BOND PRICES AND YIELDS

Bond Characteristics
■A bond or debenture is a debt instrument issued by the government or a
government agency or a business enterprise.
• It is described in terms of:
• Par value
• Coupon rate
• Maturity date
• Government bonds are also called government securities (G-secs)
or gilt-edged securities. These are generally medium to long-term
bonds issued by RBI on behalf of the government of India and state
governments.
• Corporate bonds or corporate debentures are debt instruments
issued by companies
 Types Of Bonds

• Straight bonds: bond that pays interest at regular intervals, and at maturity pays back the

principal that was originally invested. A straight bond has no special features compared to

other bonds with embedded options.

• Zero coupon bonds: A zero coupon bond is a bond in which the face value is repaid at the

time of maturity. That definition assumes a positive time value of money. It does not make

periodic interest payments or have so-called coupons, hence the term zero coupon bond.

Zero-coupon bonds trade at deep discounts, offering full face value (par) profits at maturity
• Floating rate bonds: The rate of interest of a floating rate bond is

linked to a benchmark rate and is reset at a regular interval.

Bonds with embedded options: convertible, callable etc.

© 2017 by Prasanna Chandra

 Recall: Why Time Value
A rupee today is more valuable than a rupee a year hence. Why ?
• Preference for current consumption over future consumption
• Productivity of capital
• Inflation
Many financial problems involve cash flows occurring at different
points of time. For evaluating such cash flows, an explicit
consideration of time value of money is required.
Value of a bond?
• Value of a Bond – present value of all cash flows expected from it.
• ?
• Requirements – an estimate of expected cash flows
- An estimate of required return

Assumption?
Coupon interest rate is fixed for the term
coupon payments are made every year end
The bond is redeemed at par on maturity

© 2017 by Prasanna Chandra

 Bond Pricing (Valuation)

n C M
P = Σ +
t=1 (1+r)t (1+r)n

P = C × PVIFAr, n + M × PVIFr, n
Compute the value of a bond, considering a 10-year, 12 per cent
coupon bond with a par value of Rs. 1000. Assume that the required
yield on this bond is 13 per cent.
C= RS.120, M= 1000, r= 13%, n=10
P = 120 x PVIFA10yrs@13% + 1000/(1.13)^10
= 120x5.426 + 294.6
= 945.72

© 2017 by Prasanna Chandra

Compute the value of a bond, considering a 10-year, 12 per cent
coupon bond with a par value of Rs. 1000. Assume that the required
yield on this bond is 13 per cent.
C= RS.120, M= 1000, r= 13%, n=10
= 120x PVIFA (13%, 10) + 1000(1/1.13)^10
= (120x 5.426) + (1000x0.295)
=Rs.946.

© 2017 by Prasanna Chandra

10 annual coupon payments of Rs. 120.
Rs. 1000 principal repayment 10 years from now.
The value of the bond is:
P= 120 × PVIFA13%, 10 yr + 1,000 × PVIF13%, 10yr
120 × 5.426 + 1000 × 0.295
651.1 + 295 = Rs. 946.1

© 2017 by Prasanna Chandra

Bond values with semi-annual interest
the bond valuation equation has to be modified along the following lines:
•The number of years to maturity must be multiplied by two to get the number of
half-yearly periods.
•The discount rate has to be divided by two to get the discount rate applicable to
half-yearly periods.
•The annual interest payment, C, must be divided by 2 to obtain the semi-annual
interest payment.
•With the above modifications, the basic bond valuation becomes:

P =A C/2 (PVIFAr/2, 2n) + M (PVIFr/2, 2n)

•whereP = value of the bond
C/2 = semi-annual interest payment
R/2 = discount rate applicable to a half-year period
M = maturity value
2n = maturity period expressed in terms of half-yearly periods.

© 2017 by Prasanna Chandra

 Bond Pricing (Valuation)

n C M
P = Σ +
t=1 (1+r)t (1+r)n

P = C × PVIFAr, n + M × PVIFr, n

2n C/2 M
P = Σ +
t=1 (1+r/2)t (1+r/2)2n
Consider a 8-year, 12 per cent coupon bond with a par value of Rs. 100
on which interest is payable semi-annually. The required return on this
bond is 14 percent
C/2= 6%= Rs. 6
r/2= 7%=0.07
2n= 16.
P = 6 x PVIFA (7%,16) +100/(1.07)^16

© 2017 by Prasanna Chandra

Solution.

the value of the bond is:

6 (PVIFA7%, 16 yr) + 100 (PVIF7%, 16 yr)
Rs. 6 (9.447) + Rs. 100 (0.338) = Rs. 90.5.

© 2017 by Prasanna Chandra

 Bond Pricing
A Rs.600 face value bond carries a coupon rate of 12 percent p.a.
payable semi-annually. The bond is redeemable at par after 5 years.
If investors require a return of 9% per half-year period, what will be
the price of the bond.
C=72, C/2= 36
2n=10
r= 9%(semiannual)
P = 36xPVIFA(10, 9%) +600/(1.09)10
 Bond Pricing
A Rs.600 face value bond carries a coupon rate of 12 percent p.a.
payable semi-annually. The bond is redeemable at par after 5 years.
If investors require a return of 9% per half-year period, what will be
the price of the bond.
© 2017 by Prasanna Chandra
 Bond Pricing
A Rs.600 face value bond carries a coupon rate of 12 percent p.a.
payable semi-annually. The bond is redeemable at par after 5 years.
If investors require a return of 9% per half-year period, what will be
the price of the bond.

10 36 600
P0= Σ +
t=1 (1.09)t (1.09)10
= 36 x 6.418 + 600 x 0.422 = Rs. 484.25
Arvind considers Rs. 1000 par value bond bearing a coupon
rate of 11% that matures after 5 years. He wants a
minimum yield to maturity of 15%. The bond is currently
sold at Rs. 870. Should he buy the bond ?

C=110,N=5 , R=15%
solution
P0 = 110 (PVIFA 15%, 5 years) + 1000 (PVIF/15%, 5 yrs)
110 (3.352) + 1000 (0.497)
368.7 + 497 = 865.7.

At Arvind’s anticipated minimum yield of 15% the price should be Rs.

865.70 but the market price is higher. Hence, he should not buy.

© 2017 by Prasanna Chandra

Anand owns Rs. 1,000 face value bond with five years to
maturity. The bond has an annual coupon of Rs. 75. The
bond is currently priced at Rs. 970. Given an appropriate
discount rate of 10%, should Anand hold or sell the bond?

© 2017 by Prasanna Chandra

P0 = Coupon (PVIFA k, n) + Principal amount (PVIF k, n)
75 (PVIFA 10%, 5 yrs) + 1000 (PVIF 10%, 5 yrs)
75 × 3.7908 + 1000 (0.6209)
Rs. 284.31 + 620.9
Rs. 905.21.
The market price Rs. 970 is higher than the estimated price Rs. 905.2.
It is better for Anand to sell the bond.

© 2017 by Prasanna Chandra

Relationship between coupon rate, req.
rate and Price /interest rate risk
The risk that arises for the bond owner from fluctuating
interest rates is called interest rate risk.
It depends on
1. Time to maturity
2. coupon rate
The basic property of bond is that it varies inversely with
yield
Reason?

© 2017 by Prasanna Chandra

Illustration

A firm issues a bond three years ago carrying a coupon rate of 14% for rs.1000 (par).
Original maturity was 10yrs, calculate the bond value , if
A) interest rate falls to 10%
B) interest rate increases to 18%
Case 1
M=1000,C= 140, r= 14%, n=10yrs
p = 140xPVIFA(14%,10yrs) + 1000(pvif @14%, 10yrs)
= ( 140x 5.2161) + 1000(0.2697) = 999.95 =Rs1000
Case 2 : r=10%, C=140, Fv=1000, n=7 yrs
= (140x 4.868) + 1000(0.513) = 1194.6
Case 3 : M=1000,C= 140, r= 18%, n=7yrs
(140x 3.812) +1000(0.314) = 847.

© 2017 by Prasanna Chandra

Illustration

A firm issues a bond three years ago carrying a coupon rate of 14% for
rs.1000 (par). Original maturity was 10yrs, calculate the bond value , if
A) interest rate falls to 10%
B) interest rate increases to 18%
Case 1
M=1000,C= 140, r= 14%, n=10yrs ( cse2 – r = 10%, n=7yrs) = 1194.7
( case 3 - r = 18%, n= 7 yrs)= 847.4
P = Cx PVIFA(10yrs,14%) + 1000(1.14)^10
= 140X5.216 + 1000X 0.269
= 730.256 + 269 = 999.99 = 1000

© 2017 by Prasanna Chandra

 Price-Yield Relationship

Price Premium

Par Discount

0 10 14 18 Yield
 Price-Yield Relationship
Price

Yield
 Bond Yields
• Current Yield
Annual interest
Price
• Yield To Maturity
C C C M
P = + + …. +
(1+r) (1+r)2 (1+r)n (1+r)n

• Yield to Call
n* C M*
P = Σ +
t=1 (1+r)t (1+r)n
Current yield
10 year bond, Coupon rate is 12%, par value = Rs.1000 is selling at
Rs.950…

Current Yield =

( only coupon, Premium and discount purchases….TVM)

© 2017 by Prasanna Chandra

YTM
Given : Rs.1000 par value bond
Coupon: 9%, maturity=8 years, Selling price = 800

= 90x PVIFA(12%,8yrs) + 1000(PVIF @8yrs,12%)

= 90x4.96 =1000x.4038
=851
800=851
R=13%.......
P = 808.,…….R= 14 , p= 768.

© 2017 by Prasanna Chandra

YTM
Given : Rs.1000 par value bond
Coupon: 9%, maturity=8 years, Selling price = 800
P= 90x PVIFA (12%,8yrs) + 1000(PVIF @12%,8years)
=(90 x4.967) + 1000(0.4039)
= 851/
@13%,
= 90 x4.7988 + 1000x 0.3762 = 808
@ 14%
=( 90x 4.638 ) + 1000x0.351 = 768

© 2017 by Prasanna Chandra

@ 12%
90x4.968 + 1000(0.404) = Rs.851

@ 13%, 808

@14%
90x 4.639 + 1000(0.351) =768.1

© 2017 by Prasanna Chandra

 formula

Lower difference between PV of CF@LDF

discount Higher Lower
and Bond Price
discount – discount
+ rate rate
rate(LDF)difference between PV of CF @
at the lower and the higher
discount rates
 Bond Yields
C + (M - P) / n
YTM ≃
0.4M + 0.6 P
 YTM
• Someone who invests in a coupon - paying bond will earn
the YTM promised on the purchase date if and only if all of the
following three conditions are fulfilled.
• The bond is held until it matures rather than being sold at
a price which differs from its face value before its maturity
• The bond does not default
• All cash flows are re-invested at an interest rate equal to the
promised YTM
 Risks In Bond Investment
• Interest rate risk Interest Bond
(market risk) Rate Price
• Reinvestment Interest rate on
Risk Interim cash flow
• Default risk Issuer may default
(credit risk)
• Inflation risk Purchasing power risk
• Call risk Issuer may recall the bonds
• Exchange rate risk A non-rupee
denominated bond
• Liquidity risk Marketability risk
• Event risk Issuer’s ability.. Change..
Unexpectedly
(a) a natural accident or
(b) .. corp. Restr’g