Chapter 12

BOND PRICES AND YIELDS

Figuring out the Assured Returns
 OUTLINE

• Changes in Bond Market

• Bond Characteristics
• Bond Prices
• Bond Yields
• Risks in Bonds
• Rating of Bonds
• The Yield Curve
• Explaining the Term Structure
• Determinants of Interest Rates
 CHANGES IN DEBT MARKET
THEN NOW
• PLAIN VANILLA BONDS • BONDS WITH COMPLEX
FEATURES
• STABLE & ADMINISTERED • VOLATILE & MARKET-
INTEREST RATES DETERMINED INTEREST
RATES
• SIMPLISTIC MEASURES OF • PRECISE MEASURES OF
RETURN & LIFE RETURN & LIFE
• RULES OF THUMB • ANALYTICAL METHODS
• FEW PLAYERS • MORE PLAYERS
• PASSIVE APPROACH • RELATIVELY MORE
ACTIVE APPROACH
• ILLIQUID MARKET • LIQUID MARKET ?
• ABSENCE OF A REFERENCE • EMERGENCE OF A REFERENCE
RATE RATE
 BOND CHARACTERISTICS

• A BOND IS AN IOU. IT IS DESCRIBED IN TERMS OF:

• PAR VALUE
• COUPON RATE
• MATURITY DATE

• GOVERNMENT BONDS ALSO CALLED GOVERNMENT

SECURITIES (G-SECS) OR GILT-EDGED SECURITIES.
THESE ARE GENERALLY MEDIUM TO LONG-TERM
BONDS ISSUED BY RBI ON BEHALF OF THE
GOVERNMENT OF INDIA AND STATE GOVERNMENTS.

• CORPORATE BONDS OR CORPORATE DEBENTURES ARE

DEBT INSTRUMENTS ISSUED BY COMPANIES
 TYPES OF BONDS

• STRAIGHT BONDS

• ZERO COUPON BONDS.

• FLOATING RATE BONDS

• BONDS WITH EMBEDDED OPTIONS

•Convertible, Callable. Puttable

 BOND PRICING (VALUATION)

n C M
P =  +
t=1 (1+r)t (1+r)n

2n C/2 M
P =  +
t=1 (1+r/2)t (1+r/2)2n
 BOND PRICING
A RS.600 FACE VALUE BOND CARRIES A COUPON RATE OF
12 PERCENT P.A. PAYABLE SEMI-ANNUALLY. THE BOND IS
REDEEMBALE AT PAR AFTER 5 YEARS. IF INVESTORS
REQUIRE A RETURN OF 9% PER HALF-YEAR PERIOD,
WHAT WILL BE THE PRICE OF THE BOND.
10
P0= 36 + 600
t=1 (1.09)t (1.09)10
= 36 x 6.418 + 600 x 0.422
= RS.484.25
 PRICE - YIELD RELATIONSHIP
PRICE

YEILD

PRICE CHANGES WITH TIME

VALUE OF
BOND PREMIUM BOND: rd = 11%

A
PAR VALUE BOND: rd = 13%

B
DISCOUNT BOND: rd = 15%

8 7 6 5 4 3 2 1 0
YEARS TO MATURITY
 BOND YIELDS
• CURRENT YIELD
ANNUAL INTEREST
PRICE
• YIELD TO MATURITY
C C C M
P = + + …. +
(1+r) (1+r) 2
(1+r) n
(1+r)n
8 90 1,000
800 =  +
t=1 (1+r)t (1+r)8
AT r = 13% … RHS = 808
AT r = 14% … RHS = 768.1
808 - 800
YTM = 13% + (14% - 13%) = 13.2%
808 - 768.1
C + (M - P) / n
YTM ≃
0.4M + 0.6 P
• YIELD TO CALL
n* C M*
P =  +
t=1 (1+r)t (1+r)n
 YTM

• SOMEONE WHO INVESTS IN A COUPON - PAYING

BOND WILL EARN THE YTM PROMISED ON THE
PURCHASE DATE IF AND ONLY IF ALL OF THE
FOLLOWING THREE CONDITIONS ARE
FULFILLED
• THE BOND IS HELD UNTIL IT MATURES RATHER
THAN BEING SOLD AT A PRICE WHICH DIFFERS
FROM ITS FACE VALUE BEFORE ITS MATURITY
• THE BOND DOES NOT DEFAULT
• ALL CASHFLOWS ARE RE-INVESTED AT AN
INTEREST RATE EQUAL TO THE PROMISED YTM
 REALISED YIELD TO MATURITY
FUTURE VALUE OF BENEFITS
0 1 2 3 4 5
 INVESTMENT 850
 ANNUAL INTEREST 150 150 150 150 150
 RE-INVESTMENT
PERIOD (IN YEARS) 4 3 2 1 0
 COMPOUND FACTOR
(AT 16 PERCENT) 1.81 1.56 1.35 1.16 1.00
 FUTURE VALUE OF
INTERMEDIATE CASH FLOWS 271.5 234.0 202.5 174.0 150.0
 MATURITY VALUE 1000

 TOTAL FUTURE VALUE = 271.5 + 234.0 + 202.5 + 174.0 + 150.0 + 1000

= 2032

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

r* = 0.19 OR 19 PERCENT
 RISKS IN BOND INVESTMENT
• INTEREST RATE RISK INTEREST BOND
(MARKET RISK) RATE PRICE
• REINVESTMENT INTEREST RATE ON
RISK INTERIM CASH FLOW
• DEFAULT RISK ISSUER MAY DEFAULT
(CREDIT RISK)
• INFLATION RISK PURCHASING POWER RISK
(1+r) = (1+a) (1+b)
• CALL RISK ISSUER MAY RECALL THE
BONDS
• EXCHANGE RATE RISK Uncertain
DENOMINATED BOND
• LIQUIDITY RISK MARKETABILITY RISK
• EVENT RISK ISSUER’S ABILITY.. CHANGE..
UNEXPECTEDLY
(a) A NATURAL ACCIDENT OR
 DEBT RATING
• WHAT IS IT ?
PROBABILITY OF TIMELY PAYMENT OF INTEREST &
PRINCIPAL BY A BORROWER
• WHAT IT ‘IS NOT’ ?
NOT A RECOMMENDATION
NOT A GENERAL EVAL’N OF THE ISSUING ORGANISATION
NOT A ONE-TIME EVALUAT’N CREDIT RISK . . VALID
ENTIRE LIFE
• HOW IS IT DONE ?
INDUSTRY & BUS ANALYSIS. FINANCIAL ANALYSIS
QUANTITATIVE RATING MODELS
• VALUE OF RATINGS ?
• RATING SCENARIO ?
 FUNCTIONS OF DEBT RATING

DEBT RATINGS (OR DEBT RATING FIRMS) ARE SUPPOSED

TO :
• PROVIDE SUPERIOR INFORMATION
• OFFER LOW-COST INFORMATION
• SERVE AS A BASIS FOR A PROPER RISK-RETURN
TRADEOFF.
• IMPOSE HEALTHY DISCIPLINE ON CORPORATE
BORROWERS.
• FACILITATE THE FORMULATION OF PUBLIC POLICY
GUIDELINES ON INSTITUTIONAL INVESTMENT.
 CREDIT RATING
• CRISIL’S RATING SYMBOLS
AAA : HIGHEST SAFETY
AA : HIGH SAFETY
A : ADEQUATE SAFETY
BBB : LOW SAFETY
BB : INADEQUATE SAFETY
B : HIGH RISK
C : SUBSTANTIAL RISK
D : IN DEFAULT

• KEY FACTORS CONSIDERED IN CREDIT RATING

INDUSTRY & BUSINESS ANALYSIS FINANCIAL ANALYSIS
• GROWTH RATE & REL’N WITH THE ECONOMY • EARNING POWER
• INDUSTRY RISK CHARACTERISTICS • BUSINESS & FINANCIAL RISKS
• STRUCTURE OF INDUSTRY & NATURE • ASSET PROTECTION
OF COMPETITION
• COMPETITIVE POSITION OF THE ISSUER • CASH FLOW ADEQUACY
• MANAGERIAL CAPABILITY OF THE ISSUER • FINANCIAL FLEXIBILITY
• QUALITY OF ACCOUNTING
 THE YIELD CURVE
THE YIELD CURVE., OR THE TERM STRUCTURE OF INTEREST RATES, SHOWS HOW YTM
IS RELATED TO TERM TO MATURITY FOR BONDS THAT ARE SIMILAR IN ALL RESPECTS,
EXPECTING MATURITY.
FACE INTEREST MATURITY CURRENT YIELD TO
VALUE RATE (YRS) PRICE 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

YIELD CURVE
YIELD TO MATURITY
(YTM)
14.0

13.0

12.0

1 2 3 4 5 TERM TO MATURITY (YRS)

 TYPES OF YIELD CURVE
YTM A. UPWARD SLOPING YTM B. DOWNWARD SLOPING

TERM TERM

YTM C. FLAT YTM D. HUMPED

TERM TERM
 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 a similar vein, set up the equation for the value of the four-year bond :

13,500 13,500 13,500 113,500

99,706 = + + +
(1+r1) (1+r1) (1+r2) (1+r1) (1+r2) (1+r3) (1+r1) (1+r2) (1+r3) (1+r4)

13,500 13,500 13,500 113,500

= + + +
(1.124) (1.124) (1.1289) (1.124)(1.1289)(1.1512) (1.124)(1.1289)(1.1512)(1+r4)

Solving this equation for r4, leads to r4 = 0.1458.

 FORWARD RATES

Forward rate
15.0 -

14.0 -

13.0 -

12.4
Year
1 2 3 4
 EXPLAINING THE
TERM STRUCTURE

• EXPECTATIONS THEORY

• LIQUIDITY PREFERENCE THEORY

• PREFERRED HABITAT THEORY

• MARKET SEGMENTATION THEORY

 EXPECTATIONS THEORY

SHAPE …. YIELD CURVE … DEPENDS ON ..

EXPECTATIONS … THOSE WHO PARTICIPATE …
MARKET
(1 + tRn) = [ (1 + tR1) (1 + t+1R1) … (1 + t+n-1Rn)]1/n

YIELD CURVE EXPLANATION

ASCENDINGSHORT-TERM RATES RISE IN FUTURE
DESCENDING SHORT-TERM RATES … FALL IN FUTURE
HUMPED SHORT-TERM RATES … RISE …. FALL
FLAT SHORT-TERM RATES . . UNCHANGED IN
FUTURE
 LIQUIDITY PREFERENCE THEORY

FORWARD RATES SHOULD INCORPORATE

INTEREST RATE EXPECTATIONS AS WELL AS A
RISK (OR LIQUIDITY) PREMIUM
(1 + tRn) = [ (1 + tR1) (1 + t+1R1+L2) … (1 + t+n-1Rn +Ln)]1/n

AN UPWARD-SLOPING YIELD CURVE SUGGESTS

THAT FUTURE INTEREST RATES WILL RISE (OR
WILL BE FLAT) OR EVEN FALL IF THE LIQUIDITY
PREMIUM INCREASES FAST ENOUGH TO
COMPENSATE FOR THE DECLINE IN THE FUTURE
INTEREST RATES
 PREFERRED HABITAT THEORY

INVESTORS PREFER TO MATCH THE MATURITY

OF INVESTMENT TO THEIR INVESTMENT
OBJECTIVE
BORROWERS . . TOO
IF MISMATCH … INDUCEMENT TO SHIFT

MARKET SEGMENTATION THEORY

EXTREME FORM OF PREFERRED HABITAT

THEORY
 DETERMINANTS OF INTEREST RATES
•INFLATION RATE
•REAL GROWTH RATE
•TIME PREFERENCE
SHORT-TERM RISK-FREE RATE

MATURITY PREMIUM DEFAULT PREMIUM

•FUTURE EXPECTATIONS •BUSINESS RISK

•LIQUIDITY PREFERENCE INTEREST RATE •FINANCIAL RISK

•PREFERRED HABITAT •COLLATERAL

SPECIAL FEATURES
•CALL/PUT FEATURE
•CONVERSION FEATURE
•OTHER FEATURES
 SUMMING UP
• The debt market in India has registered an impressive growth
particularly since mid-1990s and has been accompanied by
increasing complexity in instruments,interest rates, methods of
analysis, and so on
• The value of a noncallable, nonconvertible bond is:
n C M
P=  +
t =1 (1+ r)t (1 + r)n
• The commonly employed yield measures are : current yield, yield
to maturity (YTM), yield to call, and realised yield to maturity.
• The YTM of a bond is the discount rate that makes the present
value of the cash flows receivable from owning the bond equal to
the price of the bond.
• Bonds are subject to diverse risks, such as interest rate risk,
inflation risk, real interest rate risk, default risk, call risk, and
liquidity risk.
• Default risk or credit risk is reflected in credit rating of debt
instruments.
• The term structure of interest rates, popularly called the yield
curve, shows how yield is related to maturity.
• Three principal explanations have been offered to explain the term
structure of interest rates : expectations theory, liquidity
preference theory, and preferred habitat theory.
• The interest rate is determined by four factors : short-term risk-
free interest rate, maturity premium, default premium, and
special features.
• Convertible bonds may be viewed as a debenture – warrant
package.