BONDS

Topic common for FMI & Wealth management

as per syllabus

Coupon rate
Be it, for any maturity period, the interest rate offered to the investor and which is known to the investor at the beginning of the period is known as coupon rate The coupon rate on a bond instrument is the annual cash flow that the bond issuer promises to pay to the bond holder

Required Rate of Return (rrr) {Minimum required rate of return} To calculate the Fair Present Value (FPV) of the instrument, an investor would consider time value of money. Risk involved in the instrument is also considered The interest rate used to find the FPV of a financial security is called as Required Rate of Return (rrr)

Calculating FPV

FPV = CF1 + CF2 + CF3

(1 + rrr) (1+rrr)
2

+
3

CFn
(1+rrr)

(1+rrr)

Rrr = Required Rate of Return CF = Cash Flow N = period

Fair Present Value (FPV): Interpretation Investors compare Fair Present Value of the security with the current market price
If current market price (200) < calculated FPV (250), Security is under valued Investor would buy more of the security If current market price (300) > calculated FPV (250), Security is over valued Investors would not buy this security

Application..
A bond you purchased 2 years ago for $ 890 is now selling at $ 925
You intend to hold it for 4 more years . You will be able to sell it at $ 960 at the end of 4 years. The bond will continue to pay $ 100 as interest per year If the required rate of return over the next 4 years is 11.25 %, calculate Fair Present value of the bond and comment.

Calculating FPV
FPV = CF1 + CF2 + CF3
(1 + rrr) FPV = 100 + (1+0.1125) FPV = $ 935.31 CMP = $925 The bond is undervalued. The investor would therefore make a purchase decision (1+rrr)
2

+
3

CFn
(1+rrr) n 100+960 4 (1+0.1125)

(1+rrr)

100 + (1+0.1125) 2

100 + 3 (1+0.1125)

Expected Rate of Return (Err)

The interest rate that an investor would earn by buying the security at its CMP and selling the security at the end of the maturity is called as Err Err is based on current market price and not on FPV This is also based on Time value of money It can be termed as discount rate which makes projected cash flow equal to current market price

Expected Rate of Return (Err)

CMP = CF1 + CF2 + CF3 + CFn 2 (1+Err) 3 (1+Err) 4 (1 + Err) (1+Err) CMP = Current Market Price Err = Expected Rate of Return CF = Cash Flow N = period

Expected Rate of Return (Interpretation)

Once Err is calculated, investor would compare Err with Required rate of return If Err > rrr :
It means cash flow from the investment is higher than the required cash flow to compensate the risk Investor would want to buy more of this security

If Err < rrr :

It means that cash flows from the investment is not sufficient to meet the required cash flow to compensate for the risk Investors

Err - Application
A bond you purchased 2 years ago for $ 890 is now selling at $ 925
You intend to hold it for 4 more years . You will be able to sell it at $ 960 at the end of 4 years. The bond will continue to pay $ 100 as interest per year If the required rate of return over the next 4 years is 11.25 %, calculate Fair Present value of the bond and comment.

Expected Rate of Return (Err)

CMP = CF1 + CF2 + CF3 + CFn (1 + Err) (1+Err)2 (1+Err) 3 (1+Err) 4 CF = Cash Flow N = period 925 = 100 + 100 + 100 + 100 (1+Err) (1+Err) 2 (1+Err) 3 (1+Err)4 11.6%

Realized Rate of Return

The realized rate of return on a security is the interest rate actually earned on the security It is the historical interest rate of return

Relationship between Bond price & Interest rate

Lets Discuss ! Is it directly related? Or Inversely related?

Gist
Based on time value of money Fair value of a bond (what can be paid Vs What is the CMP) rrr (minimum required rate of return)

Bond - Types
Government Bonds
Also called G-Secs or Gilt edged securities Medium to long term bonds issued by RBI on behalf of GOI Interests: annually or semi annually Issues by central government and state governments

Bond - Types
Corporate Bonds
Straight Bonds: Plain Vanila bonds Most popular type of bond It pays fixed periodic interest (coupon) over its life & returns the principal on maturity date Zero Coupon Bonds: - Does not carry any regular interest payment - It is issued at a deep discount over its face value & redeemed at face value at maturity

Bond - Types
Floating rate Bonds: - Interest rate is not fixed unlike straight bonds - Interest rate is linked to a benchmark rate such as treasury bill interest rate Bonds with Embedded Option: Options may be embedded with the bond; for example:
Convertible Bonds: Gives bond holders the right to convert them into equity shares Callable Bonds: Gives the issuer of the bond, a right to redeem prior to maturity on certain terms Puttable bonds: Gives the investor a right to prematurely sell them to the issuer on certain terms Commodity Linked Bonds: Payoffs are linked to the extent of price of a certain commodity

Topics to be covered in next class

Calculation of yield to maturity Premium Bonds, Discount Bonds, Par Bonds Relationship between Bond price & Time Determinants of interest rate of bonds Bond duration