Chapter 12

Bond Prices and Yields

Figuring out
the Assured Returns
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Estimate the price of abond.
s Calculate various measures of bond yield.
Show how bond prices vary in response to interest rate changes.
Identify the risks in bonds.
s Understand the meaning and functions of credit rating.
Explain what determines the term structure of interest rates.
Analyse the factors that determine interest rates.

Tn our previous discussion on risk and return relationships, we looked at securities at

La high level of abstraction. We assumed that each security had been analysed in detail
and its risk and return assessment had been done.
We now turn our attention to the assessment of risk and return characteristics of
securities in some detail. This chapter looks at fixed income securities or bonds. The
basic character of these instruments is that they promise to pay a stipulated stream of
cash flows. This generally comprises of periodic interest payments overthelife of the
instrument and principal payment at the time of maturity.
The bondmarket in Indiahas registered an impressive growth particularly from early
to mid-1990s and, not surprisingly, has been accompanied by increasing complexity of
instrumnents, interest rates, and methods of analysis. It is instructive to compare the
characteristics of the pre-liberalisation scenario with those of the post-liberalisation sce
nario. This comparison is given in Exhibit 12.1

BOND CHARACTERISTICS
12.1

A bond represents a security issued in connection with a borrowing arrangement. In

essence, it is an "IOU" issued by the borrower. A bond obligates the issuer to make
340 Investment Analysis and Portiolio Marnagement
specified payments (interest and principal) to the bondholder. A bond may be de
scribed in terms of par value, coupon rate, and maturity date. The par value is the value
stated on the face of the bond. It represents the amount the issuer promises to pay at the
The
time of maturity. The coupon rate is the interest rate payable to the bondholder.
bondholder The
maturity date is the date when the amont is payable to the
b P lissuer and the bondholder, specifies the par
bond indenture, the contract the
value, coupon rate, and maturity date. For example, an issuer may sell a bond witha
par value of Rs 1,000, a coupon rate of eight percent payable semi-annually, and a ma
turity period of 12 years. The buyer of sucha bond would receive an interest of Rs 40
every six months for 12 years and a principal amount of Rs 1000 at the end of
12 years.
Exhibit 12.1 Changing Complexion of Bond Market in India

Pre-liberalisation Scenario Post-liberalisation Scenanio

Instruments The plain vanilla bond was the most Bonds with complex features are gaining
popular instrument in importance
Interest rates Stable and administered interest Volatile and market-deternined interest
rates prevailed rates have come into vogue
Number of players There were few players in the Many players have entered the debt
debt market market
Reference rate Practically, there was no reference A reference rate is gradually emerging
rate
Methods of analysis Investors used simplistic measures Investors have begun calculating more
like current yield and years to precise measures Iike yield to maturity
maturity and followed ad hoc rules and duration and are applying more
of thumb scientific methods
Nature of market The market was by and large There are signs of increasing liquidity:
highly illiquid of course, a lot needs to be done
Approach to portfolio In general, investors followed a The active approach is now receiving
management fairly passive approach more attention

Government Bonds

The largest borrowers in India, and in most other countries, are the central and state
governments. The Government of India periodically issues bonds which are called gov
ernment securities (G-secs) or gilt-edged securities. These are essentially medium to
long-term bonds issued by the Reserve Bank of India on behalf of the Government of
India. Interest payments on these bonds are typically semi-annual. State governments
also sell bonds. These are also essentially medium to long-term bonds issued by the
Reserve Bank of India on behalf of state governments. Interest payments on these bonds
are typically semi-annual.
Apart from the central and state governments, a number of governmental agencies
issue bonds that are guaranteed by the central government or some state government.
Interest payments on these bonds are typically semi-annual.
 des
Bond Prices and Yields
Corporate Bonds
deb e
Companies, like the governments, borrow money by issuing bonds called corporate
bonds (also called corporate debentures). Internationally, a
strument is calledacorporate bond whereas an unsecured corporatesecured corporate debt in
debt
called a corporate debenture. In India, corporate debt instruments have instrument is
been referred to as debentures, although typically they are secred. For the traditionally
sake of sim
plicity, we will refer to all corporate debt instruments as corporate bonds.
A wide range of innovative bonds have been issued in India, particularly from the
earlv 1990s. This innovation has been stimulated by a variety of factors, the most impor
tant being the increased volatility of interest rates and changes in the tax and regulatory
framework. A brief description of various types of corporate bonds is given below.
Straight Bonds The straight bond (also called plain vanilla bond) is the most popular
type of bond. It pays a fixed periodic (usually semi-annual) coupon over its life and
returns the principal on the maturity date.
Zero Coupon Bonds A zero coupon bond (or just zero) does not carry any regular
interest payment. It is issued at asteep discount over its face value and redeemed at face
value on maturity. For example, the Industrial Development Bank of India (iDBI) issued
deep discount bonds in 1996 which have a face value of Rs 200,000 and a maturity
period of 25 years. The bonds were issued at Rs 5,300. These bonds also had call and
put options.

Floating Rate Bonds Straight bonds pay a fixed rate of interest. Floating rate bonds, on
the other hand, pay an interest rate that is linked to a benchmark rate such as the Treas
ury bill interest rate. For example, in 1993 the State Bank of India came out with the first
ever issue of floating interest rate bornds in India. It issued 5 million (Rs.1000 face value)
unsecured, redeemable, subordinated, floating interest rate bonds carrying interest at
three percent per annum over the bank's maximum term deposit rate.
Bonds with Embedded Options Bonds may have options embedded in them. These
options give certain rights to investors and/or issuers. The more common types of
bonds with embedded options are:
Convertible Bonds Convertible bonds give the bond holder the right (option) to convert
them into equity shares on certain terms.
Callable Bonds Callable bonds give the issuer the right (option) to redeem them prema
turely on certain terms.

Puttable Bonds Puttable bonds give the investor the right to prematurely sell them
back to the issuer on certain terms.

Commodity-Linked Bonds The payoff from a commodity linked bond depends to a

certain extent on the price of a certain commodity. For example, in June 1986, Standard
 Management
342 Investment Analvsis and Portfolio

zero coupon notes that would mature in 1992. The payoff from
Oil Corporation issued
note was defined as: $1,000 + 200 [Price per barrel of oil in dollars-$25]. The sec
each
subject to a floor of zero.
ond term of the payoff, however, was

12.2 BOND PRICES

present value of the

(The value of a bond--or anv asset, real or financia!-is equal to the requires:
cash flows expected frommit Hence determining the value of a bond
An estimate of expected cash flows
An estimate of the required return
To simplify our analysis of bond valuation we will make the following assumptions:
The coupon interest rate is fixed for the term of the bond
The coupon payments are made every year and the next coupon payment is
receivable exactlyayear from now
The bond will be redeemed at par on maturity
Given these assumptions, the cash flow for anoncallable bond comprises of an annu
ity of a fixed coupon interest payable annually and the principal amount payable at
maturity. Hence the value of a bond is:
C M
(12.1)
P= Z0+ (1+n"
where P =value (in rupees)
n= number of years
C: annual coupon payment (in rupees)
r= periodic required return
M= maturity value
t= time period when the payment is received
Since the stream of annual coupon payments is an ordinary annuity, we can apply
the formula for the present value of an ordinary annuity. Hence the bond value is given
by the formula:
P= Cx PVIFA,, + Mx PVIF,n (12.2)
To illustrate how to compute the value of a bond, consider a 10-vear, 12 percent
coupon bond with a par value of 1,000. Let us assume that the required vield on this
bond is 13 percent. The cash flows for this bond are as follows:
10 annual coupon payments of Rs 120
Rs 1000 principal repayment 10 years from now
The value of the bond is:
P= 120 x PVIFA13% 10vst 1,000 x PVIF3%,.10yrs
= 120 x 5.426 + 1,000 x 0,295
= 651.1+ 295 = Rs 946.1
 Bond Prices and Yields 343
. Bond Values with
Semi-annual Interest
Most of the bonds pay interest semi-annually. To value
with a unit period of six months, and not one such bonds, we have to work
year. This means that the bond valuation
equation has to be modified along the following lines:
The annual interest payment, C, must be divided by
two to obtain the semi
annual interest payment
The number of years to maturity must be
multiplied by two to get the number of
half-yearly periods
n The discount rate has to be divided by two to get
the discount rate applicable to
heariyY periods
ha
With the modifications, the basic bond valuation becomes:
2
P= SC/2 M
t (1+r/2) (1+r/2)2"
= C/2 (PVIFA,/22) + M(PVIF,/22) (12.3)
where P = value of the bond
C/2= semi-annual interest payment
r/2 = discount rate applicable to a half-year
M= maturity value period
2n = maturity period expressed in terms of half-yearly
periods.
As an illustration, consider an eight-year, 12 percent coupon bond with a par
of Rs 1,009 on which interest is payable semi-annually. The value
bond is 14 percent. required return on this
Applying Eq. 12.3, the value of the bond is:
16
p 100

=6 (PVIFAl6vr + 100 (PVIF%,l6vr)

- Rs 6 (9.447) + Rs 100 (0.339) = Rs 95.5

Price-Yield Relationship
A basic property of a bond is that its price varies inversely with yield.
The reason is
simple. As the required yield increases, the present value of the cash flow decreases;
hence the price decreases. Conversely, when the required yield
decreases, the present
value of the cash flow increases; hence the price increases. The graph of the price-yield
relationship for any callable bond has a convex shape as shown in Exhibit 12.2.
 Management
344 Investment Analysis and Portfolio

Exhibit 12.2 Price-Yield Relationship

Price

Yield

Relationship between Bond Price and Time

there is no
Since the price of a bond must equal its par value at maturity (assuming thatredeemable
risk of default), bond prices change with time. For example, a bond that is
for Rs.1000 (which is its par value) after five years when it matures, will have a price of
Rs.1,000 at maturity, no matter what the current price is. If its current price is, say,
Rs.1,100, it is said to be a premium bond. If the required yield does not change between
now and the maturity date, the premium will decline over time as shown by curve A in
Exhibit 12.3. On the other hand, if the bond has acurrent price of say Rs.900, it is said to
be a discount bond. The discount too will disappear over time as shown by curve Bin
Exhibit 12.3. Only when the current price is equal to par value -insuch a case the bond
is said to be a par bond--there is no change in price as time passes, assuming that the
required yield does not change between now and the maturity date. This is shown by
the dashed line in Exhibit 12.3.

Exhibit 12.3 Price Changes with Time

Value of
bond

Premium bond: ra = 11%

A
Par value bond: ra= 13%

Discount bond: r = 15%

6 5 4 2 1 0
Years to maturity
 Bond Prices and Yields 345

12.3 BOND YIELDS

not
Bonds are generally traded on the basis of their prices. However, they are usually
compared in terms of prices because of significant variations in cash flow patterns and
other features. Instead, they are typically compared in terms of yield.
and dis
In the previous section we learned how to determine the price of a bond
cussed how price and yield were related. We now discuss various yield measures.yield
The commonly employed yield measures are: current yield, yieldyield to maturity,
measures are
to call, and realised yield to maturity. Let us examine how these
calculated.

Current Yield

the market price. It is expressed

The current yield relates the annual coupon interest to
as:
Annual interest
Current yield
Price
current yield of a 10 year, 12 percent coupon bond with a par value
For example, the
12.63 percent.
of Rs 1000 and selling for Rs 950 is
120 =0.1263 or 12.63 percent
Current yield =
950
calculation reflects only the coupon interest rate.)It does not con
(The current yield investor will realise if the bond is purchased at a
sider the capital gain (or loss) that an
held till maturity. It also ignores the time value of money.
discount (or premium) and
measure of yield.
Hence it is an incomplete and simplistic
discoct
" Yield to Maturity
are not quoted a promised rate of return. Using the
you
When you purchase a bond,maturity payments, you figure out the
date, and coupon
information on bond price, over its life. Popularly referred to as the yield to
bond
rate of return offered by the rate that makes the present value of the cash flows
maturity (YTM), it is the discount to theprice of the bond. Mathematically, it
is the
receivable fromowning the bond eqkal equation:
interest rate (r) which satisfies the C M
C C (12.4)
P= + r ) ² +(1+ r)" (1+r"
(1+r) (1 +
where P= price of the bond
C= annual interest (in rupees)
 Portfolio Management
346 Investment Analysis and

M= maturity value (in rupees)

n = number of years left to maturity and error procedure. To illustrate this, con
requires a trial
The computation of YTM carrying a coupon rate of nine percent,
maturing after
sider a Rs 1,000 par value bond, selling for Rs 800. What is the YTM on this bond? The
eight years. The bond is currently
YTM is the value of r in the following equation:
90 1000
+
800 = 1+r' (1+r)"
= 90 (PVIFA, Ny) t 1,000 (PVIF,8yrs)
begin witha discount rate of 12 percent. Puttinga value of 12 percent for r we
Let us is:
find that the right-hand side of the above expression
Rs 90 (PVIFA, v) t Rs 1,000 (P\VIF12%,8yrs)
Rs 90(4.968) + Rs 1,000(0.404) = Rs 851.0
higher value for r. Let us
Since this value is greater than Rs 800, we may have to try a
try r= 14 percent. This makes the right-hand side equal to:
Rs 90 (PVIFAj4% 8vr)+ Rs 1,000 (PVIF}4%, Svrs)
= Rs 90 (4.639) + Rs 1,000 (0.351) = Rs 768.1
Since this value is less than Rs 800, we try a lower value for r. Let us try r = 13
percent. This makes the right-hand side equal to:
Rs 90 (PVIFA13%,8vrs) + Rs 1,000 (PVIF13%,Svrs)
= Rs 90 (4.800) + Rs 1,000 (0.376) = Rs 808
Thus r lies between 13 percent and 14 percent. Using a linear interpolation' in the
range 13 percent to 14 percent, we find that r is equal to 13.2 percent:
808-800
13% + (14% - 13%) 13.2%
S08 -768.1
An Approximation If you are not inclined to follow the trial-and-error approach de
scribed above, you can employ the following formula to find the approximate YTM on a
bond:
C+(M- P)ln
YTM (12.5)
0.4M + 0.6P

The procedure for linear interpolation is as follows:

(a) Find the difference between the present value for the two rates, which in this case is
Rs 39.9 (Rs 808-Rs 768.1).
(b) Find the difference between the present value corresponding to the lower rate (Rs 808 at
13 percent) and the target value (Rs 800), which in this case is Rs 8.0.
Diidethe outcome of (b) with the outcome of (a), which is 8.0/39.9 or 0.2. Add this frac
tion to the lower rate, i.e., 13 percent. This gives the YTM of 13.2 percent.
 Bond Prices and Yields 347
where YTM = yield to maturity
C= annual interest paynment
M= maturity value of the bond
P= present price of the bond
n= years to maturity
To illustrate the use of this formula, let us consider the bond discussed above. The
approximate YTM of the bond works out to:
YTM
90+ (1000 800)/8
= 13.1%,
0.4 × 1000 + 0.6 x 800
Thus, we find that this formula gives a value which is very close to the true value.
Hence it is very useful.
The YTM calculation considers the current coupon income as well as the capital gain
or loss the investor will realise by holding the bond to maturity. In addition, it takes into
account the timing of the cash flows.
The YTM of a bond is the internal rate of return on an investment in the bond. It can
be interpreted as the compound rate of return over the life of the bond, assuming that all
the coupons can be reinvested at a rate of return equal to the YTM of the bond.
Yields are reported in the financial press on an annualised basis. Annualisation, how
ever, is done by simply doubling the semi-annual yield. Thus, if the semni-annual yield
is, say, four percent, the annualised yield, referred to as the annual percentage rate or
APR is stated as eight percent. Essentially, APR is based on simple interest-annualised
vields based on simple interest are also called bond equivalent yields. However, if you
want to calculate the effective annual yield of a bond you have to use compound interest.
If the bond earns 4percent every six months, then one rupee of investment grows to 1x
(1.04)² =1.0816 after one year. Hence, the effective annual yield works out to 8.16 per
cent.

" Yield to Call

Some bonds carrya call feature that entitles the issuer to call (buy back) the bond prior
call
to the stated maturity date in accordance with acall schedule (which specifies a
to call
price for each call date). For such bonds, it is a practice to calculate the yield
(YTC) as well as the YTM. Mathematically
The procedure for calculating the YTCis the same as for the YTM.
the YTC is the value of r in the following equation:
C M (12.6)
+
(1+r)"
where M= call price (in rupees) call date
n = number of years until the assumed
348

" Realised Vield to Maturity

lhe \TM calulatin assunes that the cash tlows veived
through the lite of a bond
hTesevi at a rate vual o the viel omaturity. This assumption mav not be validareas
IRmTestitent rate s aplirable tu future cash flows mav be ditterent. lt is necessarv to
tethne the futue evestment raters and tfigure out the alised vield to
this is dne mav maturitv. How
illustratei bv an evannple.
Cnsider a Rs l n r value nd. carrving an interest rate of 15 percent
annuall anni maturing atter 5 vears. The resent market price of this bond is(pavable
Rs 850.
The einvestent rat arpicable to the future cash tlows ot this bond is
l6
tutune value of the benetits veivable tom this bond, calculated in Exhibitpercent. The
12.4 works
out to Ns 232. 1The alisi vield tomaturity is the
value ofr in the tollowing equation:
Iresent market prie (1 + ) = Future value
N50 (1 + )=2032
1 + -2032/S50 =2.391
r =0.19 or 19 percent.
Exhibit 12.4 Future Value of Benetits

1 2 3
Ivestment 850
Annual interest 150 150 150 150 150
RRe-investment
peiod (in years) 2
Compound factor
(at 16 percent) 1.81 1.56 1.35 1,16 1.00
Future value of
intermediate cash tlows 271.5 234.0 202.5 174.0 150.
Maturity value
1000
Total tuture value = 271.5+ 234.0+ 202.5+ 174.0+ 150.0 + 1000 = 2032
 SOLVED PROBLEMS

1. A Rs 100 par value bond bearing a coupon rate of 12 percent will mature after five years.
What is the value of the bond, if the discount rate is 15 percent ?
Solution
Since the annual interest payment will be Rs 12 for five
ment will be Rs 100 after five years, the value of the years and the principal repay
bond, a discount rate of 15 percent,
at
will be

V= Rs 12 (PVIFAjs%, 5yr) + Rs 100

Rs 12
(PVF15%, 5yrs)
(3.352) + Rs 100 (0.497)
= 40. 22+ 49.70 = Rs 89.92
2. The market price of a Rs 1,000 par
value
maturing after five years is Rs 1050. Whatbond carrying a coupon rate of 14 percent and
What is the approximate YTM? What willis bethethevield to maturity (YTM) on this bond?
investment rate is 12 percent? realised vield to maturity if the re
 Bond Prices and Yields 371
Solution
The YTM is the value of r in the following
equation:
140 1,000
1,050 = (1+r
+)
140 (PVIFA, sy) + 1,000 (PVIF,,s yrs
Let us try a value of 13 percent for r.The right hand side of the above expression becomes:
140 (PVIFAj, 5yr)+ 1,000 (PVIF1, 5yr
= 140 (3.517) + 1,000 (0.543)
492.4 + 543.0 = Rs 1035.4
Since this is less than Rs 1,050, we try a lower value for r. Let us try r= 12 percent. This
makes the right-hand side equal to:
140 (PVIFAj2%, 5yrs)+ 1,000 (PVIF12%,5 yr)
= 140 (3.605) + 1,000 (0.567)
= 504.7 +567.0 =Rs 1071.7
Thus, r lies between 12 percent and 13 percent. Using a linear interpolation in this range,
we find that r is equal to:
1071.7 - 1050.0
12% + (13% - 12%) = 12.60 percent
1071.7 -1035.4
(b) The approximate YTM works out to:
YTM 140 + (1,000 -1,050)/5
12.62 percent
0.40 x 1000 +0.6>x 1050
(c) The realised yield to maturity may be calculated as follows:
Future value of interest and principal repayment
= 140 (1.12) + 140 (1.12) +140 (1.12)° + 140 (1.12) + 140 + 1000
= Rs 1925.4
Present market price (1+r') = Rs 1925.4 o 8 4 3 0 2

Rs 1050 (1+r)= Rs 1925.4

(1+r'$ = 1.8337
r'= 1.8337}-1
= 1.1289-1 = 12.89 percent
3. A Rs 100 par value bond bears a coupon rate of 14 percent and matures after five years.
Interest is payable semi-annually. Compute the value of the bond if the required rate of
return is 16 percent.
Solution
In this case the number of half-yearly periods is 10, the half-yearly interest payment is
Rs. 7, and the discount rate applicable to a half-yearly period is 8 percent. Hence, the
value of the bond is:
10
100
V= Za0s (1.08)° +
 Management
Investment Analysis and Portfolio
372
=7 (PVIFAg%, 10 yrs 100 (PVIFg%, 10 yrs)
=7 (6.710) + 100 (0.463)
46.97 + 46.30

= Rs 93.27

4. Consider the following data for government securities:

Interest Rate (%) Maturity (Years) Current Price
Face value
0 91,000
100,000 2 99,000
100,000 10.5
11.0 3 99,500
100,000
100,000 11.5 99,900
Calculate the forvward rates.
Solution
bill
To get forward interest rates, begin with the one-year treasury
91,000 = 100,000/(1+r;) ’r, = 0.099
Next consider the two-year government security
110,500
99,000 = 10,500
(1.099) (1.099) (1 +r,)
r; = 0.124
Then consider the three-year government security
11,000 11,000 111,000
99.500 = (1.099)
(A.099) (1.124) (1.099) (1.124) (1 +,)
I3 = 0.115
Finally consider the four-year government security
99.500 = 11500 11,500 11,500 111500
(1.099) (L.099) (1.124) (1.099) (1.124) (1.1 15) (L099) (1.124) (1.115) (1+ )
T4= 0.128