Bond Pricing and Analysis

Dr. Himanshu Joshi

Review of Time Value of Money Concepts

Concepts of Compounding and Discounting Future Values and Present Values Annuities

Review of Time Value of Money Concepts

When we invest in debt securities, investors receive periodic coupons, which must be reinvested. Wealth accumulated by investors will then depend upon rate at which they are able to reinvest their coupon incomes. And the price they will be able to sell their security in future will depend upon the prevailing interest rates in the market at the time of sale.

Review of Time Value of Money Concepts

There are two methods of interest calculation: Simple interest FV = P 1+ y * x
365

Compounding interest FV = P (1+ y)N (annual compounding) Semiannual Compounding P (1+y/2)*(1+y/2) = P {1 + y/2}2

Review of Time Value of Money Concepts

Continuous Compounding FV = P eyN Conversion Formula (1+y/2)2 = (1+y*)

Annuities
A security that pays c (in dollars) per period for N periods is known as an annuity. A security that pays c for two years: FV1 = c FV2= c + c (1+y) -------- (1) Ratio = (1+y) FV2 (1+y) = c (1+y) + c (1+y)2 ----------(2) (2) (1)

Annuities

FVn = c/y [

N (1+y)

1]

Example:
Consider a loan in which a payment of C= 100 per annum has to be made for the next 10 years. Let the interest rate y be equal to 9%. What is the future value of this annuity? Consider a bond that pays a $10 coupon for three years (annually) and $100 par value at maturity. Assuming a 9% reinvestment rate, what is the future value of this bond after three years? Lets assume that an investor purchased this bond at a price of $100. what is the investors annualized return under the reinvestment assumption?

Annuities
Present Value: PV = c/y [ 1 1/(1+y)N ]

Perpetual Annuities
What if the annuity is perpetual: Present Value = ? P= A/(1+r)k
k =1

Bond Characteristics
Face or par value Coupon rate Zero coupon bond Compounding and payments Accrued Interest Indenture

Bond Indenture: Illustration

A bond with par value of $1000 and coupon rate of 8% might be sold for $1000. the bondholder is then entitled to a payment of 8% of $1000 = $80 per year, for the stated life of a bond say, 30 years. The $80 payment typically comes in two semiannual installments of $40 each. At the end of 30 year life of the bond issuer also pays the $1000 par value to the bondholder.

Accrued Interest and Quoted Bond Prices

The bond prices that you see quoted in financial pages are not actually the prices that investors pay for the bond. This is because the quoted price does not include the interest that accrues between coupon payment dates.

Accrued Interest
Accrued Interest = Annual Coupon Payment Days since last coupon payment 2 Days Separating coupon payments

Example: Suppose that the coupon rate is 8% on bond of par value $1000. 30 days have been passed since the last coupon payment. If the quoted price of the bond is $990, then what should be the invoice price?
Bonds are quoted net of accrued interest in the financial pages and thus appears as &1000 at the maturity. In contrast to the bonds, stocks do not trade at flat prices with adjustments for accrued dividends. Whoever owns the stock when it goes exdividend receive the entire dividend on the ex-day. And the stock price reflect value of the upcoming dividend. The price therefore falls after the ex-dividend date.

Different Issuers of Bonds

Government Treasury Notes and Bonds Corporations Municipalities International Governments and Corporations Innovative Bonds Floaters and Inverse Floaters Asset-Backed Catastrophe

Floaters and Inverse floaters

Floaters: LIBOR + 25 BPS Inverse Floaters: these are similar to the floaters, except the coupon rate on these bonds falls when general level of interest rate rises. 14% - LIBOR

Asset Backed Bonds

Walt Disney has issued bonds with coupon rates tied to the financial performance of several of its films. More conventional examples are mortgaged backed securities or securities backed by auto or credit card loans. In these securities income from specified group of assets is used to service debt.

Catastrophe Bonds
The Swiss insurance firm Winterthur has issued bonds whose payments will be cut if a severe hailstorm in Switzerland results in excessive payout on Winterthur policies. These bonds are a way to transfer catastrophe risk from firm to capital market. Investors in these bonds receive compensation for taking risk in form of higher coupon rates, but in the event of catastrophe, the bondholders will give up all or part of their investments. Disaster can be defined by total insured losses or by criteria such as wind speed in a hurricane or Richter level in an earthquake.

Principal and Interest Payments for a Treasury Inflation Protected Security

Indexed Bonds
Nominal Return = Interest + Price appreciation Initial price Real Return = 1+ Nominal Return 1 1 + Inflation Rate

Provisions of Bonds
Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Preferred Stock

Bond Pricing
The price of any financial instrument is equal to the present value of the expected cash flows from financial instrument. Determining the price require: 1. An estimate of the expected cash flows. 2. An estimate of the appropriate required yield.

Bond Pricing
The required refers to the yield for financial instruments with comparable risk, or alternative (or substitute) investments. The first step in determining the price of a bond is to determine its cash flows. The cash flows of a bond that the issuer can not retire prior to its stated maturity date. (a non callable bond) consist of: 1. Periodic coupon payments to the maturity date. 2. The Par (or maturity) value at maturity.

Bond Pricing
Assumptions to simplify the calculation: 1. coupon payments are made every six months. 2. The next coupon payment for the bond is received exactly six months from now. 3. The coupon payment is fixed for the term of the bond.

Bond Pricing

C  ParValue PB ! T t (1 r ) t !1 (1 r )

PB = Price of the bond Ct = interest or coupon payments T = number of periods to maturity y = semi-annual discount rate or the semi-annual yield to maturity

Bond Pricing
You may recall that PV of an annuity was: PV = c/y [ 1 1/(1+y)N ] Where 1/y [ 1 1/(1+y)N ] is called an annuity factor. And also PV of Terminal Value is: Par Value * 1/(1+r)N Where 1/(1+r)N is called PV factor. So Price = Coupon* Annuity factor (r, T) + Par Value* PV factor (r, T)

Bond Pricing bond price.xlsx

8% coupon, 30-year maturity bond with par value of $1,000 paying 60 semiannual coupons of $40 each. Suppose that interest rate is 8% annually or 4% per six months period. Then Price = $40* Annuity factor (4%,60) + $1000* PV factor (4%,60) Price = $909.94 + $95.06 = $ 1000

Pricing a Zero Coupon Bond

Zero coupon bonds do not make any periodic payments. Instead, the investor realizes interest as the difference between the maturity value and purchase price. P= M/(1+r)n Where P= Price of the bond, M = Maturity Value r is the required yield.

Bond Prices and Yields

Prices and Yields (required rates of return) have an inverse relationship When yields get very high the value of the bond will be very low When yields approach zero, the value of the bond approaches the sum of the cash flows

The Inverse Relationship Between Bond Prices and Yields

Bond Prices at Different Interest Rates (8% Coupon Bond, Coupons Paid Semiannually)

Coupon Rate, Required Yield and Price

Coupon Rate < Yield Coupon Rate = Yield Coupon Rate > Yield Price < Par Price = Par Price > Par Discount Par Premium

Relationship Between Bond Price and Time if Interest Rates are Unchanged
If the required yield does not change between the time the bond is purchased and the maturity date, what will happen to the price of the bond? For a Bond Selling at Par: as the bond moves towards maturity it will continue to sell at par value. Its price will remain constant as the bond moves towards the maturity date. Bond Selling at Discount: ? Bond Selling at Premium: ?

Reasons for the change in the Bond Price

1. There is a change in the required yield owing to changes in the credit quality of the issuer. 2. There is a change in the price of the bond selling at a premium or a discount, without any change in the required yield, simply because the bond is moving towards the maturity. 3. There is a change in the required yield owing to a change in the yield on comparable bonds. (i.e., change in the required yield by the market)

Complications
The framework for pricing a bond discussed here assumes that: 1. The next coupon is exactly six month away. 2. The cash flows are known. 3. The appropriate required yield can be determined. 4. One rate is used to discount all the cash flows.

Next Payment is due in less than six months..

n
P = C/ [(1+r)v + (1+r)t-1 ] + M/ [(1+r)v + (1+r)t-1 ] t =1 V = days between the settlement and next coupon days in six month period Note: when v = 1.

Cash Flows may not be known

Callable bonds.

Determining the Appropriate Required Yield

We will discuss later how one can decompose the required yield for a bond/security into its component parts.

One Discount rate applicable to all the cash flows

A bond can be viewed as a package of zero coupon bonds, in which case a unique discount rate should be used to determine value of each cash flows.

Pricing Floating Rate and Inverse Floating Rate Secuirties

Floater and inverse floater are created from one collateral security. The two bonds are created such that: (1) total coupon interest paid to the bonds in each period is less than or equal to the collateral s coupon interest in each period. (2) the total par value of the two bonds is less than or equal to the collateral s total par value.

Pricing Floating Rate and Inverse Floating Rate Securities

Consider a 10 year 7.5% coupon semiannual-pay bond. Suppose that $100 million of the bond is used as a collateral to create a floater with a par value of $50 million. Floater Coupon = reference rate + 1% Inverse Floater Coupon = 14% - reference rate The weighted average of the coupon rate of the combination of the two bonds is: 0.5 (Ref Rate+1%) + 0.5(14% -Ref Rate) = 7.5 Collateral s Price = floater s Price + Inverse Price

Measuring Yields
Current Yield Yield to Maturity Yield to Call Yield to Put Yield to Worst