM, the
RCY would have turned out to be
less than the YTM.
 The RCY can be an ex-ante or an
ex-post measure.
 Ex-ante means that we make an
assumption about the
reinvestment rate and then
calculate the RCY. 93
 Ex-post means that we take into
account the actual rate at which
we have been able to reinvest and
calculate the RCY.
94
The Horizon Return
 Let us now relax both the
assumptions which were used to
calculate the YTM.
 Firstly the investor need not hold
the bond until maturity.
 Secondly he may not be able to
reinvest the coupons at the YTM.
95
The Horizon Return
(Cont…)
 Now the return will depend on
three sources – the coupons
received, the reinvestment
income, and the price at which the
bond is sold prior to maturity.
 The important issue is that the sale
price of the bond would depend on
the prevailing market yield at that
point in time, and need not equal 96
Illustration
 Assume that an investor with a 7
year investment horizon buys the
L&T bond that we discussed
earlier.
 He will get coupons for 14 periods
(not 20).
 The total coupon income will be
 50x14 = 700
 We will assume that the
reinvestment rate is expected to 97
 We will also assume that the
investor expects the YTM after 7
years to be 12% per annum.
 The first step is to calculate the
expected price at the time of sale.
 At that point in time the bond will
have 3 years to maturity.
98
 The price using a YTM of 12% can
be shown to be Rs 950.865.
 The interest on interest
99
The total terminal cash flow
= 700 + 427.50 + 950.865 =
2,078.365
 The initial investment as before is
885.295
100
 The nominal annual rate of return
is
6.29x2 = 12.58%
 This is the Horizon Yield.
 Once again, it can be calculated
ex-post or ex-ante.
101
Yield to Call (YTC)
 This measure of the rate of return
is used for callable bonds.
 The YTC is the yield that will make
the present value of the cash flows
from the bond equal to the price,
assuming the bond is held till the
call date.
 In principle a bond can have many
possible call dates.
102
YTC (Cont…)
 In practice the cash flows are
usually taken only till the first call
date, although they can easily be
taken to any subsequent call date.
 The YTC is given by the equation
103
YTC (Cont…)
 N* is the number of coupons till the call
date.
 M* is the price at which the bond is
expected to be recalled.
 M* need not equal the face value.
 In practice companies pay as much as
one year’s coupon as a Call Premium at
the time of recall.
 If so, M* = M + C
104
 Let us assume that the L&T bond is
a callable bond and that the first
call date is 7 years away.
 Assume that a call premium of Rs
100 will be paid if the bond is
recalled.
105
 The YTC is the solution to the
following equation
106
 The solution comes out to be
6.74%.
 So the YTC on an annual basis is
13.48%.
 The YTC is very important for
Premium Bonds.
 The very fact that a bond is selling
at a premium, indicates that the
coupon is greater than the yield,
and that therefore there is a 107
The Yield to Worst
 In practice the investors compute
the YTC for every possible call
date.
 They then compute the YTM as
well.
 The lowest of all possible values is
called the Yield to Worst.
108
Portfolio Yield
 Consider a case where you hold a
portfolio or a collection of bonds.
 You cannot simply calculate the
yield from the portfolio as a
weighted average of the YTMs of
the individual bonds.
109
Portfolio Yield (Cont…)
 You have to first compute the cash
flows from the portfolio, and then
find that interest rate which will
make the present value of the cash
flows equal to the sum of the
prices of the component bonds.
110
Illustration
 Consider a person who buys a
TELCO bond and a Ranbaxy bond.
 The TELCO bond has a time to
maturity of 5 years, face value of
1000, and pays coupons semi-
annually at the rate of 10% per
annum.
111
 The Ranbaxy bond has a face
value of 1000, time to maturity of
4 years, and pays a coupon of 10%
per annum semi-annually.
 Consider a portfolio consisting of
one bond of each company.
 What is the portfolio yield?
112
 The first step is to calculate the
two prices.
 The price of the TELCO bond can
be shown to be 926.405.
 The price of the Ranbaxy bond can
be shown to be 827.63.
 The total initial investment is
therefore
 1,754.035 113
The Cash Flow Table
Period Investmen Inflow Inflow Total
t from from
0 (1754.035) TELCO Ranbaxy (1754.035)
1 50 50 100
2 50 50 100
3 50 50 100
4 50 50 100
5 50 50 100
6 50 50 100
7 50 50 100
8 50 1050 1100
9 50 50
10 1050 1050 114
 Using a financial calculator or a
spread sheet, the portfolio yield
can be calculated to be 13.76%.
115

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Prices & Yields:

The YTM Calculation assumes that r/2 = y/2.

= 1000 + 839.3 + 1000 = 2839.3

has to make an initial investment

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