Bonds & Loans- Part-2

Concept of Holding Period Return (HPR)…..

In finance, holding period return is the return on an asset or portfolio over
the whole period during which it was held. It is one of the simplest and most
important measures of investment performance. HPR is the change in value
of an investment, asset or portfolio over a particular period

HPR= ((Income + (end of period value – original value))/Original Value)*100

 Example of HPR…
Ravi invested Rs. 10000 in a stock A on 1st Jan 2018. On 31st Dec 2019, the value of the stock is Rs. 11000. Also Ravi
earned a dividend of Rs. 500 over 2 year period. We have to compare its return with another investment stock B
made on 1st Jan 2017. The stock returned 5% till Dec 31st 2017 & in subsequent 2 years (1st Jan 2018 to 31st Dec
2019), it returned 15%.
Calculate each stock’s HPR & identify which investment did better.

HPR (A) =(500+(11000-10000)/10000)*100 = 15%

Composite holding period for stock B:
HPR (B) = (1+5%) x (1+15%) – 1 = 20.75%
Stock A was hold for 2 years and stock B for 3 years. So we can not directly compare them. We have to find out
annualized HPR.
Annualized HPR for stock A = (1+15%)1/2 -1 = 7.24%
Annualized HPR for stock B = (1+20.75%)1/3 – 1 = 6.49%

Therefore stock A did better.

Price/YTM…is it a perfect means to valuation?

Both price and YTM can not be a judgmental tool for valuing a bond. Sometimes investors purchase
an overpriced bond, with an expectation of interest rate will increase in future. Similarly there might
be the tax factor which lures the investors to invest in some bonds which are over priced…
 Clean Price Vs. Dirty Price…..
The concept of clean & dirty price exists in the secondary market. The clean price is the price of a coupon bond not
including accrued interest payments. The clean price is typically the quoted price on financial news sites. This price does
not include any interest accrued between the scheduled coupon payments for the bond.

The price of a bond is the present value of its future cash-flows. To avoid the impact of the next coupon payment on the
price of a bond, this cash flow is excluded from the price of the bond and is called the accrued interest. In finance,
the dirty price is the price of a bond including any interest that has accrued since issue of the most recent coupon
payment. This is to be compared with the clean price, which is the price of a bond excluding the accrued interest.

Dirty Price = Clean Price + Accrued Interest

Determinants of interest rate of loan/bond….
• Tenor
• Liquidity in the system
• Repo Rate and reverse repo rate
• Credit Risk
Different yield curves w.r.t. maturity….

• Normal Yield Curve

• Inverted Yield Curve
• Flat yield Curve
• Humped Yield Curve
Normal yield curve- when short term yield is lower than long
term yield…
25%

20%

15%

10%

5%

0%
10 15 20 25
Yield
Inverted Yield Curve-when short term yield is more than
long term yield
Yield
16%

14%

12%

10%

8%

6%

4%

2%

0%
5 8 10 12 15
Yield
Flat Yield Curve- No change in yield with maturity…

Yield
5%
4%
4%
3%
3%
2%
2%
1%
1%
0%
5 10 15 20
Yield
Humped Yield Curve….short and long term yields are lower
than mid term…
Yield2
12%

10%

8%

6%

4%

2%

0%
5 10 15 20 25 30
Yield2
Theories to explain shape of term structure….

• Pure Expectation Theory/Unbiased Expectation Theory

• Liquidity Premium Theory
• Market Segmentation Theory
Pure Expectation Theory/Unbiased expectation theory…

This theory states that market expectation of future rates will consistently impact
the yield curve shape. A positively shaped curve indicates rates will increase in
future. A flat curve indicates rates will remain same whatever the period of
maturity is. An inverted yield curve points, rates will fall in future.
Liquidity Premium Theory…

This theory assumes that the investors prefer short term bonds to long term
bonds because of increased uncertainty in the long term horizon. Therefore
investors demand a liquidity premium for longer dated bonds. This theory has a
natural bias towards positively sloped curves…
Market Segmentation theory…

Market segmentation theory is a theory that long and short-term interest rates are not related to each
other. It also states that the prevailing interest rates for short, intermediate, and long-term bonds should
be viewed separately like items in different markets for debt securities.

Thus the yield curve is determined by supply and demand at different maturities…
Price Value of a Basis Point (PVBP)….
Price value of a basis point (PVBP) is a measure used to describe how a basis point change in yield affects the
price of a bond.
Price value of a basis point is also known as the value of a basis point (VBP), dollar value of a basis point
(DVBP), or basis point value (BPV).

Let’s assume an analyst wants to understand how a price change for a bond will affect the value of the
security if yields change by 100 basis points. The par value of the bond purchased at par is $10,000, and the
price value of a basis point is given as $13.55.
PVBP = modified duration x $10,000 x 0.0001
13.55 = modified duration x 1
Modified duration = 13.55
This means that if rates go down 100bp (i.e. 1%), the value of the bond will increase by 13.55% x $10,000 =
$1,355.
Modified Duration…
Modified duration is a formula that expresses the measurable change in the value of a security in response to a
change in interest rates. Modified duration follows the concept that interest rates and bond prices move in
opposite directions. This formula is used to determine the effect that a 100-basis-point (1 percent) change in
interest rates will have on the price of a bond
Impact of Monetary Policy on Bonds….
In expansionary monetary policy, the interest is kept low, which results in high price of the Bond.

On the contrary, in contractionary monetary policy, the interest is high, which leads to low price of the bond.

We have previously discussed that the Bond price is discounted by interest rate….
Loan Valuation Formulae…

Pt= {QDFt (1 – LGD) + (1- QDF)(c + LIBOR + EQ (Pt+1 ‫ ן‬no default))}/(1+r)

Pt = Value of a loan today

QDFt = Risk neutral probability of non payment
LGD= Risk neutral loss in case of default
C+LIBOR= Payments which will be paid in the next period
EQ (Pt+1 ‫ ן‬no default) = Value of the loan if the borrower does not default
r = Risk Free Rate

Full form of LIBOR-> London Interbank Offered Rate