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Bonds and their Valuation

Chapter Learning Objectives:

To understand the concept of long term debt financing and the types of bonds.
To explain some of the basic features of a bond.
To compute a bond holders expected rate of return.
To estimate the value of a bond and different yields.
To understand the term structure of interest rates and various hypothesis.
To explain the important relationships those exist in bond valuation.
To understand the duration of a bond and the sensitivity of a bond.
To discuss the factors those affect the bond pricing.
To understand the indenture and the callability features in it.

Bond is a debt instrument issued for a period of more than one year with the purpose of
raising capital by borrowing. So bonds are long-term debt or funded debt, issued by
corporations, and governments and their agencies to finance operations or special projects.
Corporations pay back interest and principal from earnings, whereas governments pay from
taxes, or revenues from special projects.
Most individual bonds have five features when they are issued: issue size, issue date,
maturity date, maturity value, and coupon. Once they are issued, yield to maturity becomes
the most important figure for determining the actual yield an investor will receive. Here
yield means return.
Issue size The issue size of a bond offering is the number of bonds issued multiplied by
the face value. For example, if an entity issues two million bonds with a 1000 taka face
price, the issue size is 2000 million taka or 2 billion taka. The issue size reflects both the
borrowing needs of the entity issuing the bonds, as well as the markets demand for the bond
at a yield thats acceptable to the issuer.
Issue date The issue date is simply the date on which a bond is issued and begins to
accrue interest. For example, if bond is issued on January 1 st then the bond issuer will have
to pay coupon/interest from that day to the bond holders.
Maturity date The maturity date is the date on which an investor can expect to have his or
her principal repaid. It is possible to buy and sell a bond in the open market prior to its
maturity date. After the maturity day when the principal is paid bond issuers have no
business with the bond holders.
Maturity value the amount of money the issuer will pay the holder of a bond at the
maturity date. This can also be referred to as par value or face value. Normally it is
either 1000 taka or 100,000 taka which should be paid to the bond holders at the maturity
date.
Periodically, the issuer pays interest to the investor, which is calculated by multiplying the
par value by the interest rate divided by the number of payments in a year. Example: if the
interest rate is 14% and the par value is 1,000 taka, then the interest earned annually is 140

taka. If the company pays interest semi-annually, which most do, then the bondholder will
receive 2 payments of 70 taka every year until maturity. When the bond matures, then the
current owner gets back the par value of the bond. In other words, the loan is paid off.
Because the amount of interest the bond pays is fixed, bonds are a type of fixed-income
security.
Since bonds trade on the open market from their date of issuance until their maturity, their
market value will typically be different than their maturity value. However, if we think the
risk of default is non-existence; investors can expect to receive the maturity value at the
specified maturity date, even if the market value of the bond fluctuates during the course of
its life.
Coupon The coupon rate is the periodic interest payment that the issuer makes during the
life of the bond. For instance, if a bond with a 100,000 taka maturity value offers a coupon
of 14%, the investor can expect to receive 14,000 taka each year until the bond matures. The
term coupon comes from the days when investors would hold physical bond certificates
with actual coupons that they would cut off and present for payment.
Yield to Maturity Since corporate bonds trade on the open market, the actual yield an
investor receives if they purchase a bond after its issue date (the yield to maturity) is
different than the coupon rate.
For example, a company issues 10-year bonds with a face value of 100,000 taka each and a
coupon of 14%. In the two years following the issuance, the company experiences rising
earnings, which adds cash to its balance sheets and provides it with a stronger financial
position. All else equal, its bonds would rise in price, say to 101,000 taka, and the yield
would fall (since prices and yields move in opposite directions). While the coupon would
remain at 14%, meaning that investors would receive the same payment each year (14,000
taka), an investor who purchased the bond after it had already risen in price would receive a
lower yield to maturity. In this case 14,000 taka coupon divided by the 101,000 taka, for a
yield to maturity of 13.86% instead of 14% coupon. In this way, a bonds coupon and its
actual yield are not necessarily the same. Yield to maturity, and not the coupon, is the yield
an investor will actually receive after they buy a bond.
Types of Bonds
Bonds can be classified on various bases. One classification may be based on the nature of
the issuer. It is called government bonds and corporate bonds. There are many types of
corporate bonds that can be offered in order to finance corporate activity. Each corporation
chooses the particular type of bond that it offers depending on a variety of factors. These
include general financial market conditions, the financial strength of the corporation, the
length of time during which the funds are needed, and so on. On the other side of the coin,
investors choose among available types of bonds depending on their investment goals. Some
investors are seeking safety, while others are seeking high current yields and are willing to
take more risk.
Bangladesh governments Treasury Bills are less than one year maturity, but Treasury Notes
mature in 2 to 10 years which is considered as intermediate term bond and the long-term
Treasury bond has a maturity over 10 years.

A company can issue bonds just as it can issue stock. Large corporations have a lot of
flexibility as to how much debt they can issue: the limit is whatever the market will bear.
Corporate bonds are characterized by higher yields because there is a higher risk of a
company defaulting than a government. The upside is that they can also be the most
rewarding fixed-income investments because of the risk the investor must take on. The
company's credit quality is very important: the higher the quality, the lower the interest rate
the investor receives. We will discuss the credit ratings of a company later on.
Variations on corporate bonds include Convertible bonds, Callable bonds, Floating rate
bonds, Zero coupon bonds, Debentures, and so on.
Convertible bonds
Convertible bonds are bonds that are issued by corporations and that can be converted to
shares of the issuing company's stock at the bondholder's discretion.
Issuing convertible bonds is one way for a company to minimize negative investor
interpretation of its corporate actions. For example, if an already public company chooses to
issue stock, the market usually interprets this as a sign that the company's share price is
somewhat overvalued. To avoid this negative impression, the company may choose to issue
convertible bonds, which bondholders will likely convert to equity should the company
continue to do well.
From the investor's perspective, a convertible bond has a value-added component built into
it: it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower
rate of return in exchange for the value of the option to trade the bond into stock.
An example of convertible bond in Bangladesh is ACI 20% convertible bond.
Callable bonds
A bond that can be redeemed by the issuer prior to its maturity is known as callable bonds.
Usually a premium is paid to the bond owner when the bond is called. It is also known as a
"redeemable bond." By issuing this type of bonds, the issuer reserves the right but no
obligation to call the bond prior to the prescribed maturity. One of the benefits for
corporations to issue this type of bond is to save interest payment when the interest rate is
falling or now have a better financing deal. So it can pay off the high coupon payment and
reissue it with lower rate. Since it puts the investors at a disadvantaged position, usually a
premium is paid to the bond owners when the bond is called.
Puttable bonds
A puttable bond has the option which allows the bond holder to sell it to the bond issuer at
specific dates before maturity where the repurchase price is set at the time of issue. The
holder of the puttable bond has the right, but not the obligation, to demand early repayment
of the face value or principal.

Price of a puttable bond is always higher than the price of a straight bond because the put
option adds value to an investor and so the yield on a puttable bond is lower than the yield
on a conventional bond.
Floating rate bonds
Floating rate bonds are so named because the coupon rate is tied to some basic rate such as
T-bill rates, Fed Fund rate or London Interbank Offered rate (LIBOR). These provide
protection against inflation and interest rate risk and keep bonds selling close to their par
values.
Debentures
A debenture is a bond that is not secured by any property or collateral. Debentures are
backed only by the general creditworthiness and reputation of the issuer. Its safety depends
on the assets and earning power of the issuer. Thus, debentures are not as safe as other bonds
from the same company, but will usually pay a higher interest rate to compensate for the
added risk.
Zero Coupon Bonds
Bonds that pay no coupons or interest payments to the bond holders are known as zero
coupon bonds. These bonds have a face value that is redeemed at the end of maturity.
Instead, investors buy zero coupon bonds at a deep discount from their face value, which is
the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond
matures, the investor will receive one lump sum equal to the initial investment.
Junk Bonds
A junk bond, also known as a "high-yield bond" or "speculative bond," is a bond rated "BB"
or lower because of its high default risk. Since junk bonds have a higher risk of defaults, it
typically offers interest rates much higher than safer government bonds or even other
corporate bonds.
Sovereign Bonds
A long term debt security issued by a national government for international capital investors
and institutional buyers and usually denominated in a foreign currency. The foreign currency
used will most likely be a hard currency, and may represent significantly more risk to the
bondholder. To finance the Padma Bridge Bangladesh government is considering issuing
sovereign bonds.
Islamic Bonds
Shariah is the law of Islam which bans usury and interest paymentsconsequently, it also
bans conventional bonds. As if Muslim countries can benefit from international investment,
and so international investors can invest in projects in Muslim countries, variations of the
typical bond have been financially engineered to work somewhat like bonds, but still be
compliant with Shariahthus, they are called Islamic bonds.

One such structured product is the lease-back, or ijarah, structure. If a company wanted to
raise money to build a plant, for instance, using this method, it would set up a special entity
specifically for this project that would buy the plant. Investors would lend money to the
special entity, in return for lease payments, in lieu of interest, for the term of the deal. At the
end of the term, the principal is returned to investors, and the project becomes the property
of the company.
Another way to avoid paying interest, at least in name, is to form a joint venture called
a musharakah. The joint venture partners buy Islamic bonds and receive a percentage of
profits over the term of the loan. An example of Islami bond in Bangladesh is Mudaraba
savings bond issued by Islami bank.

Main Reasons for Issuing Bonds are as follows:


Governments have no choice but to borrow when they are unable to meet their expenses
from current revenue. Corporations, on the other hand, have a wider choice in the matter of
financing their operations e.g., retained earnings, new equity issues, etc. But they still prefer
to go in for borrowing for the following reasons:
1. To Reduce the Cost of Capital :
Bonds are the cheapest source of financing. A corporation is willing to incur the risk of
borrowing in order to reduce the cost of capital by financing a portion of its assets with
securities bearing a fixed rate of return in hope of increasing the ultimate return to the equity
holder.
2. To Gain the Benefit of Leverage :
The presence of debt and/or preference shares in the companys financial structure means
that it is using financial leverage. When financial leverage is used, changes in earnings
before interest and tax (EBIT) translate into the larger changes in earnings per share.
However, leverage is a two-edged sword as EBIT can rise or fall. If it falls, and financial
leverage is used, the equity holders endure negative changes in EPS that are larger than the
relative decline in EBIT. For example, if a company can borrow at 10% and put the funds to
works to earn more than 10%, the earnings on the equity holders are increased and vice
versa.
3. To Effect Tax Saving :
Unlike dividends on equity, the interest on bonds is deductible in figuring up corporate
income for tax purposes. Hence, the EPS increases if the financing is through bonds rather
than with preference or equity shares.
4. To Widen the Sources of Funds :

By issuing bonds, the corporation can attract funds from individual investors and especially
from those investing institutions which are reluctant or not permitted to purchase equity
shares.
5. To Preserve Control :
An increase in debt does not diminish the voting power of present owners since bonds
ordinarily carry no voting right. However, a manager must be concerned with the effect of
fixed cost securities on both EPS and the price earnings ratio.
An increase in risk has a depressing influence on a price- earnings ratio, while an increase in
growth will tend to increase the price-earnings ratio.
Fixed cost securities affect both risk and growth. If the risk effect outweighs the growth
effect, then the price-earnings ratio will decline. If the growth effect outweighs the risk
effect, then the price earnings ratio will increase.
Bond Principles: Terms of Repayment
Interest only - the periodic payments are entirely interest.
Sinking fund - periodically, a portion of the debt principal is set aside or a certain number
of the bonds are retired.
Balloon loan - the debt may be partially amortized with each payment.
Income bond- interest is payable only if it is earned.
Annuities - most bonds are annuities plus an ultimate repayment of principal.
Zero coupon - only the par value is returned at maturity.
Variable (adjustable) rate - the rate fluctuate in accordance with some market index or
predetermined schedule.
Inflation-indexed Treasury bonds - the principal value is adjusted based on the consumer
price index.
Why would an investor invest in bond market?
There are various reasons for an investor to consider in investing bonds like:

Diversification
Regular income
Potential tax benefits
Preservation of principal.

Cash Flows of a Bond


Cash flows of a typical bond consists of two parts- the periodic coupon payments and the
final redemption payment.

Consider a bond that pays a 10% coupon, has a par or face value of 1,000 taka and matures
in 5 years. Suppose also that the market rate of interest for such a bond (i.e., your required
rate of return, kb) is 8%. Thus,
Par = 1,000 taka
Coupon Rate = 10%
Maturity = 5 years
Kb = 8%
The cash flows that are promised by the company include interest payments of 100 taka per
year for five years and the payment of the face value of 1,000 taka at the end of five years.
0

100

100

100

100

100
1,000
1,100

PVIFA 8%,4 = 3.3121


331.21
PVIF 8%,5 = .6806
748.66
1,079.87 taka
The value of the bond is 1,079.87 taka which is selling at a premium relative to the par value
of 1,000 taka. (A bond selling at less than par is said to be selling at a discount.)
Pricing of Bonds
The price or value of a bond is determined by discounting the bond's expected cash flows to
the present using the appropriate discount rate. The price of the bond should equal the
present value of its expected cash flows. The coupons and principal repayment of 1,000 taka
are known and the present value, or price, can be determined by discounting these future
payments from the issuer at a appropriate required yield, r, for the issue.
This relationship is expressed for coupon bond by the following formula:
PV of a Bond = C. Pmt*{1 (1+ r/n) t*n} +
n
r/n
Where,

Face Value
(1+r/n)t*n

C = the annual coupon payment,


r = the required return on the bond, and
t = the number of years remaining until maturity.
n = Number of compounding in a year.
Problem 3.1: If a 1000 taka face value bond paying 15% coupon whereas it is maturing in
10 years and the interest rate is 12%. How much should you pay for this bond?

Face Value
1000

Coupon rate
15%

PV of a Bond = C. Pmt*{1 (1+ r/n) t*n} +


n
r/n
-10
=150*[{1-(1+.12) }/.12] + (1000/1.1210)
=150*5.6502230+ 321.973
=847.53345+321.973
=1169.50 taka.

Maturing time
10 years

Interest rate
12%

Face Value
(1+r/n)t*n

So, an investor should pay maximum 1159.50 taka for this bond.
Problem 3.2: If a 12% semi-annual bond maturing in 10 years is selling in the market for
750 taka when the market interest rate is 16%. Should you buy this bond at 750 taka?
Face Value
1000

Coupon rate
Annual 12% or
6% semi-annual

Maturing
10 years or 20
semi-annual

Interest rate
Annual 16% or
semi-annual 8%

PV of a Bond = C. Pmt*{1 (1+ r/n) t*n} +


Face Value
n
r/n
(1+r/n)t*n
-10*2
=120/2*[{1- (1+.16/2) }/.16/2] + (1000/(1+.16/2) 10*2)
= 803.63 taka.
Yes, we should buy the bond because its intrinsic value 803.63 taka is higher than the market
price of 750 taka.
Discount and premium bonds
A bond whose market price is less than its par value is selling at a discount. It is called
discount bond. The price of such bonds rise as maturity approaches.
If the market price is more than the par value, the bond is selling at a premium. It is
called premium bond. The price of such bonds fall as maturity approaches.
Yield on the bond
The return of a bond is largely determined by its interest rate, which, in turn, is determined
by the prevailing interest rate and the creditworthiness of the issuer, assessed by credit rating
companies, such as Standard & Poors and Moodys. A higher credit rating allows the issuer
to sell its bonds for a higher price, i.e. at a lower interest rate.
Nominal yield, or the coupon rate, is the stated interest rate of the bond, which is a
percentage of par value, which, in most cases, is 1,000 taka for corporate bonds. The coupon
is usually paid semiannually. Thus, a bond that pays 14% interest pays 140 taka per year in 2

semi-annual payments of 70 taka. The return of a bond is the return/investment, or in the


example just cited, 140/1,000 = 14%.
Bonds trading in the secondary market will usually have prices that are less or more than par
value, thus yielding an interest rate that differs from the nominal yield, called the current
yield, or current return. So the price of bonds moves in the opposite direction of
interest rates.
Current Yield:
Because current bond prices fluctuate, an investor can pay more or less than the par value
for a bond. If the investor holds the bond until maturity, he will lose money if he paid a
premium for the bond, and he will earn money if he paid for it at a discount. Current yield
measure looks at the current price of a bond instead of its face value and represents the
return an investor would expect if he or she purchased the bond and held it for a year. This
measure is not an accurate reflection of the actual return that an investor will receive in all
cases because bond prices are constantly changing due to market factors.
Current Yield Formula
Current Yield =

Annual Interest Payment


Current Market price of Bond

Problem 3.3: If a bond is paying 14% annual coupon which is now selling in the market for
880 taka, what is the current yield of this bond?
Current Yield = 140/880 = 15.91%.
Recall that if the market price of a bond goes down, the current yield will go up. Using the
above example, if the current bond piece goes down to 700 taka instead 880 taka, the current
yield would be: 140/700 = 20%.
Yield to Maturity:
The yield-to-maturity, or true yield, of a bond that is held to maturity will have to account
for the gain or loss that occurs when the par value is repaid. The yield to maturity is the
single interest rate that, when applied to the stream of cash flows associated with a bond,
causes the present value of those cash flows to equal the bonds market price.
Yield to Maturity and Present Value of a Bond
The yield to maturity is found in the present value of a bond formula:
n

Value of the bond = Price, P0 =


1

Ct +
Face Value
( 1 + YTM)t ( 1 + YTM)n

Assuming investment at the current price of the bond, YTM of the bond is the internal rate
of return on the investment of the bond. So, the yield to maturity is the interest rate that will
make the present value of the cash flows equal to the price of the bond.
Example, If a 1000 taka face value with 12% annual coupon with maturity of 6 years is now
trading for 900 taka and assuming that the investors buys it for 900 taka and hold it until
maturity. The cash flows of the bond can be shown below:
Price of the bond, P0 = 900 = 120 +
1+r

120 + 120 + 120 + 120 + 120 + 1000


(1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)6 (1+r)6

The solution to determine the YTM of the bond can be attempted through trial and error
method by taking an approximate value of r and checking if the right hand side of the
equation matches with the price of the bond. The Scientific calculator or excel spreadsheet
will give us the yield to maturity of 14.62%.
For calculating yield to maturity, the price of the bond, or present value of the bond, is
already known. Calculating YTM is working backwards from the present value of a bond
formula and trying to determine what r (YTM) is.
The formula for yield to maturity is complicated and difficult to solve, but it generally will
yield an interest rate comparable to newly issued bonds with the same credit rating. The
following formula provides an approximation:
Approximate YTM = Coupon Payment + Face Value Market value
No. of years to maturity
(Face value + Market value)/2
Notice that the formula shown above is used to calculate the approximate yield to maturity.
To calculate the actual yield to maturity requires trial and error by putting rates into the
present value of a bond formula until P, or Price, matches the actual price of the bond. Some
financial calculators and computer programs can be used to calculate the yield to maturity.
But if we use our approximation equation of YTM on our above example where the actual
YTM was given at 14.62% using the scientific calculator but by using our approximation,
we get
Approximate YTM = 120 + (1000 +900)/6
(1000 +900)/2
= 120 + 16.666
950
= 14.385% which is close to 14.62%.
Problem 3.4: The price of a bond is 920 taka with a face value of 1000 taka which is the
face value of many bonds. Assume that the annual coupons are 100 taka, which is a 10%

coupon rate, and that there are 10 years remaining until maturity. What is the YTM of this
bond?
Solution: Using the approximate YTM formula:
Approximate YTM = 100 + (1000 920)/10
(1000 + 920)/2
= 11.25%.
After solving this equation, the estimated yield to maturity is 11.25%. But if you use the
computer generated trial and error software it will give you the exact YTM of 11.38% which
is pretty close.
YTM takes into account the capital loss or gain upon maturity as well as the time value of
money. Current yield considers neither. If the current price of the bond is less than its face
value, YTM shall be greater than the current yield as the investor would have capital gain
upon maturity. But if the bond is selling above face value, YTM shall be lower than current
yield since upon maturity the investor would incur a capital loss.
Normally when a bond is issued, it is traded at face value and if this is the case then the
YTM and the coupon will be the same. Simply speaking if the price of the bond is selling at
par (face value) the YTM will remain the same which equals to coupon rate. Only a change
in price above or value to face value will change the YTM and there is an inverse
relationship between the price and the YTM of the bond which means if the price of a bond
rises the YTM falls and vice versa.
Assumptions on YTM:
The rate of return on bonds most often quoted for investors is the yield to maturity (YTM), a
promised rate of return that will occur only under certain assumption. It is the compound
rate (not simple) of return an investor will receive only under certain assumption:
The bond is held to maturity.
The coupons received while the bond is held are reinvested at the calculated yield to
maturity.
If a bond pays periodic interest, it is not possible to lock in a prescribed yield to
maturity.
When a bond is bought at a discount, yield to maturity will be greater than the current yield
and if bought at a premium, the yield to maturity will be less. If a bond trades at a discount,
an investor will earn a return both from receiving the coupons and from receiving a face
value that exceeds the price paid for the bond. On the other hand, if a bond trades at a
premium its coupon rate will exceeds its yield to maturity.
The yield to maturity formula is used to calculate the yield on a bond based on its current
price on the market. The yield to maturity formula looks at the effective yield of a bond

based on compounding as opposed to the simple yield which is found using the dividend
yield formula.
YTM measures three sources of a bonds return:
Coupon return: Return from coupon payments (current yield).
Capital gain return: Capital gain / loss when bond matures, or is sold / called at a
predictable point in the future.
Reinvestment return: Interest income generated from the reinvestment of coupons (interest
on interest).
Problem 3.5: If a 1000 taka face value bond paying 15% coupon whereas it is maturing in
10 years and the interest rate is 12%. If it is trading for 1150 taka, what is the current yield
and YTM?
Solution: Current Yield = (Annual Coupons/Current bond price)
= (150/1150)
= 0.1304 Or 13.04%
YTM

= (150+{1000-1150)/10)/{(1000+1150)/2)
=135/1075
=0.1256 Or 12.56%.

Problem 3.6: If a 12% annual bond maturing in 10 years is selling in the market for 750
taka when the market interest rate is 16%. What is the current yield and YTM of this bond?
Solution: Current Yield
= (Annual Coupons/Current bond price)
= (120/750)
= 0.16
Or 16%.
YTM

= {120+{1000-750)/10}/{(1000+750)/2}
=145/875
=0.1657
Or 16.57%

Yield to Call
The term Yield to Call is often abbreviated as YTC, defined that the bond is called on the
next eligible call date. The yield is calculated from the cash flows from the coupon payments
plus the cash flow of the redemption proceeds at the time of the call. When bond issuers
include call options in indenture then it becomes their discretion whether they will expire the

bonds early after the call date. Since bond may not wait until maturity and may be redeemed
prior to the maturity YTM becomes useless to count. In that case, it would be more relevant
to compute the yield to the point of earliest call which is known as yield to call (YTC).
Like the yield to maturity, the yield to call usually cannot be solved for directly. It generally
must be determined using trial and error or an iterative technique. Fortunately, financial
calculators make the task of solving for the yield to maturity quite simple.
To calculate the yield to first call, the YTM formula is used, but the number of periods until
the first call date substituted for the number of periods until maturity and the call price
substituted for the face value. Issuers often pay a call premium for a specific period of time
to call a bond, and therefore the call price usually differ either by an extra coupon payment
or fixed at the time of issuance.
Yield to call can be approximately calculated from the formula given below:

When it comes to estimate the actual return on a callable bond, yield to maturity has a flaw.
If the bond is called, the par value will be repaid and interest payments will come to an end,
thus reducing its overall yield to the investor. Therefore, for a callable bond, you also need
to know what the yield would be if the bond were called at the earliest date possible. That
figure is known as its yield to call. The calculation is the same as with yield to maturity,
except that the first call date is substituted for the maturity date. YTC is therefore a good
measurement gauge for the expected investment return of a bond at a callable time
Many bonds, especially those issued by corporations, are callable. This means that the issuer
of the bond can redeem the bond prior to maturity by paying the call price, which is usually
greater than the face value of the bond, to the bondholder. Often, callable bonds cannot be
called until 5 or 10 years after they were issued. When this is the case, the bonds are said to
be call protected. The date when the bonds can be called is referred to as the call date.
The yield to call is the rate of return that an investor would earn if he bought a callable bond
at its current market price and held it until the call date given that the bond was called on the
call date. It represents the discount rate which equates the discounted value of a bond's
future cash flows to its current market price given that the bond is called on the call date.
Example, if a 12% annual coupon bond with a face value of 1000 taka maturing in 10 years
has a call provision which states that the issuer can call the bond after 4 years at a call price
of 1050 taka. If the bond is selling at 900 taka in the market then what is the yield to call of
this bond?
Value of the bond = 900 = 120/(1+YTC) + 120/(1+YTC)2 + 120/(1+YTC)3 + 120/(1+YTC)4

Approximate, YTC = 120 + (1050 900)/4


(1050+900)/2
= 157.5/975 = 16.15%
Using scientific calculator or excel function we get YTC of 16.59%.
DURATION OF THE BOND
As we know the price of a bond changes with the changes in interest rate. But the question
is, if say, interest rate changes 1%, do all bonds change by the same amount or in same
ratio? The answer is no and since the value of a bond is sum total of present values of all
cash flows attached with the bond. Now we have o find out what proportion each of the cash
flows constitutes the price. This price sensitivity of the bond is measured by the term known
as Duration.
Duration is the time weighted average of the cash flows as compared to its total value. It is
calculated using the following formula:
Duration of the bond = [ 1x CF1 + 2x CF2 + 3x CF3 + .]
(1+r)1 (1+r)2
(1+r)3
P0
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 flows. It is an
important measure for investors to consider, as bonds with higher durations carry more risk
and have higher price volatility than bonds with lower durations.
It is important to note, however, that duration changes as the coupons are paid to the
bondholder. As the bondholder receives a coupon payment, the amount of the cash flow is
no longer on the time line, which means it is no longer counted as a future cash flow that
goes towards repaying the bondholder.
Some aspects of duration
To obtain maximum price volatility, investors should choose bonds with the longest
duration
Duration is additive
Portfolio duration is just a marketvalue weighted average of each individual bonds
modified duration
Duration measures volatility which isnt the only aspect of risk in bonds.
Duration depends on three factors:

Maturity of the bond.


Coupon payments.
Yield to maturity.
Duration increases with time to maturity but at a decreasing rate.

For coupon paying bonds, duration is always less than maturity


For zero coupon-bonds, duration equals time to maturity

Duration increases with lower coupons.


Duration increases with lower yield to maturity.
Importance of duration
Allows comparison of effective lives of bonds that differ in maturity, coupon.
Used in bond management strategies particularly immunization.
Measures bond price sensitivity to interest rate movements, which is very important in
any bond analysis.
Estimating Price Changes Using Duration
Problem 3.7: If a 10 year maturity bond with a face value of 1000 taka paying 12% annual
coupon when the market interest rate for this type of security with the same risk is 10%.
What is the duration of this bond?
Face Value = 1000
Coupon Rate = 12%
Maturity = 10 Years
So the Duration of the bond is
Year

Cash Flow

PV
of
cashflow(10%)

1
2
3
4
5
6
7

Tk.120.00
Tk.120.00
Tk.120.00
Tk.120.00
Tk.120.00
Tk.120.00
Tk.120.00

Tk.109.09
Tk.99.17
Tk.90.16
Tk.81.96
Tk.74.51
Tk.67.74
Tk.61.58

Proportion of
total value
(PV
of
cashflow/Total
value)
9.72%
8.83%
8.03%
7.30%
6.64%
6.03%
5.48%

Time
X
Proportion

0.10
0.18
0.24
0.29
0.33
0.36
0.38

8
9
10

Tk.120.00
Tk.120.00
Tk.1,120.00

Tk.55.98
Tk.50.89
Tk.431.81
Tk.1,122.89

4.99%
4.53%
38.46%
100.00%

0.40
0.41
3.85
6.54

The duration of the bond is 6.54 Years.


Approximate, YTM

= [{C+(F-P)/n}\] / {(F+P)/2}
= [{120+(1000-1122.89)/10}\] / {(1000+1122.89)/2}
= 107.711/1061.445
= 0.10147

The duration of a bond is primarily affected by its coupon rate, yield, and remaining time to
maturity. The duration of a bond will be higher if the coupon is lower, lower its yield, and
longer the time left to maturity. The following scenarios of comparing two bonds should
help clarify how these three traits affect a bonds duration:
If the coupon and yield are the same, duration increases with time left to maturity.
If the maturity and yield are the same, duration increases with a lower coupon.
If the coupon and maturity are the same, duration increases with a lower yield.
Sensitivity of bond prices
Duration of the bond is a measure of the sensitivity of bond price with the change in the
yield. The volatility of the bond is approximately given by the following equation:
Volatality of the bond = - Duration
(1+ YTM/m)
Where m is the number of times the coupons payments are made in a year. Here duration is
measured in years and YTM is expressed as decimal.
So the volatility of the bond is
Volatility = (-Duration)/ (1+YTM)
= (-6.54) / (1.1)
= -5.945
So for 1% change in the YTM, the price will change by -5.945%.
Three Sources of Earning from bond investment:
Note that a bondholder has three possible sources of dollar returns from a bond investment,
which we call the total dollar return:
The coupons, which are the semiannual interest payments on a coupon-paying bond.

A capital gain or loss- the difference between the purchase price and the price received
when the bond is sold, matures or is called.
Interest on interest, resulting from the reinvestment of the coupons.
Problem 3.8: If a 10 years 1000 taka face value bond is paying 12% annual coupon where
the YTM is 14%, what is the duration of this bond?
Solution:
Face Value = 1000
Coupon Rate = 12%
Maturity = 10 Years
YTM = 14%
So the Duration of the bond is

Year

1
2
3
4
5
6
7
8
9
10

Cash
Flow
Tk.120.
00
Tk.120.
00
Tk.120.
00
Tk.120.
00
Tk.120.
00
Tk.120.
00
Tk.120.
00
Tk.120.
00
Tk.120.
00
Tk.1,12
0.00

PV
of
cashflow(14
%)

Proportion
of
total
value
(PV
of
cash
flow/Total value)

Time
X
Propor
tion

PV
of
cashflow(15
%)

Tk.105.26

11.75%

0.12

Tk.104.35

Tk.92.34

10.31%

0.21

Tk.90.74

Tk.81.00

9.04%

0.27

Tk.78.90

Tk.71.05

7.93%

0.32

Tk.68.61

Tk.62.32

6.96%

0.35

Tk.59.66

Tk.54.67

6.10%

0.37

Tk.51.88

Tk.47.96

5.35%

0.37

Tk.45.11

Tk.42.07

4.70%

0.38

Tk.39.23

Tk.36.90

4.12%

0.37

Tk.34.11

Tk.302.11

33.73%

3.37

Tk.276.85

Tk.895.68

100.00%

6.12

Tk.849.44

The duration of the bond is 6.12 Years.


So the volatility of the bond if YTM changes from 14% to 15% is
Volatility = (-Duration)/ (1+YTM)

= (-6.12) / (1.01)
= -6.059%
So for 1% change in the YTM, the price will change by -6.059%.
And the new price of the bond will be 849.44 taka.
Convexity of a bond
Duration is the linear measure of how the price of a bond changes in response to changes in
interest rates. As interest rates change, the prices of a bond wont change linearly but would
change in some curved function form which is convex in shape. The change in a bonds
duration for a given change in yields can be measured by its convexity.
As the yield on a bond changes so too does its duration, a bonds convexity measures the
sensitivity of a bonds duration to changes in yield. Duration is an imperfect way of
measuring a bonds price change, as it indicates that this change is linear in nature when in
fact it exhibits a sloped or convex shape. A bond is said to have positive convexity if
duration rises as the yield declines. A bond with positive convexity will have larger price
increases due to a decline in yields than price declines due to an increase in yields. Positive
convexity can be thought of as working in the investors favor, since the price becomes less
sensitive when yields rise (prices down) than when yields decline (prices up). Bonds can
also have negative convexity, which would indicate that duration rises as yields increase and
can work against an investors interest
Malkiels theorems:
Malkiels theorems are a set of relationships among bond prices, time to maturity, and
interest rates.
RULE 1: The higher the expected rate of inflation, the higher the required returns on bonds.
RULE 2: The higher a bonds credit rating, the lower its default risk and the lower its yield.
RULE 3: All other things remaining the same, the longer the maturity of a bond, the higher
its interest rate (yield) will be (at least most of the time).
RULE 4: The higher a bonds liquidity risk, the higher its yield will be.
RULE 5: All other things remaining the same, convertible bonds will have lower yields than
nonconvertible bonds.
RULE 6: All other things remaining the same, bonds will call provisions will have higher
yields than bonds without call provisions.
Bond rating

Table 1. Quality Ratings Used by Moodys and Standard & Poor's


Moody's
Standard & Poor's
Interpretation
Rating
Rating System
System
Aaa
AAA
High-quality debt instruments
Aa
AA
A
Baa

A
pay
BBB

Ba
B
Caa
Ca
C

BB
B
CCC
CC
C
DDD
DD
D

Strong to adequate ability to


principal and interest

Ability to pay principal and


interest speculative

In default

Note: Both rating services use factors to amend the above rating categories to indicate a
range within a given rating. Moody's uses a 1, 2, or 3 factor, and Standard & Poor's uses a
plus or minus factor. For example, a Moody's rating of Aa2 indicates a firm that is in the
midrange of all firms with a double-A rating.
The Bond Indenture
The bond indenture is a three-party contract between the bond issuer, the bondholders, and
the trustee. The trustee is hired by the issuer to protect the bondholders interests.
The indenture includes:

The basic terms of the bond issue.


The total amount of bonds issued.
A description of the security.
The repayment arrangements.
The call provisions.
Details of the protective covenants.

Factors Affecting Bond Yields


The real rate of interest
Expected future inflation
Interest rate risk

Default risk premium


Taxability premium
Liquidity premium
Change in inflation risk- A rise in inflation will cause the nominal interest rates to go up
since the central bank would be keep to control inflation by raising the cost of borrowings
and so does the value of bond would go down.
Default risk or credit risk- It is the possibility that a borrower will be unable to repay
principal and interest as agreed upon in the loan document. Usually, it is rated by
agencies like Moodyand Standard & Poors.
Interest rate risk - the chance of loss due to changing interest rates. If the market interest
goes up investors would like to invest in money market which will make investment in bond
less attractive and thus lower bond prices.
Call risk - the possibility that the company will exercise a bonds call feature.
Reinvestment rate risk - the chance that the interest received cannot be reinvested to earn
as much as the bonds original yield to maturity.
- the higher the coupon on a bond, the higher its reinvestment rate risk.
Marketability risk or liquidity risk - the difficulty of selling a bond in the secondary
market.
Perpetuities
There is a type of bond that never matures called perpetuity, or a consol. (The term consol
comes from the fact that the first perpetuities were issued by the British government
following the Napoleonic Wars to consolidate their war debts.) If long-term bonds are
more sensitive to changes in interest rates than short-term bonds, then consol is more
sensitive to changes in interest rates.
When N is infinity, the value of a perpetual bond reduces to
Value of a Consol = Coupon payment/ market interest rate
Problem 3.9: if a consol (perpetuity bond) is paying 140 taka per year forever what should
be the value of that bond given the market interest rate is 12%?
Value of that Consol = 140/0.12 = 1166.67 taka.
Problem 3.10: A perpetual bond has a 10% coupon. The bond yields 8% and the par value is
1000. What is the price of the bond?
The price of this bond = 100/0.08 = 1250 taka.

The dirty (or full) price is the amount that the buyer agrees to pay the seller, which is the
agreed-upon price plus accrued interest. The price of a bond without accrued interest is
called the clean price. The exceptions are bonds that are in default. Such bonds are said to be
quoted flat, that is, without accrued interest.
Term Structure of Interest Rates
A plot of interest rates against time to maturity is known as a yield curve. The term structure
of interest rates is a schedule showing the yields of securities that are alike in all respects
except for their term to maturity (number of years until the bonds mature). As mentioned
above, the longer the time to maturity, the riskier the bond and (usually) the higher the yield.
The term structure of interest rates is usually demonstrated using U.S. Treasury securities as
shown below:
Term Structure for U.S. Treasury Debt
Time to Maturity
1 month
3 months
6 months
1 year
5 years
10 years
20 years
30 years

Yield
.01%
.20%
.50%
1.00%
1.50%
2.00%
3.00%
3.80%

Notice that the required return on U.S. Treasury bonds rises as the time to maturity of the
bonds rises. This is the normal state of things. However, on rare occasions, the returns on
long-term bonds are lower than those on short-term bonds.
The data in the table can be graphed with the time to maturity on the X axis and the required
return or yield on the Y axis as shown below.
U.S. Treasury Securities Yield Curve

Kd
(Yield)

Normal (positively
sloped) yield curve

4.0%
3.0%
2.0%
1.0%

Maturit

0
1 mo 6 mo

1 yr

5 yrs

10 yrs

20 yrs

30 yrs

The graph shows the longer the time to maturity the higher the yield on Treasury bonds. This
is called a normal (because this is normally the shape of the yield curve) or positively sloped
yield curve. Investors interpret a normal yield curve as indicating rising inflation in the
future (because the inflation is expected to rise in the future) or as indicating an expanding
economy (meaning the real rate of interest is expected to rise).
The graph shown below portrays a declining or negatively-sloped yield curve. Notice the
rates on longer-term bonds are lower than those of shorter-term bonds. This shape of yield
curve is rare, but when it occurs it is usually interpreted to mean a recession is about to
occur.

Kd
(Yield)

Declining (negatively
-sloped) yield curve

4.0%
3.0%
2.0%
1.0%
0

1 mo 6 mo
yrs

1 yr

5 yrs

10 yrs

20 yrs

30

Finally, a flat yield curve is shown on the following page. The required return is the same
regardless of maturity. Again, this is rare and indicates an economy in transition from
expanding to contracting or contracting to expanding.

Kd
(Yield)

Flat
yield

curve

4.0%

3.0%

2.0%

1.0%

1 mo 6 mo

1 years

5 years

10 years

20 years

30 years

Theories of the Term Structure of Interest Rates


(or Why the Yield Curve Has A Particular Shape)
There are three theories which try to explain the shape of the yield curve. They are:
1. Expectations Hypothesis
2. Liquidity Hypothesis
3. Market Segmentations Hypothesis
Expectations Hypothesis
The expectations hypothesis says the shape of the yield curve reflects the average annual rate
of inflation investors expect for any given maturity. If investors expect inflation rates to rise
in the future, then longer term bonds should have higher yields to compensate investors for
the higher expected rates of inflation. This would result in a normal (positively-sloped) yield
curve. Conversely, if investors expect inflation rates to fall in the future, longer term bonds
should have lower yields than shorter term bonds. This would result in a declining
(negatively sloped) yield curve. The expectations hypothesis can therefore explain any shape
of yield curve (normal, declining or flat).
Liquidity Preference Hypothesis
The liquidity preference hypothesis states that investors prefer to hold short-term bonds
(because its easier to predict the short-term prospects for a firm than it is to predict its longterm prospects) and bond issuers would prefer to issue long-term bonds (to lock in access to
funds over a long time period in case, in fact, the firms prospects do deteriorate). The result
of these assumptions, if true, is that issuers will issue lots of long-term bonds (and few shortterm bonds) and investors will want to buy lots of short-term bonds (and few long-term
bonds). Together, this means:
1. Short-term bonds will be scarce but demand for them will be high
2. Long-term bonds will be plentiful but demand for them will be low.
To illustrate how the liquidity preference hypothesis might work in action, assume we start
out a flat yield curve. Now assume the finance fairy flutters down and decrees that the
liquidity preference hypothesis is true. Suddenly bond issuers will issue more long-term
bonds at the same time investors sell off those that they already own. As we shall learn
shortly, the effect of this is to lower the price of the long-term bonds which causes their yield
to rise (trust me on this for now). While all of this is going on, bond issuers are issuing fewer
short-term bonds precisely at the moment bond investors are buying all of them they can.
Again, as we shall learn, this will cause the prices of the short-term bonds to rise and their
yields to fall. The yield curve shown below illustrates how all this might play out:
Yield Curve Under Liquidity Preference Hypothesis

Kd
(Yield)

18.0%
16.0%

Bond issuers
issue fewer
short-term
bonds
as
investors buy
all they can.
Short-term
bond prices
rise and their
yields fall.

12.0%

Bond
issuers
issue more
long-term
bonds as
investors
sell them.
Long-term
bond
prices fall
and their
yields rise.

Start:
Flat
yield
curve

10.0%
8.0%
0
1 mo 6 mo

1 yr

5 yrs

10 yrs

20 yrs 30 yrs

The liquidity preference hypothesis results in a normal or positively sloped yield curve. The
liquidity preference hypothesis can only explain this yield curve shape. It cannot explain flat
or declining yield curves.
Market Segmentations Hypothesis
The market segmentations hypothesis states that borrowers and lenders have preferred
maturity habitats and that they rarely depart from those habitats. For example, most people
borrowing money to finance the purchase of a new car do so using 4-year car loans.
Similarly, banks feel most comfortable making car loans over 4 years. As another example,
most people borrowing money to finance the purchase of a house do so using 30-year home
loans. Banks feel most comfortable making home loans over 30 years. Most of us would
never consider financing a car over 30 years (even if we could find a bank to make such a
loan) because cars typically do not last that long. A 30-year car loan would force us to pay
interest toward the purchase of a car long past its useful life. Similarly, most of us would not
be interested in financing the purchase of a house using a 4-year loan.
The market segmentations hypothesis predicts the interest rate on 4-year car loans is entirely
determined by the supply and demand for funds available for 4-year car loans. Similarly, the

interest rate on 30-year home loans is entirely determined by the supply and demand for
funds available for 30-year home loans. Car loan interest rates have nothing to do with (do
not affect) home loan interest rates and vice versa.
The market segmentations hypothesis can explain any shape of yield curve (normal,
declining and flat).
Pricing of zero-coupon bonds
An investor normally receive return from bond investment from two way- one is the
periodic coupon payments, and the second one is capital gains from the difference between
selling value and buying value. But not all bonds will give you return in this way. We may
have zero-coupon bonds which do not pay any interest and instead provide all the returns in
the form of capital gains by issuing the bond at a price substantially lower than the par value
and redeeming them on maturity at par value. This is why it is sometimes called deep
discount bond.
Some features of Zero-Coupon Bond (Zero)
Does not make coupon payments.
Always (almost always) sells at a discount (a price lower than face value), so they are
also called pure discount bonds.
Example: Suppose that a one-year, risk-free, zero-coupon bond with a 100,000 taka face
value has an initial price of 97,323.60 taka. The cash flows would be:
Although the bond pays no coupon, your compensation is the difference between the
initial price and the face value.
Example: If F = 100,000 taka; T = 8 years; and the annual discount rate is 9%, the bond
should sell for

= 50,186.63 taka

Exercises: What is the price of a Tk.1000 face value bond paying 6% semi-annual coupon if
the required yield is 15%?
Solution: We have a 10-year 6% coupon bond with a par value of Tk.1,000 and a required
yield of 15%. Given C = 0.06(Tk.1,000) / 2 = Tk.30, n = 2(10) = 20 and r = 0.15 / 2 = 0.075,
the present value of the coupon payments is:

1
1 1 r n
P=C

1
20

=
(1.075)

$30
0.075

= $30
4.2478511

0.075

1 0.2354131
0.075

= $30

Tk.30[10.1944913] = Tk.305.835.
The present value of the par or maturity value of Tk.1,000 is:

1+ r

$1, 000
=
1.075 20

$1, 000
=
4.2478511
Tk.235.413. Thus, the price of the bond (P) = Tk.305.835 + Tk.235.413 = Tk.541.25.
(b) What is the price of this bond if the required yield increases from 15% to 16%, and
by what percentage did the price of this bond change?
If the required yield increases from 15% to 16%, then we have:

1
1 1 r n
P=C

1
1

=
(1.08) 20

$30
0.08

= $30 9.8181474 = Tk.294.544.

The present value of the par or maturity value of Tk.1,000 is:

1+ r

$1, 000
=
1.08 20

Tk.214.548.
Thus, the price of the bond (P) = Tk.294.544 + Tk.214.548= Tk.509.09.
The bond price falls with percentage fall is equivalent to

$509.09 $541.25
= 0.059409 or
$541.25

about 5.94%.
(c) What is the price of this bond if the required yield is 5%?
If the required yield is 5%, then we have:

1
1

1 r n
P= C

20

=
(1.025)

$30
0.025

= $30 15.5891623 = Tk.467.675.

The present value of the par or maturity value of Tk.1,000 is:

1+ r

Tk.610.271.
Thus, the price of the bond (P) = Tk.467.675 + Tk.610.271 = Tk.1,077.95.

$1, 000
=
1.025 20

(d) What is the price of this bond if the required yield increases from 5% to 6%, and
by what percentage did the price of this bond change?
If the required yield increases from 5% to 6%, then we have:

1
1 1 r n
P= C

1
1

=
(1.03) 20 = $30 14.87747486 = Tk.446.324.

$30
0.03

The present value of the par or maturity value of Tk.1,000 is:

1+ r

$1,000
20 =
(1.03)

Tk.553.676.
The price of the bond (P) = Tk.446.324 + Tk.553.676 = Tk.1,000.00. [NOTE. We already
knew the answer would be Tk.1,000 because the coupon rate equals the yield to maturity.]
The bond price falls with the percentage fall equal to (Tk.1,000.00 Tk.1,077.95) /
Tk.1,077.95 = 0.072310 or about 7.23%.
(e) From your answers to Question 9, parts b and d, what can you say about the
relative price volatility of a bond in a high-interest-rate environment compared to a
low-interest-rate environment?
We can say that there is more volatility in a low-interest-rate environment because there was
a greater fall (7.23% versus 5.94%).
Exercise: A 10-year, 1000 taka corporate bond with a 10 percent annual coupon rate is
currently selling for 850 taka:
(a)
(b)

Calculate its current yield.


Calculate its yield to maturity

Solution:

(a)

current yield =

coupon______
current market price

= 100/850 = 11.76 percent


b) Approx. YTM = 100 + (1000 + 850)/10
(1000 + 850)/2
= 115/925 = 12.43% (Approximately)
Exercise: Two 10 percent coupon bonds are selling at par. Bond A has a 15 year maturity
and Bond B has a 25 year maturity. If the appropriate required rate of return for these two
bonds drops to 8 percent, calculate the percentage change in the price of each bond, using a
financial calculator. Assume interest is paid semi-annually.

Solution:

Bond A = original price = Tk.1,000; new price = 1000 FV, 8 interest


rate, 50 pmt, 30 N, solve for PV = Tk.1,172.92
Percentage change in price = 1172.92 - 1000
1000
= .1179 = 11.79%
Bond B = original price = Tk.1,000; new price = 1000 FV, 8 interest
rate, 50
pmt, 50 N, solve for PV = Tk.1,214.82
Percentage change = 1214.82 - 1000
1000
= .2148 = 21.48%

Exercise: Calculate the duration of a bond with a 7 percent coupon and a 3-year maturity
currently priced at Tk.1,000. Interest is paid annually.
Solution:
Year

Cashflow

Present Value PV of CF

1
2
3

Tk.70
Tk.70
Tk.1070

.9346
.8734

PV/ Price Year X PV/Price

Tk.65.42
Tk.61.14
.8163
Tk.873.44
Tk.1000

.065
.061
.873

Exercise:
Face Value = 1000
Coupon Rate = 15%
Maturity = 10 Years
Interest rate = 12%
So the price of the bond is
PV = C.Pmt * [{1-(1+r/n)^-t*n} / (r/n)] + {Face Value / (1+r/n)^t*n}
PV = 150 * [{1-(1+.12)^-10} / (.12)] + {1000 / (1+.12)^10}
PV = 850+321.97
PV = 1172
So the present value of the bond is 1172.
The current Yield is
Current Yield
= (Annual coupons / Current Bond Price)
= 150 / 1150
= 0.1304

.065
.122
2.619
2.806 years

The YTM is
Appx. YTM
= [{C+(F-P)/n}\] / {(F+P)/2}
= [{150+(1000-1150)/10}\] / {(1000+1150)/2}
= 135/1075
= 0.1255
So the YTM is 12.56%
Case Study 1: Dissecting the numbers and trying to make some sense in bond
valuation.
Mr. Akram is confused about the corporate bond market in Bangladesh. He finds the coupon
rate is quite handsome compare to the fixed deposit rate or even with the government
Treasury bond. He is wondering if it is too good to be true. He is evaluating these three
options and trying to work out some numbers. He is asking for your help!
Offer 1: Fixed deposit on one lac taka is paying 1,000 taka per month forever.
Offer 2: Bangladesh governments Treasury bond is paying 12.50% annual coupon which
matures in 10 years.
Offer 3: ABC Company issued a corporate bond of 1000 taka face value. It is paying 15%
annual coupon which is a medium sized company who are involved in textile sector. This
bond has a maturity of 15 years but callable after 5 years. The market price of this bond
today is 925 taka.
Mr. Akram wants to know where he should invest his one lac taka. The market expectation is
that interest rate will fall in coming months since the inflation has fallen back to single digit
and it seems to continue the trend in the next 3-4 years. He is asking for your financial
management knowledge which will help him in making the right decision.
Question 1: What is the Current Yield, YTM, and YTC of ABC Company?
Question 2: How does it differ investing in Treasury instrument compare to corporate bond?
Question 3: What are some of the risk involved in corporate bond?
Question 4: How fallen inflation will affect the return from bond investment?
Case Study 2: Bond investing risks: So you think bonds are totally safe and
predictable?

Many people believe they can't lose money in bonds. Wrong! Although the interest
payments you'll get from owning a bond are "fixed," your return is anything but. Here are
the major risks that can affect your bond's return:
Inflation risk
Since bond interest payments are fixed, their value can be eroded by inflation. The longer
the term of the bond, the higher the inflation risk. On the other hand, bonds are a classic
deflation hedge; deflation increases the value of the takas that bond investors get paid.
Interest rate risk
Bond prices move in the opposite direction of interest rates. When rates rise, bond prices fall
because new bonds are issued that pay higher coupons, making the older, lower-yielding
bonds less attractive. Conversely, bond prices rise when interest rates fall because the higher
payouts on the old bonds look more attractive relative to the lower rates offered on newer
ones.
The longer the term of the bond, the greater the price fluctuation - or volatility - that results
from any change in interest rates. There is a close connection between inflation risk and
interest rate risk since interest rates tend to rise along with inflation. Interest rate shifts are
also a concern for mortgage-backed bondholders, but for a different reason: If interest rates
fall, home owners may decide to prepay their existing mortgages and take out new ones at
the lower rates. That doesn't mean you'll lose your principal if you hold such a bond. But it
does mean you get your principal back much sooner than expected, forcing you to reinvest it
at the newly lower rates. For that reason, the prices of mortgage-backed securities don't get
as big a boost from falling rates as other kinds of bonds.
Note that price fluctuations only matter if you intend to sell a bond before maturity, or you
invest in a bond fund whose manager trades regularly. If you hold a bond to its maturity, you
will be repaid the bond's full face value. But what if interest rates fall and the issuer of your
bond wants to lower its interest costs?
Call risk
Many corporate bond issuers reserve the right to redeem, or "call," their bonds before they
mature, at which point the issuer is required to pay bondholders only par value. Typically,
this happens if interest rates fall and the issuer sees it can lower its costs by selling new
bonds with lower yields.
If you happen to own one of the called bonds, not only do you get less than the market price
of the bond, but you also have to find a place to reinvest the money. Because of the risk that
you won't get the income you expect, callable bonds usually pay a higher rate of interest
than comparable, non-callable bonds. So, when you buy bonds, make sure to ask not only
about the time to maturity, but also about the time to a likely call.
Credit risk
This is the risk that your bond issuer will be unable to make its payments on time - or at all and it depends on the type of bond you own and the borrower's financial health. Bangladesh

governments Treasuries are considered to have virtually no credit risk and junk bonds
having the highest default risk.
Bond rating agencies such as Standard & Poor's and Moody's evaluate corporations and
municipalities for their credit worthiness. Bonds from the strongest issuers are rated tripleA. Junk bonds are rated Ba and lower from Moody's, or BB and lower from S&P. The
highest-quality municipal bonds are backed by bond insurance companies, but there is a
trade-off: Insured munis typically yield up to 0.3% points less than comparable uninsured
munis. Further, the insurance only guarantees your interest and principal; it won't shield you
against interest rate or market risk.
Some higher-coupon munis are also "pre-refunded," meaning that, for esoteric reasons, they
are effectively backed by U.S. Treasuries. When a muni is pre-refunded by an issuer, its
credit quality and price rise.
Liquidity risk
In general, bonds aren't nearly as liquid as stocks because investors tend to buy and hold
bonds rather than trade them. While there is always a ready market for super-safe Treasuries,
the markets for other bonds, especially junk bonds, can be highly illiquid. If you are forced
to unload a thinly-traded bond, you will probably get a low price.
Market risk
As with most other investments, bonds follow the laws of supply and demand. The more
popular or less plentiful a bond, the higher the price it commands in the market. During
economic meltdowns in Asia and Russia, for example, the price of safe-haven U.S.
Treasuries rose dramatically.
Question 1: Is it true that the governments Treasuries are totally risk free?
Question 2: How changes in inflation would impact the return from bond investment?
Question 3: Why should an investor read the indenture to make sure the bond has a call
provision? How does it impact the return from bond investment?
Question 4: How does it help the bond issuer to add the callability clause in indenture?
Case Study 3: ACI to raise Tk 130cr in bonds
Sarwar A Choudhury, The dailystar
Advanced Chemical Industries (ACI) Limited has decided to borrow Tk 130 crore through
issuing convertible zero coupon bonds for loan repayment and fresh investment. The
decision came at the company's Board of Directors meeting on Thursday.
A zero coupon bond is a bond bought at a price lower than its face value, but at the time of
maturity the repayment will be an amount that the face value actually means. And
convertible zero coupon bond means that it is convertible into a company's common stock or
share.
The issuance of the bond 'ACI 20% Convertible Zero Coupon Bond', first of its kind, is
however subject to the approval of Securities and Exchange Commission, the company
officials said.
"The prime object of issuing the zero coupon bond is to repay the loan provided by the
existing financiers," said Muallem A Choudhury, executive director (finance and planning)
of ACI.

"The rest of the borrowed money, if there is any, will be injected to the company's business
as fresh investment," he added.
Maturity period of the bond is five years with yearly redemption. It means 20 percent value
of the bond will be repaid to the investors in each year with a 10.5 percent discount rate.
Of the yearly repaying amount, 20 percent will be converted into ACI shares.
Along with the discount or interest, the investors, excluding banks and insurance companies,
will also get tax exemption on the income from the zero coupon bond.
The bond will be traded in Dhaka and Chittagong stock exchanges, which is also subject to
the approval of the authorities.
The trading of the debt instrument will help the capital market in activating the bond market,
as the existing one is almost inactive.
The bond will be issued through both private placement and initial public offering. Alliance
Financial Services Ltd is the issue manager of the bond, while Industrial and Infrastructure
Development Finance Co Ltd is the facility manager.
ACI, which has investments in pharmaceuticals, consumer brands and commodity products,
agribusinesses, crop care and public health, livestock and fisheries, fertiliser and seeds
business, posted net profits of Tk 36.25 crore in 2007. The company posted net profits of Tk
17.18 crore as of June 30.
The ACI subsidiaries include ACI Formulations Limited, Apex Leathercrafts Limited, ACI
Salt Limited, ACI Pure Flour Limited, ACI Foods Limited, Consolidated Chemicals
Limited, Premiaflex Plastics Limited, Creative Communications Limited, ACI Motors
Limited and ACI Logistics Limited.
Question 1: What is a zero coupon bond?
Question 2: What is convertible bond? How would ACI convert this ACI 20% convertible
bond?
Question 3: How would ACI use the money raised from the issuance of bond?
Question 4: What factors should an investor keep an eye once he/she bought this ACI bond?
Case Study 4: Bond market in Bangladesh- problems and prospects.
Bond is a long term debt instrument which is mostly backed up by either assets or goodwill.
This long-term debt market plays a complementary role in developing economy through
allocation of funds to the different deficit sectors. The debt market consists of money
market, mortgage market, bond market and derivative market. Unfortunately, the corporate
bond market of Bangladesh is quite small. Bond market in Bangladesh is dominated by
treasury debt securities which is almost risk free and used by the government of Bangladesh
to finance the budget deficit. Like in any other country, a well-developed tradable private
bond market is critical to ensuring stability and efficiency of the financial market in
Bangladesh. An efficient bond market is also important for managing public debt and bank
liquidity and for efficient conduct of the monetary policy.
The bond market in Bangladesh is characterized by low base market, very few market
participants, non-diversified products, lack of tailor-made financial instruments etc. There is
a lack of quality bond issuers, very little interest for individual investors to buy corporate
bonds and almost non-existence of intermediaries who could be a market player.

Bond markets in most countries have been built on the same basic elements: a number of
issuers with long term financing needs, investors with a need to place savings or other liquid
funds in interest bearing securities, and intermediaries that bring together investors and
issuers, and an infrastructure that provide a conducive environment for transaction of
securities, ensures legal title to securities and settlement of transactions and provides price
discovery information. The regulatory regime provides the basic framework for bond
market. Developing bond market can be more complicated than developing equity market.
This need supporting pricing infrastructure and more sophisticated market participants.
Bond Market acts as buffer of equity market. This enables issuers and investors to convert
the limitations of equity market into the opportunities. Financial system to be sound and
effective has to have an efficient bond market. Otherwise, Capital Market especially cannot
play its due role for developing economy through allocation of capital; and generating
employment opportunities through industrialization of economy of the country.
Developing bond market can be attributed to the following reasons (IOSC, 2002):
a) An alternative source of domestic debt finance;
b)
Lower cost of capital;
c)
Reduced risks associated with maturity and currency mismatch;
d) Broadening of capital markets;
e)
Efficient pricing of credit risk; and
f)
Ensuring financial stability.
Following policies have been put forwarded for the development of bond market in
Bangladesh:
1. Bangladesh Securities and Exchange Commission (BSEC) can deregulate the existing
laws and promulgate new laws for creating congenial regulatory environment for the
development of bond market in the country.
2. Establishment of Dhaka Inter-bank Offered Rate (DIBOR) like London Inter-bank
Offered Rate (LIBOR) is one step ahead for the developing of bond market. This has to give
a fair opportunity for establishment of long term yield curve which is pre-condition for that.
3. BSEC (Bangladesh Stock Exchange Commission) can undertake both education and
training program for the market participants which will create awareness among the market
participants.
4. The Government has to offer some fiscal benefits like it does for FDIs for the
development of bond market in Bangladesh.
5. The government should stop issuing securities offering interest rate higher than market
yield rate.
6. Government should encourage state owned enterprises for raising funds by issuing
corporate bond from the market.
Question 1: How does issuing bonds benefit the bond issuers?
Question 2: What are some of the problems exists in bond market of Bangladesh?
Question 3: What could be done for the development of bond market in Bangladesh?
Question 4: How would a vibrant corporate bond market help the Bangladesh economy?

True/False
1. A bond's payment at the maturity is referred to as its face value.
2. When the market interest rate exceeds the coupon rate, bonds sell for less than face value
to provide enough compensation to investors.
3. Current yield overstates the return of premium bonds since investors who buy a bond at a
premium face a capital loss over the life of the bond.
4. A bond's rate of return is equal to its coupon payment divided by the price paid for the
bond.
5. Bonds selling at a premium price offer a higher current yield (which overstates the true
return) than bonds selling at par value.
6. The current yield measures the bond's total rate of return.
7. Zero-coupon bonds are issued at prices considerably below face value, and the investor's
return comes from the difference between the purchase price and the payment of face value
at maturity.
8. If the appropriate rate of interest on a bond is greater than its coupon rate, the market
value of that bond will be above par value.
9. There is a direct relationship between bond ratings and the required rate of return on
bonds; that is, the higher the rating, the higher is the required rate of return.
10. A bond holder is the owner of the company.
11. A legal document that has all the terms and conditions of a bond is called indenture.
12. A zero coupon bond always sells at discount and will be redeemed at face value.
13. Bond ratings measure the bond's credit risk.
14. If the current yield is above the coupon rate, the bond is selling at a premium.
15. In bond valuation, the appropriate discount rate is the required yield.
16. The higher the discount rate used in bond valuation, the higher the bonds intrinsic value.
17. When interest rates go up, the price of bonds go up as well.
MULTIPLE CHOICE QUESTIONS:
1. The coupon rate of a bond equals:
A) its yield to maturity.
B) a percentage of its face value.
C) the maturity value.
D) a percentage of its price.
2. Periodic receipts of interest by the bondholder are known as:
A) the coupon rate
C) the default premium
B) a zero-coupon
D) coupon payments
3. Which of the following presents the correct relationship? As the coupon rate of a bond
increases, the bond's:

A) face value increases.


B) interest payments increase.

C) current price decreases.


D) maturity date is extended

4. What happens when a bond's expected cash flows are discounted at a rate lower than the
bond's coupon rate?
A) The price of the bond increases.
B) The coupon rate of the bond increases.
C) The par value of the bond decreases.
D) The coupon payments will be adjusted to the new discount rate.
5. A __________ bond is a bond where the bondholder has the right to cash in the bond
before maturity at a specific price after a specific date.
A) callable
B) coupon
C) puttable
D) treasury
6. Everything else equal the __________ the maturity of a bond and the __________ the
coupon the greater the sensitivity of the bond's price to interest rate changes.
A) longer; higher
C) shorter; higher
B) longer; lower
D) shorter; lower
7. A coupon bond which pays interest of 60 taka annually, has a par value of 1,000 taka,
matures in 5 years, and is selling today at a 75.25 taka discount from par value. The
current yield on this bond is _________.
A) 6.00%
B) 6.49%
C) 6.73%
D) 7.00%
8. A coupon bond which pays interest of 4% annually, has a par value of 1,000 taka,
matures in 5 years, and is selling today at 785 taka. The approximate yield to maturity on
this bond is _________.
A) 7.2%
B) 8.8%
C) 9.1%
D) 9.6%
9. A callable bond pays annual interest of 60 taka, has a par value of 1,000 taka, matures in
20 years but is callable in 10 years at a price of 1,100 taka, and has a value today of
1055.84 taka. The approximate yield to call on this bond is _________.
A) 6.00%
B) 6.58%
C) 8.00%
D) 7.20%
10. Consider a 7-year bond with a 9% coupon and a yield to maturity of 12%. If interest
rates remain constant, one year from now the price of this bond will be _________.
A) higher
B) lower
C) the same
D) indeterminate
11. The ___________ is the document defining the contract between the bond issuer and the
bondholder.
A) indenture
B) covenant
C) trustee
D) collateral
12. If you are holding a premium bond you must expect a _______ each year until maturity.
If you are holding a discount bond you must expect a _______ each year until maturity.
A) capital gain; capital loss
C) capital loss; capital gain
B) capital gain; capital gain
D) capital loss; capital loss
13. Which of the following statements is correct for a 10% coupon bond that has a current
yield of 7%?
A) The face value of the bond has decreased.

B) The bond's maturity value exceeds the bond's price.


C) The bond's internal rate of return is 7%.
D) The bond's maturity value is lower than the bond's price.
14. A bond's yield to maturity takes into consideration:
A) current yield but not price changes of a bond.
B) price changes but not current yield of a bond.
C) both current yield and price changes of a bond.
D) neither current yield nor price changes of a bond.
15. A debenture is _________.
A) secured by other securities held by the firm
B) secured by equipment owned by the firm
C) secured by property owned by the firm
D) unsecured.
16. The discount rate that makes the present value of a bond's payments equal to its price is
termed the:
A) rate of return.
C) yield to maturity.
B) current yield.
D) coupon rate.
17. What is the coupon rate for a bond with three years until maturity, a price of 1,053.46
taka, and a yield to maturity of 6%?
A) 6%
B) 8%
C) 10%
D) 11%
18. What is the yield to maturity for a bond paying 100 taka annually that has six years until
maturity and sells for 1,000 taka?
A) 6%
B) 8%
C) 10%
D)11%
19. Which of the following factors will change when interest rates change?
A) The expected cash flows from a bond
B) The present value of a bond's payments
C) The coupon payment of a bond
D) The maturity value of a bond.
20. What happens to the coupon rate of a bond that pays 80 taka annually in interest if
interest rates change from 9% to 10%?
A) The coupon rate increases to 10%.
B) The coupon rate remains at 9%.
C) The coupon rate remains at 8%.
D) The coupon rate decreases to 8%.
21. Which of the following is fixed (e.g., cannot change) for the life of a given bond?
A) Current price.
B) Current yield
C) Yield to maturity. D) Coupon rate
22. What is the rate of return for an investor who pays 1,054.47 taka for a three-year bond
with a 7% coupon and sells the bond one year later for 1,037.19 taka?
A) 5%
B) 5.33%
C) 6.46%
D) 7%

23. The __________ of a bond is computed as the ratio of coupon payments to market
price.
A) nominal yield
B) current yield
C) yield to maturity D) yield to call
24. A bond has a par value of Tk.1,000, a time to maturity of 10 years, and a coupon rate of
8% with interest paid annually. If the current market price is Tk.750, what is the
approximate capital gain yield of this bond over the next year?
A) 0.7%
B) 1.8%
C) 2.5%
D) 3.4%
25. A bond is selling at a discount if the:
A) yield-to-maturity is greater than the coupon rate.
B) yield-to-maturity is less than the coupon rate.
C) market price is greater than the par value.
D) yield-to-call is less than the coupon rate.
26. All other factors constant, the -------------- of a bond, the shorter the duration.
A) longer the term
C) higher the risk
B) higher the coupon rate
D) higher the rating
27. Duration can be used to:
A) minimize default risk
B) minimize reinvestment risk.
C) minimize interest rate risk.
D) maximize return.
28. The YTM calculation assumes:
A) reinvestment of interest is at the coupon rate.
B) no reinvestment of interest.
C) reinvestment of interest is at YTM rate.
D) reinvestment of interest is at the risk-free rate.
29. Convexity is important in bond analysis because
A) the price-yield relationship is imprecise.
B) the relationship between bond maturity and interest rate changes is convex.
C) the relationship between bond price changes and duration is an approximation.
D) bonds have a convex relationship with duration.

SHORT QUESTIONS:
1.
2.
3.
4.
5.
6.

What is a bond? How it is different from equity? What are the four types of bonds?
Why isnt Bangladesh governments treasure bonds not necessarily risk-free?
Define consol and zero coupon bonds.
Why there is a interest rate risk in bond investment, when coupon amounts are fixed?
Why do bond prices and yield to maturity vary inversely?
If there are two bonds which matures in 10 years. One has 12% coupon and the other has
8% coupon but both has the same yield to maturity. Which bond should you buy and
why?

7. How do you think the value of a bond would change with


a) Increasing face value
b) Increasing coupon rate
c) Increasing the periodicity of coupon
d) Increasing the term to maturity.
8. What is the difference between yield to maturity and yield to call?
9. Define convertable bonds like ACI 20% convertable bonds, putable bonds, income bonds,
indexed bonds, Brac epl bonds, and mudaraba islamic bond.
10. Describe how the annual bond valuation formula is changed to evaluate semi-annual
coupon bonds. Then write out the revised formula.
11. Why does the coupon rate affect the volatility of bond price?
12. To which type of risk are holders of long-term bonds?
13. How does value of a bond change as it nears its maturity?
14. What factors may aafect the bond ratings?
15. Why are bond ratings important both to firms and to investors?
16. What is duration of a bond?
BROAD QUESTIONS:
1. A 6 year bond with par value 1000 taka has a current yield 7.5 percent and a coupon rate
of 8 percent. What is the bonds price?
2. A 6 year bond with 1000 taka par value pays 80 taka interest annually and sells for 950
taka. What is the coupon rate, current yield and yield to maturity?
3. A firm sells bonds with a par value of 1000 taka, carry a 8% coupon rate, with a maturity
period of 9 years. The bond sells at a yield to maturity of 9%.
a. What is the interest payment you should receive each year?
b. What is the selling price of the bond?
c. What will happen to the bond price, if the yield to maturity falls to 7%?
4. What is the duration of a bond? What is the convexity of a bond?
5. Contrast the current yield calculation and the calculation of yield to maturity in terms of
their usefulness to investors in decision-making.
6. Bangladesh bank issues a 10 year treasury bond at 12% coupon with the par value of
1000 taka. If the market yield increases shortly afterwards, what happens to the following
parameters:
a) coupon rate b) price c) current yield d) yield to maturity.
7. Why is a call provision advantages to a bond issuer? When will the issuer initiate a
refunding call? Why?
8. ABC corporation has issued 12 percent annual coupon 1000 taka par value bonds
maturing in 10 years. What should be the current price of this bond if the interest rate is 15
percent?
9. ABC corporation has issued 14% coupon bond with a par value of 1000 taka which
matures in 20 years. The bond is callable in 5 years at 1140 taka. This bond currently sells
for 1050 taka.
a. What is the current yield?
b. Yield to call
c. Yield to maturity

10. Vermex bonds currently sell for 975 taka which has got 7 years maturity with a 12
percent annual coupon and have a per value of 1000 taka. What is their YTM? What is their
current yield.
11. Why is the yield to call a more appropriate measure to use for callable bonds with high
coupons rather than the yield to maturity?
12. Calculate the present value of 6 year bond with a par value of 1000 taka and having 9%
coupon rate if the current interest rate is 12%?
13. The interest rate increases from 10% to 12% suddenly. Find the present values of the two
bonds given below both before and after the change.
a) Both the bonds have same coupon rate of 11%.
b) Bond 1 has a maturity of 5 years and bond 2 has a maturity of 15 years.
(Note: 5 year bond sells at 1012 taka before the increase in interest rate. Now after the rise in
interest rate it is trading at 940 taka. Decrease is 7.11%. On the other hand, the 15 year bond
sells at 1060 before the rise in inters rate and now after the change in interest rate it is
trading at 720 taka. There is a fall of almost 32% decrease in price.
14. Terreta corporation 1000 taka par value bonds currently sell for 1250 taka. These bonds
can be called five years at a call price of 1120 taka and pay an annual coupon of 120 taka.
What is their yield to call?
15. Identify one way to minimize both interest rate and reinvestment rate risk for an investor
with a fixed investment horizon.
16. What is bond rating? Why is it so important for both bond issuers and bond investors?
What factors are looked upon by the credit rating agencies in grading a bond?