9Fixed income securities Bond

characteristics
CHAPTER 9
Spot rates and forward rates, yield curve, theories of term
structure, risk measures: duration, modified duration, convexity
and price value of basis point.

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 Bonds
 Bonds and debentures are terms used
interchangeably .
 Both represent long term fixed income securities .The
cash flow stream (in form of interest and principal)
as well as the time horizon (i.e. the date of maturity)
are well specified and fixed Bond returns can be
calculated in various ways Coupon rate
 Current yield
 Spot interest rate
 Yield to maturity (YTM) Yield to call (YTC)

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 Coupon rate
 It is the nominal rate of interest that is fixed and is
printed on the bond certificate
 It is calculated on the face value of the bond
 It is the rate at which interest is paid by the company
to the bondholder .
 It is payable by the company at periodical intervals of
time till maturity
 A bond has a face value of Rs 1000 with an interest
rate of 12% p.a. It means that Rs 120 will be paid by
the company on an annual basis to the bond holder
till maturity

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 Characteristics of a Bond

 A bond is generally a form of debt which the

investors pay to the issuers for a defined time frame.
 In a layman’s language, bond holders offer credit to
the company issuing the bond.
 Bonds generally have a fixed maturity date.
 All bonds repay the principal amount after the
maturity date; however some bonds do pay the
interest along with the principal to the bond holders.

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 Bond valuation
 Technique for determining the fair value of a particular bond.
 includes calculating the present value of the bond's future interest
payments, also known as its cash flow,
 and the bond's value upon maturity, also known as its face value or 
par value.
 As bond's par value and interest payments are fixed, an investor uses bond
valuation to determine what rate of return is required for an investment in
a particular bond to be worthwhile.

 Bond valuation is only one of the factors investors consider in determining

whether to invest in a particular bond.
 Other important considerations are: the issuing company's
creditworthiness, the bond's price appreciation potential, as determined by
the issuing company's growth prospects; and prevailing market interest
rates and whether they are projected to go up or down in the future. 5
 A bond yield
 is the amount of return an investor realizes on a bond.

 Types of bond yields -- 

 nominal yield which is the interest paid divided by the face value of the bond,
  
 current yield which equals annual earnings of the bond divided by its current 
market price.

 When investors buy bonds, they essentially lend bond issuers money.
 1) In return, bond issuers pay interest on bonds throughout their lifetime and
face value of bonds upon maturity. The money that investors earn is called yield.
 if Investors do not hold bonds to maturity.
 Instead, they may sell them for a higher or lower price to other investors, and if an
investor makes money on the sale of a bond, that is also part of its yield.

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 Yield /Current yield
 Yield : Current yield and YTM
 Current Yield = Coupon/ MP*100

 The current market price of the bond in the secondary market may
differ from its face value (i.e. it may be currently selling at a discount
or at a premium)

 Current yield relates the annual interest receivable on a bond to its

current market price
 It measures the annual return accruing to a bondholder who
purchases the bond from the secondary market and sells it before
maturity presumably at a price at which he bought the bond

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 Yield Example
 A bond has a face value of Rs 1000 and a coupon
rate of 12%. It is currently selling for Rs 800.
 The current yield = 120 * 100/ 800 = 15%
 A bond has a face value of Rs 1000 and a coupon rate
of 8%. It is currently selling for Rs 900.
 The current yield =80/900*100=8.89%
 Current yield > coupon rate : when bond is selling at
a discount
 Current yield < coupon rate : when bond is selling at
a premium

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 Types of Bonds
Fixed(pre decided coupon )
 Bonds with Coupon
Floating (not pre decided)
 Zero Coupon

 Plain Vanilla (pre decided coupon, duration,

Redemption in lump sum/
 Non Plain Vanilla (coupon not same/
redemption in parts )

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 Types of Bond
 Zero coupon bond or Deep discount bond is a
special type of bond which does not pay annual
interest
 bonds are issued at a discount to be redeemed at
par The return comes in form of the difference
between the issue price and the maturity value
 Callable bonds: company can redeem bond at any
time may be,after 3years before maturity of 5
years )

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 Types of Bond

 Put able Bond : Investor can redeem bond at

any time may be after 3 years before maturity
of 5 years
 Perpetual Bond : Like equity ,no maturity of
bonds ,Regular cash flow through coupons
 V= I/K
 K required rate of return

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 Example:

 A zero coupon bond has a face value of Rs

1000 and maturity period of five years. If the
issue price of the bond is Rs 519.37, what is
the spot interest rate?
 It is that rate of interest which makes the PV
of 1000 = 519.37
 519.37 = 1000 (1 + i) 5
 = 0.14 or 14%

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 Yield to maturity (YTM)

 It is the rate of return that an investor is expected

to earn on an annualized basis expressed in %
terms from a bond purchased at the current
market price and held till maturity
 It is the internal rate of return earned on a bond if
held till maturity YTM is that rate of discount (r)
which makes the present value of cash inflows
from the bond (in form of interest and redemption
value) equal to the cash outflow on purchase of the
bond 13
Yield to maturity (YTM)

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 Example
 A bond of face value Rs 1000 and a coupon rate of 15%
is currently available at Rs 900. Five years remain to
maturity and bond is redeemable at par. Calculate YTM.
 MP = 900, fv = 1000 = 15% of Rs 1000 =I
 = 150 = 5 YTM = I + (RV – MP) / N =
 RV + MP) / 2
 150 + (1000 – 900) / 5 = 0.1789
 (1000 + 900) / 2
 or 17.89% Thus actual YTM would lie between 17% and
19%, which can be arrived at through interpolation

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 Yield to call (YTC)
 Some bonds may be redeemable before their full maturity at the option
of the issuer or the investor In such cases, two yields are calculated:
 YTM (assuming that the bond will be redeemed only at the end of full
maturity period)
 YTC (assuming that the bond will be redeemed at a call date before
maturity)
 YTC is computed on the assumption that the bond’s cash inflows are
terminated at the call date with redemption of the bond at the specific
call price
 Thus, YTC is that rate of discount which makes the present value of
cash inflows till call equal to the current market price of the bond
 Same method as YTM would be used except for ‘N’ now being years
remaining to call. YTC > YTM , it would be advantageous to the
investor to exercise the redemption option at the call date If YTM >
YTC , it would be better to hold the bond till final maturity

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Yield to call (YTC) and Yield to
call (YTP)
 YTC yield to call =A bond of face value Rs
1000/-issued at coupon rate of 10% for
5 years
If this bond is callable after 3 years and
redeemable at 5%premium then what will be
YTC ?(Yield to call)
If this bond is put able after 3 years and
redeemable at 5% discount then what will be
YTP ?(Yield to put )
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Yield to call (YTC) and Yield to
call (YTP)
 YTC= I +(FV-P)/n
 (FV+P)/2
 = 100+(1050-900)/3
1050+900/2
Put-able
YTP = 100+(950-900)/3
950+900/2
= 12.61% Investors want to redeem before
maturity so company will agree only when it is
issued at discount @ 5%
 Realized YTM
1.The calculation of YTM assumes that cash flows received through
the life of the bond are being reinvested at a rate equal to YTM .
However, the reinvestment rate may differ over time. In such cases,
Realized YTM is a more appropriate measure

1. A Rs 1000 par value bond carrying a coupon rate of 15% maturing

after 5 years is being considered. The present market price of this
bond is Rs 850. The reinvestment rate applicable to future cash
flows is 16%. Calculate realized YTM.

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1. 0 1 2 3 4 5
2. Investment 850
3. Annual interest 150 150 150 150 150
4. Reinvestment period
5. @ 16% 4 3 2 1 0
6. FV of these CFs 271.5 234 202.5 174 150
7. Maturity value 1000
8. Total FVs = 271.5 + 234 + 202.5 + 174 + 150 + 1000 = 2032 For
calculating Realized YTM,
9. MP (1+r)^ 5 = 2032
10. 850 (1+r) ^5 = 2032
11. r = 0.19 or 19%

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 Bond prices
Intrinsic value of bond is equal to the present values of all future cash flows
discounted at the required rate of return
P 0 = I * PVAF (r%, n) + RV * PVF (r%, n)
where P 0 : Present value of the bond today
I : Annual interest payments
RV : Redemption value
required rate of return n : number of years

1.Example A bond has a face value of Rs 1000 and was issued five years ago at a
coupon rate of 10%. The bond had a maturity period of 10 years. If the current
market interest rate is 14%, what should be the PV of the bond?
2.I = 1000 * 10% = 100
3.n = 5
4.RV = 1000 r = 14%
5.P 0 = I * PVAF (r%, n) + RV * PVF (r%, n) =
6. 100 * PVAF (14%, 5) + 1000 * PVF (14%, 5) = Rs 862.71

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 Example

1. If in the above question, interest is payable semi-annually, what

would be the intrinsic value of the bond?

2. I = 1000 * 10% * ½ = 50
3. n = 5 * 2 = 10
4. RV = 1000
5. r = 14% * ½ = 7%
6. P 0 = I * PVAF (r%, n) + RV * PVF (r%, n)
7. 50 * PVAF (7%, 10) + 1000 * PVF (7%, 10) = Rs 859.48

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 Exercise

1. An investor is considering the purchase of a bond currently selling

for Rs 878.50. The bond has four years to maturity, a face value of
Rs 1000 and a coupon rate of 8%. The appropriate discount rate for
investments of similar risk is 10%. Calculate the YTM of the bond.
Based on the calculation, should the investor purchase the bond?
2. 2 An investor recently purchased a bond with Rs 1000 face value,
10% coupon rate and six years to maturity. The bond makes annual
interest payments. The investor paid Rs 1032.50 for the bond.
3. What is the YTM of the bond.If the bond can be called two years
from now at a price of Rs 1080, what is its YTC?
4. Would such a call be advantageous for the investor?

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1. A company issues a deep discount bond of the face value of Rs
5000 at an issue price of Rs 3550. The maturity period of the bond
is 7 years. Determine the spot interest rate of the bond.

2. A bond of Rs 1000 was issued five years ago at a coupon rate of

6%. The bond had a maturity period of 10 years to be redeemable at
par. The market interest rate currently is 10%. Determine the value
of the bond.

3. A 20 year, 10% coupon rate bond has Rs 1000 face value. The
market rate of interest is 8%. Compute the intrinsic value of this
bond if it has five years remaining to maturity. Assume that interest
is paid 1. annually 2. semi annually 3. quarterly

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 Exercise 6 and notes
1. Rs 1000 par value bond carrying a coupon rate of 10% maturing after 5 years is being
considered. The present market price of this bond is Rs 900. The reinvestment rate applicable
to future cash flows is 12%. Calculate realized YTM.
2. Bond pricing Bonds are issued at a fixed rate of interest payable on the face value which is
referred to as COUPON RATE
3. At the time of issue, coupon rate is representative of the then prevailing market interest rate
4. However, subsequent changes in the market interest rates may have its affect on the bond
prices
5. If market interest rate rises above the coupon rate
6. The existing bonds would start providing lower return Thus becoming unattractive
7. Thus the price of the bond would fall below its face value i.e. the bond would start selling at a
discount If market interest rate falls below the coupon rate
8. The existing bonds would start providing relatively higher return Thus becoming very
attractive
9. Thus the price of the bond would rise above its face value i.e. the bond would start selling at a
premium
10. Long maturity bonds A change in interest rate structure would result in a relatively large price
change in a long maturity bond

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 Bond risks
1. Risk is the possibility of variation in returns
2. The actual returns realized from investing in bond may vary from what was expected on
account of:
3. Default or delay on part of the issuer to pay interest or principal Change in market interest
rates
4. Thus there are two broad sources of risk associated with bonds: Default risk Interest rate risk
5. Default risk :It refers to the possibility that a company may fail to pay the interest or
principal on stipulated dates
6. Poor financial performance of the company may lead to such default Credit rating of debt
securities is a mechanism adopted for assessing the credit risk involved Credit rating process
involves: Qualitative assessment of company’s business and management Quantitative
assessment of company’s financial performance Specific features of the bond being issued
7. Credit rating is an opinion of the credit rating agency regarding the relative ability of issuer
of debt to fulfill the debt obligations in respect of interest and repayment

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 Interest rate risk
 It refers to variation in returns of bond because of a change in market interest rates Interest rate
risk is composed of two risks:

 Reinvestment risk
 Price risk

 Reinvestment risk

 An investor in bonds receives interest annually or semi-annually

 He reinvests it each year at the then prevailing interest rate. Thus interest is earned on the interest
received from the bonds each year
 If the market interest rate moves up, the investor would be able to reinvest the annual interest
received from the bond at a higher rate than expected. Thus he would gain from the reinvestment
activity When the market interest rates moves down, the investor would be able to reinvest the
interest only at a lower rate than expected. Thus he would lose on reinvestment activity

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 Price risk “

 The price of the bond is inversely related to

changes in market interest rate If the market
interest rate moves up, bond price may decline
below its face value. Thus the investor would
suffer a loss while selling the bond
 If the market interest rate goes down, the
existing bonds may start selling at a premium.
Thus the investor would gain from sale of such
bond
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 Interest rate risk When the market interest rate rises Investor can reinvest
the interest at a higher rate, thus gaining from reinvestment
 However the future bond price would decline, thus losing on sale of the
bond
 If the gain on reinvestment > loss on sale of bond: Net Gain
 If the gain on reinvestment < loss on sale of bond: Net loss
 When the market interest rate falls
 Investor can reinvest the interest at a lower rate, thus losing from
reinvestment
 However the future bond price would rise, thus gaining on sale of the bond
 If the loss on reinvestment > gain on sale of bond: Net loss If the loss on
reinvestment < gain on sale of bond: Net gain Thus, reinvestment risk and
price risk are inversely related. Together they constitute interest rate risk

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 Bond duration

1. When considering the reinvestment risk and price risk, loss in one may be exactly
compensated for by the gain in the other, thus completely eliminating the interest
rate risk This particular holding period at which the interest rate risk disappears is
referred to as Bond Duration
2. Bond duration is calculated as the weighted average measure of the bond’s life d
= 1I 1 + 2I 2 + 3I 3 +……………..+ nI n + RV n / P 0 1+k) 1 (1+k) 2 (1+k) 3
(1+k) n
3. A bond with face value of Rs 100 with 12% coupon rate issued 3 years ago is
redeemable after 5 years from now at a premium of 5%. The interest rate
prevailing in the market currently is 14%. Calculate bond duration. d =
386.0402 / 95.7354 = 4.03 years
4. Year Cash flow PVF(14%) PV PV * Year 1 12 0.8772 10.5264 10.5264 2 12
0.7695 9.234 18.468 3 12 0.675 8.1 24.3 4 12 0.5921 7.1052 28.4208 5 12
0.5194 6.2328 31.164 5 105 0.5194 54.537 272.685 95.7354 386.0402
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 Exercise 7
1. A new bond with face value Rs 100 is issued at a coupon rate of 15%
and maturity period of 5 years. It is redeemable at par. Calculate the
bond duration
2. Exercise 8 An investor has a 14% debenture with face value Rs 100
that matures at par in 15 years. The debenture is callable in 5 years at
Rs 114. It is currently selling for Rs 105. Calculate: YTM ,YTC,
Current yield
3.  Exercise 9 A person owns a Rs 1000 face value bond with 5 years to
maturity. The bond makes annual interest payments of Rs 80. The
bond is currently priced at Rs 960. Given that the market interest rate
is 10%, should the investor hold or sell the bond?
 Exercise 10 A bond pays interest annually and sells for Rs 835. It has 6
years remaining to maturity and a par value of Rs 1000. What is the
coupon rate if it is promised a YTM of 12%?

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 A floating rate note, also
known as a floater or FRN
 is a debt instrument with a 
variable interest rate.
 A floating rate note’s interest rate, since it is
not fixed, is tied to a benchmark such as the
Treasury bill rate,
  Floaters are mainly issued by financial
institutions and governments, and they
typically have a two- to five-year 
term to maturity.
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 FRNs

 tend to become more popular when interest rates are

expected to increase.
 Compared to fixed-rate debt instruments, floaters
protect investors against a rise in interest rates.
 This is because interest rates have an inverse
relationship with bond prices, and the market price a
fixed-rate note will drop if interest rates increase. For
this reason, however, FRNs carry lower yields than
fixed notes of the same maturity.
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 What is an 'Inverse Floater'
 An inverse floater is a bond or other type of debt
whose coupon rate has an inverse relationship to a 
benchmark rate.
 An inverse floater adjusts its coupon payment as
the interest rate changes.
 When the interest rate goes up the coupon payment
rate will go down because the interest rate is
deducted from the coupon payment. A higher
interest rate means more is deducted, thus less is
paid to the holder.

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 inverse floater
 You would want to invest in an inverse floater if the
benchmark rate is high and you think the rate will
decrease in the future at a faster rate than the
forwards show. With an inverse floater, as interest
rates fall, the coupon rate rises because less is taken
off. 
One more strategy is to buy an interest rate floater if
the rates are low now and you expect them to stay
low, but the forwards are implying an increase. If
you were correct and the rates do not change, you
will outperform the floating rate note by purchasing
the inverse floating rate note.
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 A floating rate note, also
known as a floater or FRN
 is a debt instrument with a variable interest
rate.
 A floating rate note’s interest rate, since it is
not fixed, is tied to a benchmark such as the
Treasury bill rate,
  Floaters are mainly issued by financial
institutions and governments, and they
typically have a two- to five-year term to
maturity.
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 FRNs

 tend to become more popular when interest rates are

expected to increase.
 Compared to fixed-rate debt instruments, floaters
protect investors against a rise in interest rates.
 This is because interest rates have an inverse
relationship with bond prices, and the market price a
fixed-rate note will drop if interest rates increase. For
this reason, however, FRNs carry lower yields than
fixed notes of the same maturity.
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 Spot Rates

 spot contract, spot transaction,

 is a contract of buying or selling a commodity, security, or
currency for settlement (payment and delivery) on the spot date,
which is normally two business days after the trade date.
 The settlement price (or rate) is called a "spot price" or "spot
rate. "
 For bonds, spot rates are estimated via the bootstrapping
method, which uses prices of the securities currently trading in
market, that is, from the cash or coupon curve.
 The result is the spot curve, which exists for fixed income
securities.

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 Spot interest rate

 Spot interest rate is the return on deep

discount bonds when expressed in % terms on
an annual basis Mathematically it is that rate
of discount which makes the present value of
the single cash inflow to the investor (on
redemption of bond, no interest being payable
annually) equal to the cost of the bond

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 Forward Rates
 Forward contract where contract terms are agreed now but
delivery and payment will occur at a future date.
 The settlement price of a forward contract is called a "forward
price" or "forward rate. "
 Depending on the item being traded, spot prices can indicate
market expectations of future price movements. In other words,
spot rates can be used to calculate forward rates.
 In theory, the difference in spot and forward prices should be
equal to the finance charges, plus any earnings due to the holder
of the security, according to the cost of carry model. For example,
on a share, the difference in price between the spot and forward is
usually accounted for almost entirely by any dividends payable in
the period minus the interest payable on the purchase price.

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 bootstrapping

 Method for constructing a (zero-coupon) fixed-

income yield curve
 from the prices of a set of coupon-bearing products
(e.g., bonds and swaps)
 Using these zero-coupon products, it becomes
possible to derive par swap rates (forward and spot)
for all maturities by making a few assumptions
 The term structure of spot returns is recovered from
the bond yields by solving for them recursively, by
forward substitution. This iterative process is called
the Bootstrap Method.
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