Bond Market

Session 2

Making money: Interest and capital gains

There are two ways to make money from a bond – either by earning interest or capital gains.
Let's say that you have a Rs 1,000 bond that pays 6% interest for five years. If you hold that
bond until the very end of this term (known as the maturity date), you’ll collect five interest
payments of Rs 60 for a total of Rs 300.
Principal amount Rs 1000.00 Year 1 (6% interest on 1,000) 60.00 Year 2 (6% interest on
1,000) 60.00 Year 3 (6% interest on 1,000) 60.00 Year 4 (6% interest on 1,000) 60.00 Year 5
(6% interest on 1,000) 60.00 Total principal and interest (at maturity date of 5 years) 1,300.00

•You could also decide to sell that bond to someone else for $1,100. In that case you’d earn a
capital gain of $100 (plus whatever interest payments you had received in the meantime).
•Now, why would someone pay you $1,100 for a bond that only cost you $1,000?

Selling bonds
•Your $1,000 bond pays 6% interest. Since you bought that bond, however, interest rates have
gone down. Similar companies are now only offering a 5% interest rate on their bonds. Your
original rate looks pretty good to another investor. So you can sell that 6% bond at a higher
cost than you paid for it, which is called selling for a premium. •However, if interest rates
have gone up, and similar companies are now offering 8%, you may have to sell your bond
for less – which is known as selling at a discount. •Interest rates and bond prices, then, are
like a seesaw – when interest rates go down, bond prices go

Bond Issuers
ν Government Bonds ν Municipal Bonds ν Corporate Bonds ν International Bonds

Eurobond ν Foreign bonds ν Global Bonds

ν

Bonds terminology
ν Issuer

A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending
money to a government, municipality, corporation, federal agency or other entity known as
the issuer. ν Par Value ν It is the value stated on the face of the bond. ν It represents the
amount the firm borrows and promises to repay at the time of the maturity. ν It is also
known as the principal, face value, or par value. ν Par value will vary depending on the type
of bond. Most corporate bonds have a Rs 100 face value, sometimes it can be Rs 1000. ν It is
important to remember that bonds are not always sold at par value. In the secondary market, a
bond's price fluctuates with interest rates. If interest rates are higher than the coupon rate on a
bond, the bond will have to be sold below par value (at a
ν

ν Maturity
ν

ν
ν

Maturity is the length of time before the principal is returned on a bond. It is also called term-
to-maturity. At the time of maturity, the issuer is no longer obligated to make interest
payments. Maturities range significantly, from 1 year to 40+ years for some corporate bonds.
The bonds of different maturities will behave somewhat differently. For example, bonds with
long-term maturities will be more sensitive to changes in interest rates. Shorter term bonds are
more stable and, because you are more likely to hold it to maturity, are more predictable.
There are some circumstances where a bond will be "called" before maturity.
Short-term notes: maturities of up to 4 years; Medium-term notes/bonds: maturities of five to
12 years; Long-term bonds: maturities of 12 or more years.

ν Coupon
ν ν

The coupon rate is the interest rate that is paid out to the bond holder. The name derives from
the old system of payment, in which bond holders would need to send in coupons in order to
receive payment. The coupon is set when the bond is issued and is usually expressed as an
annual percentage of the par value of the bond. Payments usually occur every six months, but
this can vary. If there is a 5% coupon on a Rs 1000 face value bond, the bondholder will
receive Rs 50 every year. If two bonds with equal maturities and face values pay out different
coupons, the prices of these bonds will behave differently in the secondary market. For
example, the bond with a lower coupon rate will be less expensive because the bondholder is
going to be getting more of his/her return from the return of principal at maturity than will the
holder of a bond with a higher coupon. There are some bonds that do not pay out any
coupons; these are called zero-coupon bonds .

CREDIT RATINGS
ν

Each of the agencies assigns its ratings based on an in-depth analysis of the issuer's financial
condition and management, economic and debt characteristics, and the specific revenue
sources securing the bond.

Credit Ratings
Credit Risk
Prime Excellent Upper Medium Lower Medium Speculative Very Speculative Default
Moody's
Aaa Aa A Baa Ba B, Caa Ca, C

Standard and Poor's

AAA AA A BBB BB B, CCC, CC D

Fitch
AAA AA A BBB BB B, CCC, CC, C DDD, DD, D

Types of Bonds
I. Classification on the basis of Variability of Coupon ν Zero Coupon Bonds
ν

Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the
principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and
hence, there are no cash inflows in zero coupon bonds. The difference between issue price
(discounted price) and redeemable price (face value) itself acts as interest to holders. The
issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the
maturity period lesser would be the issue price and vice-versa. These types of bonds are also
known as Deep Discount Bonds.

Floating Rate Bonds ν In some bonds, fixed coupon rate to be provided to the holders is not
specified. Instead, the coupon rate keeps fluctuating from time to time, with reference to a
benchmark rate. Such types of bonds are referred to as Floating Rate Bonds. For better
understanding let us consider an example of one such bond from IDBI in 1997. The maturity
period of this floating rate bond from IDBI was 5 years. The coupon for this bond used to be
reset half-yearly on a 50 basis point mark-up, with reference to the 10 year yield on Central
Government securities (as the benchmark). This means that if the benchmark rate was set at
“X” %, then coupon for IDBI’s floating rate bond was set at “(X + 0.50)” %.

Coupon rate in some of these bonds also have floors and caps. For example, this feature was
present in the same case of IDBI’s floating rate bond wherein there was a floor of 13.50%
(which ensured that bond holders received a minimum of 13.50% irrespective of the
benchmark rate). On the other hand, a cap (or a ceiling) feature signifies the maximum
coupon that the bonds issuer will pay (irrespective of the benchmark rate). These bonds are
also known as Range Notes. More frequently used in the housing loan markets where coupon
rates are reset at longer time intervals (after one year or more), these are well known as
Variable Rate Bonds and Adjustable Rate Bonds. Coupon rates of some bonds may even
move in an opposite direction to benchmark rates. These bonds

ν Fixed
ν
Stays same until maturity; ie: buy a Rs 1000 bond with 8% fixed interest rate and you will
receive Rs 80 every year until maturity and at maturity you will receive the Rs 1000 back.

ν Payable at Maturity
ν

Receive no payments until maturity and at that time you receive principal plus the total
interest earned compounded semi-annually at the initial interest rate.

II. Classification on the Basis of Variability of Maturity

ν Callable Bonds
ν

The issuer of a callable bond has the right (but not the obligation) to change the tenor of a
bond (call option). The issuer may redeem a bond fully or partly before the actual maturity
date. These options are present in the bond from the time of original bond issue and are
known as embedded options. This embedded option helps issuer to reduce the costs when
interest rates are falling, and when the interest rates are rising it is helpful for the holders.

ν Puttable Bonds
ν

The holder of a puttable bond has the right (but not an obligation) to seek redemption (sell)
from the issuer at any time before the maturity date. In riding interest rate scenario, the bond
holder may sell a bond with low coupon rate and switch over to a bond that offers higher
coupon rate. Consequently, the issuer will have to resell these bonds at lower prices to
investors. Therefore, an increase in the interest rates poses additional risk to the issuer of
bonds with put option (which are redeemed at par) as he will have to lower the re-issue price
of the bond to attract investors.

ν Convertible Bonds
ν

The holder of a convertible bond has the option to convert the bond into equity (in the same
value as of the bond) of the issuing firm (borrowing firm) on pre-specified terms. This results
in an automatic redemption of the bond before the maturity date. The conversion ratio
(number of equity of shares in lieu of a convertible bond) and the conversion price
(determined at the time of conversion) are prespecified at the time of bonds issue. Convertible
bonds may be fully or partly convertible. For the part of the convertible bond which is
redeemed, the investor receives equity shares and the non-converted part remains as a bond.

III. Classification on the basis of Principal Repayment

ν Amortizing Bonds
ν

Amortizing Bonds are those types of bonds in which the borrower (issuer) repays the
principal along with the coupon over the life of the bond. The amortizing schedule (repayment
of principal) is prepared in such a manner that whole of the principle is repaid by the maturity
date of the bond and the last payment is done on the maturity date. For example - auto loans,
home loans, consumer loans, etc.

Debt Instruments
Type Central Government Securities Typical Features Medium – long term bonds issued by
RBI on behalf of GOI. Coupon payment are semi annually Medium – long term bonds issued
by RBI on behalf of state govt. Coupon payment are semi annually Medium – long term
bonds issued by govt agencies and guaranteed by central or state govt. Coupon payment are
semi annually Medium – long term bonds issued by PSU. 51% govt equity stake Short -
Medium term bonds issued by private companies. Coupon payment are semi annually State
Government Securities

Government – Guaranteed Bonds

PSU Corporate

Risk Associated with Investing in Bonds

ν Interest Rate Risk ν The price of the bond will change in the opposite direction from the
change in interest rate. As interst rate rises the bond price decreases and vice versa. ν If an
investor has to sell a bond prior to the maturity date, it means the realisation of capital loss.
ν This risk depends on the type of the bond; callable puttable etc???? ν Reinvestment
Income or Reinvestment Risk ν The additional income from such reinvestment called
interest on interest, depends on the prevailing interest rate levels at the time of reinvestment.

ν Call Risk ν The issuer usually retains this right in order to have flexibility to refinance the
bond in the future is market interest rate drops below the coupon rate ν Disadvantage for
investors for callable bond: cash flow pattern not known with certainty, interest rate drop,
capital appreciation will reduce. ν Credit Risk
ν

If the issuer of a bond will fail to satisfy the terms of the obligation with respect to the timely
payment of interest and repayment of the amount borrowed. Yield = market yield + risk
associated with credit risk
ν Inflation Risk
ν

Purchasing power risk arises because of the variation in the value of cash flow from the
security due to inflation. Eg: ??? Risk associated with the currency value for nonrupee
denominated bonds. Eg: US treasury bond

ν Exchange Rate Risk

ν

ν Liquidity Risk ν Its depends on the size of the spread between bid and ask price quoted.
Wider the spread is risky. ν For investors keeping till maturity, this is uminportant. ν
Market to market should be calculated portfolio value. ν Volatility Risk
ν

Value of bond will increase when expected interest rate volatility increases.

ν Risk Risk ν Natural uncertainty. ν Avoid securities in which knowledge is less.

Time value of Money

ν Present value of money

PV = Pn

1 (1+r)n

Present value of an Ordinary Annuity

ν When the same amount of rupees is received

each year or paid each year is referred to as an annuity. ν When the first payment is received
one period from now is called as an ordinary annuity. PV = 1
1-

(1+r)n r

Question
ν Suppose that an investor expects to receive

Rs 100 at the end of each year for the next eight year. Interest rate 9% ν When the first
payment is received one period from now is called as an ordinary annuity. PV = 1
1-

100

(1.09)8

0.09 100 [5.534811] = Rs 533.48

Bond Pricing
ν Reason –

Indicate the yield received ν Should the bond be purchased

ν

ν Priced at – Premium, Discount, or at Par

Calculating Bond Price

ν Sum of the present values of all expected

coupon payments plus the present value of the par value at maturity.

C = coupon payment, ordinary annuity n = number of payments i = interest rate, or

required yield M = value at maturity, or par value

Session 3
Yield YTM Duration

Question 1
ν Calculate the Bond price for a 20 year 10%

coupon bond with a par value of Rs 1000. Lets suppose the yield on this bond is 11%. The
cash flows for this bond are as follows:
40 semi anually coupon payment of Rs 50 ν Rs 1000 to be received 40 six month period
from now.
ν

Solution
50
1-

1 (1.055)40 0.055

1000

+
+

(1.055)40

ν Rs 50 1- 0.117463

0.055 = Rs 802.31 + 117.46 = Rs 919.77

Rs 100 8.51332

Question 2
ν Calculate the Bond price for a 20 year 10%
coupon bond with a par value of Rs 1000. Lets suppose the yield on this bond is 6.8%. The
cash flows for this bond are as follows:
40 semi anually coupon payment of Rs 50 ν Rs 1000 to be received 40 six month period
from now.
ν

Solution
50
1-

1 (1.034)40 0.034

1000

(1.034)40

= Rs 1084.51 + 262.53 = Rs 1,347.04

ν Calculate the Bond price for a 20 year 10%

coupon bond with a par value of Rs 1000. Lets suppose the yield on this bond is 10%. The
cash flows for this bond are as follows:
40 semi anually coupon payment of Rs 50 ν Rs 1000 to be received 40 six month period
from now. Ans Rs 1000
ν

Price Yield Relationship

ν When yield increases, investor would not buy

the issue because it offers a below market yield; the resulting lack of demand would cause the
price to fall. ν When yield decreases ?????? ν This is how bond price falls below its par
value. ν When bond sells below its par value, it is said to be selling at a discount

ν Coupon rate is less than the required yield

Price is less than the par ( Discount Bond) ν Coupon rate is equal to the required yield Price
is equal to the par ν Coupon rate is more than the required yield Price is more than the par
( premium Bond)

ν A fundamental property of a bond is that its

price changes in the opposite direction from the change in the required yield ν As the
required yield increases, the present value of cash flow decreases; hence the price decreases.
ν As the required yield decreases, the present value of cash flow increases; hence the price

price

yield
Premium and Discount Bonds

Pricing Zero-Coupon Bonds

ν No coupon payment until maturity. Because of this,

the present value of annuity formula is unnecessary. ν Calculate the price of a zero-coupon
bond that is maturing in 5 years, has a par value of $1,000 and required yield of 6%....?

Determine the Number of Periods ν Determine the Yield

ν

Determining Interest Accrued

ν Accrued interest is the fraction of coupon payment

that the bond seller earns for holding the bond for a period of time between bond payments

The amount that the buyer pays the seller is the agreed upon the price plus accrued interest.
This is referred as a Dirty bond prices ν The price of a bond without accrued interest is
called the Clean bond prices
ν

Eg: On March 1, 2003, X is selling a corporate bond with a face value of $1,000 and 7%
coupon paid semi-annually. The next coupon payment after March 1, 2003, is expected on
June 30, 2003. What is the interest accrued on the bond?

Bond Basics
ν Two basic yield measures for a bond are its coupon

rate and its current yield.

Annual coupon Coupon rate = Par value

Annual coupon Current yield = Bond price

10-64

Yield
ν Yield is the return you actually earn on the

bond--based on the price you paid and the interest payment you receive ν Two Types of
Yields:
ν

Current Yield: annual return on the dollar amount paid for the bond and is derived by dividing
the bond's interest payment by its purchase price Yield To Maturity: total return you will
receive by holding the bond until it matures or is called.
Yield
n

Current yield: Annual coupon receipts/ Market price of the bond It does not consider:
ν ν

Time value of money Complete series of future cash flow

It compares a pre-specified coupon with the current market price, it is called as current
yield.

Example
ν The current yield for a 15 years 7% coupon

bond with a par value of Rs 1000, selling for Rs 769.40 Current yield = Rs 70 Rs769.40 =
9.10%

Yield to Maturity
ν

Given a pre-specified set of cash flows and a price, the YTM of a bond is that rate which
equates the discounted value of the future cash flows to the present price of the bond.

YTM
ν Yield to maturity (YTM) is the interest rate (i) that equates the ν ν ν

present value of cash flow payments received from a debt instrument with its value today. It is
the most accurate measure of interest rates. The yield to maturity is the annual return annual
rate (discounted) earned over a bond kept until maturity. The yield to maturity is the discount
rate estimated mathematically that equals the cash flow of payment of interest and principal
received with the purchasing price of the bond. This term is also referred to as internal rate of
return or as the expected rate of return of the bond and it is the yield in which most bond
investors are interested in.

YTM
n

P=Σ
t=1

C (1+y)n

M (1+y)n
P= Price of the bond C = coupon payment N = No. of years left to maturity M =
Maturity value Y = yield to maturity

Yield of Bond
Eg: You hold a bond whose par value is $100 but has a current yield of 5.21% because the
bond is priced at $95.92. The bond matures in 30 months and pays a semi-annual coupon of
5%.

ν The yield is the interest rate that will make the

present value of cash flow equals to the bond price. ν YTM is calculated same way as IRR,
the cash flows are those that the investor would realized by holding the bond till maturity. ν
To compute the YTM requires a trial and error method

Example
ν Calculate the YTM for a 15 years 7% coupon

bond with a par value of Rs 1000. Lets suppose the bond price is Rs 769.42. The cash flows
for this bond are as follows:
30 semi anually coupon payment of Rs 35 ν Rs 1000 to be received 30 six month period
from now.
ν

769.42 = Rs 35

1-

1 (1+y) y
30

1000 +

1 (1+y)
30

ν Trial and error method

Annual Interest rate 9% 9.5% 10% 11.5 % 11 % PV of 30 payments of Rs 35 570.11 553.71
538.04 532.04 508.68 PV of Rs 1000 30 periods from now 267 248.53 231.38 215.45 200.64
PV of cash flows

837.11 802.24 769.42 738.49 709.32

Would you prefer to buy a 10-year, 10% annual coupon bond or a 10-year, 10% semiannual
coupon bond, all else equal?
The semiannual bond’s effective rate is:

 iNom   0.10 EFF% =  1 +  − 1 = 1+  − 1 = 10.25% m 2   

10.25% > 10% (the annual bond’s effective rate), so you would prefer the semiannual bond.
Calculating Yield for Callable and Puttable Bonds
ν A callable bond's valuations must account for the

issuer's ability to call the bond on the call date ν The puttable bond's valuation must include
the buyer's ability to sell the bond at the pre-specified put date. ν The yield for callable
bonds is referred to as yield-to-call, and the yield for puttable bonds is referred to as yield-to-
put.

Yield to Call (YTC)

ν Yield to call (YTC) is the interest rate that

investors would receive if they held the bond until the call date. The period until the first call
is referred to as the call protection period. ν Yield to call is the rate that would make the
bond's present value equal to the full price of the bond. Essentially, its calculation requires
two simple modifications to the yield-to-maturity formula:

YTC
ν When the bond may be called and at what

price are specified at the time the bond is issued. ν The price at which bond may be called is
referred to as the call price.

Example
ν Consider an 18 years 11% coupon bond

payable semi annually with a maturity value of Rs 1000 selling at Rs 1169. suppose that the
first call date is 8 years from now and that the call price is Rs 1055. ν Call price = 1055 ν N
= 8*2 = 16 m ν C = 1000*11%/2 = 55 ν Bond price = 1169

Solution
1169 = Rs 55
1-

1 (1+y) y
16

1055 +

1 (1+y)
16

ν 8.54% is the yield to first call

Yield to Put (YTP)

ν This mean that the bond holder can force the issuer ν ν

ν ν
to buy the issue at a specified price. Yield to put (YTP) is the interest rate that investors would
receive if they held the bond until its put date. To calculate yield to put, the same modified
equation for yield to call is used except the bond put price replaces the bond call value and the
time until put date replaces the time until call date. M = put price n = number of periods until
assumed put date.

Example of YTP
ν Consider an 18 years 11% coupon bond

payable semi annually issue selling Rs 1169. assume that issue is putable at par (Rs 1000) in
five years. ν Put price = 1000 ν N = 5*2 = 10 m ν C = 1000*11%/2 = 55

Solution
1169 = Rs 55
1-

1 (1+y) y
10

1000 +

1 (1+y)
10

ν 6.94% ≈ 7% is the yield to put