Changing debt market world over

• Widened array of debt instruments

• Complex and integrated features
• Deregulated interest rate regime
• Entry of new issuers
• Improved market liquidity
• Volatile market
• Enhanced regulatory framework
• Analysis based valuation
 Types of Bonds

• Coupon bonds and zero coupon bonds

•Convertible and non-convertible bonds
•Infrastructure bonds
•RBI relief bonds
•Tax savings bonds
•Government bonds and corporate bonds
•Municipal bonds
 Bond Characteristics

• A bond is an IOU. It is described in terms of:

• Par value
• Coupon rate
• Liquidity
• Maturity date
• Callability
• Re-investment Risk
 The Fundamentals of Bond Valuation
The present-value model
2n
C 2 Pp
P =∑
m + t
(1 + i 2) (1 + i 2)
t =1
t
2n

Where:
Pm=the current market price of the bond
n = the number of years to maturity
Ci = the annual coupon payment for bond i
i = the prevailing yield to maturity for this bond issue
Pp=the par value of the bond
 The Present Value Model
The value of the bond equals the present
value of its expected cash flows
2n
Ci 2 Pp
Pm = ∑ +
t =1 (1 + i 2) (1 + i 2)
t 2n

where:
Pm = the current market price of the bond
n = the number of years to maturity
Ci = the annual coupon payment for Bond I
i = the prevailing yield to maturity for this bond issue
 The Yield Model
The expected yield on the bond may be
computed from the market price
2n
Ci 2 Pp
Pm = ∑ +
t =1 (1 + i 2) (1 + i 2)
t 2n

where:
i = the discount rate that will discount the cash flows to
equal the current market price of the bond
 Computing Bond Yields
Yield Measure Purpose
Nominal Yield Measures the coupon rate

Current yield Measures current income rate

Promised yield to maturity Measures expected rate of return for bond held
to maturity
Promised yield to call Measures expected rate of return for bond held
to first call date
Realized (horizon) yield Measures expected rate of return for a bond
likely to be sold prior to maturity. It considers
specified reinvestment assumptions and an
estimated sales price. It can also measure the
actual rate of return on a bond during some past
period of time.
 Nominal Yield
Measures the coupon rate that a bond
investor receives as a percent of the bond’s
par value
 Current Yield
Similar to dividend yield for stocks
Important to income oriented investors
CY = Ci/Pm
where:
CY = the current yield on a bond
Ci = the annual coupon payment of bond i
Pm = the current market price of the bond
 Promised Yield to Maturity
• Widely used bond yield figure
• Assumes
– Investor holds bond to maturity
– All the bond’s cash flow is reinvested at the
computed yield to maturity
 Computing the
Promised Yield to Maturity
2n
Ci 2 Pp
Pm = ∑ +
t =1 (1 + i 2) (1 + i 2)
t 2n

Solve for i that will equate the current price to all cash flows
from the bond to maturity, similar to IRR
 Computing Promised Yield to Call

2 nc
Ci / 2 Pc
Pm = ∑ +
t =1 (1 + i ) (1 + i )
t 2 nc
where:
Pm = market price of the bond
Ci = annual coupon payment
nc = number of years to first call
Pc = call price of the bond
 Realized (Horizon) Yield
Present-Value Method
2 hp
Ct / 2 Pf
Pm = ∑ +
t =1 (1 + i 2) (1 + i 2)
t 2 hp
Calculating Future Bond Prices
2 n − 2 hp
Ci / 2 Pp
Pf = ∑ + 2 n − 2 hp
t =1 (1 + i 2) (1 + i 2)
t

where:
Pf = estimated future price of the bond
Ci = annual coupon payment
n = number of years to maturity
hp = holding period of the bond in years
i = expected semiannual rate at the end of the holding period
 REALISED YIELD TO MATURITY
FUTURE VALUE OF BENEFITS

0 1 2 3 4 5
• INVESTM ENT 850
• ANNU AL INTE REST 150 150 150 150 150
• RE-INVE STM ENT
PERIO D (IN YE ARS) 4 3 2 1 0
• COM PO UND FACTO R
(AT 16 PERCENT) 1.81 1.56 1.35 1.16 1.00
• FUTURE VAL UE O F
INTERM EDIATE CA SH FLO W S 271.5 234.0 202.5
174.0 150.0
• M ATURITY VALUE 1000

• TO TAL FUTURE VALUE = 271.5 + 234.0 + 202.5 + 174.0 + 150.0 + 1

= 2032

(1+r*)5 = 2032 / 850 = 2.391

r* = 0.19 OR 19 PERCENT
 Yield Adjustments
for Tax-Exempt Bonds
i
FTEY =
1- T
Where:
FTEY = fully taxable yield equivalent
i = the promised yield on the tax exempt bond
T = the amount and type of tax exemption
(i.e., the investor’s marginal tax rate)
 Bond Valuation Using Spot Rates
2n
Ct
Pm = ∑
t =1 (1 + it 2)
t

where:
Pm = the market price of the bond
Ct = the cash flow at time t
n = the number of years
it = the spot rate for Treasury securities at
maturity t
What Determines Interest Rates
• Inverse relationship with bond prices
• Forecasting interest rates
• Fundamental determinants of interest rates
i = RFR + I + RP
where:
– RFR = real risk-free rate of interest
– I = expected rate of inflation
– RP = risk premium
 What Determines Interest Rates
• Effect of economic factors
– real growth rate
– tightness or ease of capital market
– expected inflation
– or supply and demand of loanable funds
• Impact of bond characteristics
– credit quality
– term to maturity
– indenture provisions
– foreign bond risk including exchange rate risk and country risk
Spot Rates and Forward Rates
• Creating the Theoretical Spot Rate Curve
• Calculating Forward Rates from the Spot
Rate Curve
 ILLUSTRATIVE DATA FOR
GOVERNEMNT SECURITIES

Face Value Interest Rate Maturity (years) Current Price Yield to maturity

100,000 0 1 88,968 12.40

100,000 12.75 2 99,367 13.13
100,000 13.50 3 100,352 13.35
100,000 13.50 4 99,706 13.60
100,000 13.75 5 99,484 13.90
 FORWARD RATES
88968

100000
• ONE - YEAR TB RATE
100000
88968 = r1 = 0.124
(1 + r1)
• 2 - YEAR GOVT. SECURITY
12750 112750
99367 = + + r2 = 0.1289
(1.124) (1.124) (1 + r2)
• 3 - YEAR GOVT. SECURITY
13500 13500 113500
100352 = + +
(1.124) (1.124) (1 .1289) (1.124) (1.1289) (1 + r3)
 FORWARD RATES
• 4-YEAR GOVERNMENT SECURITY

Continuing in

13,
 FORWARD RATES

Forward rate
15.0 -

14.0-

13.0 -

12.4
Year
1 2 3 4
 Term Structure of Interest Rates
• It is a static function that relates the term to
maturity to the yield to maturity for a
sample of bonds at a given point in time.
• Term Structure Theories
– Expectations hypothesis
– Liquidity preference hypothesis
– Segmented market hypothesis or preferred
habitat theory or institutional theory or hedging
pressure theory
 Expectations Hypothesis
• Any long-term interest rate simply
represents the geometric mean of current
and future one-year interest rates expected
to prevail over the maturity of the issue
 Liquidity Preference Theory
• Long-term securities should provide higher
returns than short-term obligations because
investors are willing to sacrifice some
yields to invest in short-maturity obligations
to avoid the higher price volatility of long-
maturity bonds
Segmented-Market Hypothesis
• Different institutional investors have
different maturity needs that lead them to
confine their security selections to specific
maturity segments
 Trading Implications of the
Term Structure
• Information on maturities can help you
formulate yield expectations by simply
observing the shape of the yield curve
 Yield Spreads
• Segments: government bonds, agency bonds,
and corporate bonds
• Sectors: prime-grade municipal bonds versus
good-grade municipal bonds, AA utilities
versus BBB utilities
• Coupons or seasoning within a segment or
sector
• Maturities within a given market segment or
sector
 Yield Spreads
Magnitudes and direction of yield spreads
can change over time
 What Determines the
Price Volatility for Bonds
Bond price change is measured as the
percentage change in the price of the bond
EPB
−1
BPB
Where:
EPB = the ending price of the bond
BPB = the beginning price of the bond
 What Determines the
Price Volatility for Bonds
Four Factors
1. Par value
2. Coupon
3. Years to maturity
4. Prevailing market interest rate
 What Determines the
Price Volatility for Bonds
Five observed behaviors
1. Bond prices move inversely to bond yields (interest rates)
2. For a given change in yields, longer maturity bonds post larger
price changes, thus bond price volatility is directly related to
maturity
3. Price volatility increases at a diminishing rate as term to maturity
increases
4. Higher coupon issues show smaller percentage price fluctuation for
a given change in yield, thus bond price volatility is inversely
related to coupon
 What Determines the
Price Volatility for Bonds
• The maturity effect
• The coupon effect
• The yield level effect
• Some trading strategies
 The Duration Measure
• Since price volatility of a bond varies inversely
with its coupon and directly with its term to
maturity, it is necessary to determine the best
combination of these two variables to achieve
your objective
• A composite measure considering both coupon
and maturity would be beneficial
• Duration is defined as a bond’s price sensitivity to
interest rate changes
• Higher the duration, greater is the sensitivity
• Number of years to recover the trust cost of a bond
 The Duration Measure
• For instance, if the interest rate increases
from 6% to 7%, the price of a bond with 5
years duration will move down by 5%, and
that of 10 years duration by 10%....... so on.
• Variables that affect the duration are:
– Coupon Rate
– YTM
– Interest Rate changes
 The Duration Measure
C t (t )
n n

∑t =1 (1 + i )
t ∑ t × PV (C ) t
D= n = t =1
Ct price
∑t =1 (1 + i )
t

Developed by Frederick R. Macaulay, 1938

Where:
t = time period in which the coupon or principal payment occurs
Ct = interest or principal payment that occurs in period t
i = yield to maturity on the bond
Characteristics of Macaulay
Duration
• Duration of a bond with coupons is always less than its
term to maturity because duration gives weight to these
interim payments
– A zero-coupon bond’s duration equals its maturity
• There is an inverse relationship between duration and
coupon
• There is a positive relationship between term to maturity
and duration, but duration increases at a decreasing rate
with maturity
• There is an inverse relationship between YTM and
duration
Modified Duration and Bond Price
Volatility
An adjusted measure of duration can be used
to approximate the price volatility of an
option-free (straight) bond
Macaulay duration
modified duration =
YTM
1+
Where: m
m = number of payments a year
YTM = nominal YTM
Modified Duration and Bond Price
Volatility
• Bond price movements will vary proportionally with
modified duration for small changes in yields
• An estimate of the percentage change in bond prices
equals the change in yield time modified duration
∆P
×100 = − Dmod × ∆i
Where:
P
∆ P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
∆ i = yield change in basis points divided by 100
 Trading Strategies Using Modified
Duration
• Longest-duration security provides the maximum price
variation
• If you expect a decline in interest rates, increase the average
modified duration of your bond portfolio to experience
maximum price volatility
• If you expect an increase in interest rates, reduce the average
modified duration to minimize your price decline
• Note that the modified duration of your portfolio is the market-
value-weighted average of the modified durations of the
individual bonds in the portfolio
Bond Duration in Years for Bonds
Yielding 6 Percent Under Different
Terms
COUPON RATES
Years to
Maturity 0.02 0.04 0.06 0.08
1 0.995 0.990 0.985 0.981
5 4.756 4.558 4.393 4.254
10 8.891 8.169 7.662 7.286
20 14.981 12.980 11.904 11.232
50 19.452 17.129 16.273 15.829
100 17.567 17.232 17.120 17.064
17.167 17.167 17.167 17.167
8
 Bond Convexity
• Modified duration is a linear approximation of
bond price change for small changes in market
yields
∆P
×100 = − Dmod × ∆i
P
• However, price changes are not linear, but a
curvilinear (convex) function
Price-Yield Relationship for Bonds
• The graph of prices relative to yields is not a straight
line, but a curvilinear relationship
• This can be applied to a single bond, a portfolio of
bonds, or any stream of future cash flows
• The convex price-yield relationship will differ
among bonds or other cash flow streams depending
on the coupon and maturity
• The convexity of the price-yield relationship
declines slower as the yield increases
• Modified duration is the percentage change in price
for a nominal change in yield
 Limitations of Macaulay and
Modified Duration
• Percentage change estimates using modified
duration only are good for small-yield
changes
• Difficult to determine the interest-rate
sensitivity of a portfolio of bonds when
there is a change in interest rates and the
yield curve experiences a nonparallel shift
• Initial assumption that cash flows from the
bond are not affected by yield changes