Investment Management and Capital Markets

Lecture 4: Yield Curve and Bond Valuation
Definitions Yield Curve Bond Valuation The term structure

A Bond is an instrument which pays fixed amounts (usually) of interest (called a coupon) on a regular basis, over its life and is redeemed at par value (usually) at maturity, by the issuer .
C1 C2 C3 C4 C5 Ct R

0 P

1

2

3

4

5

t

t year coupon paying bond

As the cash flows on a fixed coupon paying bond are fixed in time, the market price (present value) of such an instrument varies according to the interest rate environment. Money market securities have a maturity of < 1 year; Capital market securities have a maturity of > 1 year.

Types of Bonds The interest payment on bonds is referred to as `coupon’ and is fixed on the face value of the bond at the time of issue. Coupon payments are semi-annual usually (though you should assume one annual payment unless otherwise stated in this course.) The most common type of bonds pay fixed interest and such bonds are called straights or vanillas.coupon Some bonds do not pay any interest at all , and such bonds are called zero coupon bonds. Zero coupon bonds sell at a deep discount to their par values because all the benefit from holding the bond is realised at maturity. Some Bonds link their coupons to market interest rates and such bonds are called floating rate notes

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Some bonds link their interest payment to the retail price index and such bonds are called index linked bonds. The return on Index linked bonds is closer to `real interest rates.’ Bonds which allow the holder to exercise an option to convert into equity are called convertible bonds. Bonds which have no redemption date are called consols, irredeemables or perpetuals. Debentures are bonds secured against some assets. Bonds redeemable at the option of the issuer are `callable’ while bonds redeemable at the option of the holder are `puttable.’ Gilts are Bonds issued by the British Government. Bonds issued by corporates are corporate bonds. Eurobonds are bonds sold internationally in the domestic currency of a country. Strips are securities which result from breaking down a security into various constituents which are sold off seperately. The usual way in which this is done is to sell off each future coupon payment and the redemption amount for its present value. Why are Gilts so much in demand?

Risks The holder of a bond has default risk; ie the risk that the issuer will not honour payments on the bond. It is also called the credit risk. The two main credit rating agencies are Moody’s and Standard and Poor’s. The annexure is a typical extract. Note the distinction between `investment grade’: > Baa, Moody’s or > BBB S&P

`non-investment grade’: < Ba , Moody’s or < BB S&P Bonds with lower credit ratings have a higher default risk and risk premium. Non-investment grade bonds are also known as junk bonds.

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Definitions of various yields terms The Spot rate refers to the yield (IRR) of a `pure discount’ or zero coupon bond of that maturity. R

0 P

1

2

3

4

5

6

6 year zero P = R / (1+ st) t

ie where

st

= t √ ( R/P) - 1

st = spot yield (rate) for period `t’

P = the Market Value of the Bond R = the redemption amount on the bond (amount at maturity) The yield curve is a plot of the spot yields of zero coupon bonds of different maturity. In general, a Bond makes regular payments of interest (coupon) to the holder over a period of time.
R C1 C2 C3 C4 C5 Ct

0

1

2

3

4

5

t

P

t year coupon paying bond

The Market price of a bond is the present value of various payments made by the bond and is arrived at by discounting the various payments on the bond by the related spot rate.
Ie

P

= C1/(1+ s1) + C2/( 1+ s2) 2 + ….. (Ct + R)/ (1+ st) t = Σ Cn/ (1+st)t + R / (1+st)t
Ct = the coupon payment at time `t’

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Redemption yield (also called the `yield to maturity’ or `ytm’ or the `gry’ gross redemption yield) of a bond is the IRR on the bond.

It is the `y’ which satisfies the equation:

P = C1/(1+ y) + C2/( 1+ y) 2 + ….. (Ct + R)/ (1+ y) t = Σ Ct/ (1+y)t + R/ (1+y)t
A strip is a coupon sold on its own. How will it be valued?

The Current Yield or Flat yield of a bond is simply its interest payment divided by its market price. CY = Ct / P

The Forward Rate of interest for the period t+1 is the one period Investment rate between the end of period `t’ and end of period `t+1’. Forward rates are related as below. (1+S1) (1+ 1 F2) = ( 1+ S2) 2 (1+S1) (1+ 1 F2)……….( 1+ t-1 Ft ) = ( 1+ St) t Note alternatively that that the one period forward rate on a bond can be calculated from the spot yield of two adjacent periods: ( 1 + S t) t ---------------( 1 + S t -1) t-1

ie

t-1 Ft

=

- 1

Yield curves The spot yield curve plots the spot yields (or zero coupon yields) against term to maturity. The spot yield curve is also called the Term structure of interest rates. The ytm curve is a plot of the ytms of bonds of the same maturity over time. It is usually obtained by regression. ( You will notice in the tutorial how bonds of the same maturity but different coupons have slightly different ytms based on their cash flows.) Finally, the forward yield curve plots one period forward rates against term to maturity.

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Valuing Bonds. (a) a redeemable bond Q A company has issued bonds redeemable at the end of three years from now, with a coupon of 6.0 % payable annually and redeemable at par. (The par value of a bond is £ 100 unless mentioned otherwise.). The one year, two year and three year spot rates are 6%, 8% and 10% respectively. (i) What will be the market price of this bond? (ii) Calculate the ytm of the bond. Answer: (i) The market value of the bond is the present value of all its payments: Present Value of first Coupon: 6/ (1.06) “” second “ : 6/ (1.08)2 “” third “ : 6/ (1. 10)3 = £ 5.66 = £ 5.14 = £ 4.51

Present value of redemption amount = 100/ (1.10)3 = 75.13 Total (ii) ytm of the bond is the IRR of the bond: Locate the two rates between which the NPV changes sign and interpolate. |At 9%: annuity of £6 for three years = 6 x 2.531 = 15.186 Redemption amount = 100 x 0.772 = 77.200 Total Value = 92.386 PV = 92.386 - 90.44= 1.946 At 10% annuity of £6 for three years = 6 x 2.487 = 14.922 Redemption amount = 100 x 0.751 = 75.100 Total Value = 90.022 PV = 90.022– 90.44 = - 0.418 By interpolation, the IRR is 9 + ( 1.946/2.364) = 9.823 % £ 90.44

(b) irredeemable bonds If you have an irredeemable bond with a 6.0% coupon, and the ytm is 9.823% what will be its value? Value, as a perpetuity = C/y = 6.0/ 0.09823 = £ 61.08.
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Theories of the term structure

The term structure of interest rates shows the relationship between short term and long term spot rates.

According to the expectations hypothesis, the market’s expectations of future interest rates is based on bond yields. Thus the forward interest rate between any periods can be computed from the spot yields of two adjacent periods and the spot yield for the period 0-t could be thought of as constructed from one period forward rates as below: (1+ S 2 ) 2 = ( 1+ S1 )( 1+ 1 F 2 ) ; In general: (1+ S t ) t = ( 1+o F1 )( 1+ 1 F 2 ) ( 1+ 2 F 3) ..... ( 1+ t-1 F t ); St = Spot yield for period 0-t ; = one period forward rate between (t-1) and t. t-1 F t This implies that if a contract is made to roll over one period investments, it is the same as if an investment had been made for the entire period: ie there are no excess profits to be made by following either strategy: ` perfect substitutability’. The theory also states that forward rates are the best indicators of expected future spot rates. The Liquidity preference hypothesis states that investors have a preference for liquidity and therefore they will prefer short term investments as compared to longer term investments. Therefore they are prepared to accept lower rates of interest for the short term. Conversely, borrowers have to pay a premium for longer term investors. Here then a premium term, depending upon the maturity, has to be incorporated to equate the `t’ period spot yield with the yield constructed from one period forward rates. According to the theory the liquidity premium increases with time. Ie (1+ S t ) n = ( 1+o F1 )( 1+ 1 F 2 ) ( 1+ 2 F 3) ..... ( 1+ t-1 F t ) + Tn where `Tn’ is a premium term which increases with the term to maturity.

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The Market Segmentation or preferred habitat theory states that the market is segmented by different participants who have a preference for different maturities: banks at the short end and pension funds at the long end. Supply and demand conditions thus determine the shape of the term structure. This theory explains a `hump’ noticed often in the yield curve, as there is often not much 09demand for n medium term maturities. The effects of inflation could also be kept in mind. A rising yield curve thus implies higher expectations of inflation in the future (also called the Fisher effect). Empirical evidence favours the former two theories: the expectations hypothesis remains the basis of determining what interest rates could be expected to be while liquidity premiums have been noticed from time to time.

Yield curves of different shapes: Y axis - `interest rates’ X axis - `term to maturity’

What are the implications for projects ? - discount rates - sourcing finance

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