Bonds

 : What are bonds?

 They are like a loan.

 They are issued by companies, financial institutions,
and governments at the local/state/federal level to
public investors in order to obtain capital.
 They have a set maturity date, e.g. in 10, 20, 30 years.
 They carry a certain interest rate (= coupon rate).
Advantages/Disadvantages of Debt Financing

 Advantages  Disadvantages
 Less risky for investor;  Increased Financial
therefore cheaper source of
capital than stock
Risk (risk of
 Tax deduction for interest
Bankruptcy)
results in lower after tax
cost to company
 Use someone else’s money
to increase return to
Stockholders (ROE)

Bond basics
 Face Value/Par Value
 The face value is the amount of money a holder will get back once a bond matures. A
newly issued bond usually sells at the par value.

Coupon (The Interest Rate)

The coupon is the amount the bondholder will receive as interest payments, most bonds
pay interest every six months, but it's possible for them to pay monthly, quarterly or
annually.

Maturity
The maturity date is the date in the future on which the investor's principal will be repaid.
a longer term bond will fluctuate more than a shorter term bond.
A bond that matures in one year is much more predictable and thus less risky than a bond
that matures in 20 years. Also, all things being equal,
Bond Types
 Callable, or a redeemable bond –
 gives a bond issuer the right, but not the obligation, to redeem his issue of bonds before the
bond's maturity.
 American callable bonds can be called by the issuer any time after the call protection period
 European callable bonds can be called by the issuer only on pre-specified dates.
The optimal time for issuers to call their bonds is when the prevailing interest rate is lower
than the coupon rate they are paying on the bonds.

 Convertible bonds
 give bondholders the right but not the obligation to convert their bonds into a predetermined
number of shares at predetermined dates prior to the bond's maturity.

 Puttable bonds
 give bondholders the right but not the obligation to sell their bonds back to the issuer at a
predetermined price and date. These bonds generally protect investors from interest rate risk.
Bond Market

Term
Coupon
Frequency Rate

Bond

Options Price

Maturity Face
Value Value
 Valuation of securities
6

 Valuation Concept
 A security is a series of interest or dividends
 Value= Present Values of future cash streams
 Vo = C1 + C2 +….+Cn + pn (1+ k)1
(1+ k)2 (1+ k)t (1+ k)
 where Vo= Value of asset at time O
n = expected life, Cn = expected cash flow at the
end of period t, K = Discount rate/ required rate of
return.
Securities & Portfolio Management 12/07/2021
Bond Pricing
 bond's price, which uses the basic present value (PV)
formula:

C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value 
Accrued interest
  
 A bond seller must be compensated for the portion of the coupon he
earns for holding the bond since the last payment.
 Accrued interest is fraction of the coupon payment that the bond seller
earns for holding the bond for a period of time between bond payments.  
 Dirty bond prices- include any accrued interest that has accumulated
since the last coupon payment
  clean bond prices do not include interest that accrues between coupon
payment dates.
 The amount of the coupon payment that the buyer should receive from
the seller of a bond is the coupon payment minus accrued interest.
Accrued interest
Relationship between bond price and interest rate

 The basic relationship between the price of a bond

and prevailing market interest rates is an inverse
relationship.
 example, if you have a 6% bond (this means that it
pays $60 annually per $1000 of face value) and
interest rates jump to 8%, wouldn't you agree that
your bond should be worth less now if you were to
sell it?
 Bond Yield Measures
11

 Current Yield = Coupon Interest / Current Market Price

 Example: Market Price =Rs 800/-, Coupon = 10%

 Interest= Rs 100/-p.a, Face Value=1000

 Yield= 100 X 100 = 12.5%

 800


 Current Yield exceeds the coupon rate if Bond is selling at

DISCOUNT.
Securities & Portfolio Management 12/07/2021
 Current Yield
12

 Current Yield ignores reinvestment of Income &

Capital Gain/ Loss on maturity.

 Capital gain of Rs 200/- at maturity (1000-800)

Securities & Portfolio Management 12/07/2021

 Bond Yield Measures
13

 Yield to Maturity
 Yield to maturity is the rate of return earned by
investor who purchases the bond and holds it till
maturity.
 YTM is the discount Rate which equals the present
value of promised cash flows to the current market
Price / Purchase Price.

Securities & Portfolio Management 12/07/2021

Yield To maturity
 The yield to maturity is the interest rate that makes the
present value of a bond’s payments equal to its price.
 The yield to maturity is the annual return annual rate
earned over a bond kept until maturity. 
 The yield to maturity is the discount rate estimated
mathematically that equals the cash flow of payment of
interest and principal received with the purchasing price
of the bond.
 This term is also referred to as internal rate of return or
as the expected rate of return of the bond.
 If an investor buys a bond in the secondary market and pays a price
different from par value, then not only will the current yield differ from the
nominal yield, but there will be a gain or loss when the bond matures and
the bondholder receives the par value of the bond.
 If the investor holds the bond until maturity, he will lose money if he paid a
premium for the bond, or he will earn money if he paid for it at a discount.
 The yield-to-maturity (YTM), or true yield, of a bond that is held to
maturity will have to account for the gain or loss that occurs when the par
value is repaid.
 When a bond is bought at a discount, yield to maturity will always be
greater than the current yield because there will be a gain when the bond
matures, and the bondholder receives par value back, thus raising the true
yield
Assumtions of YTM
 The yield-to-maturity depends on two assumptions:
 The bonds are held to maturity
 The interest payments received are reinvested at the
same rate as the yield-to-maturity
 Bond Yield Measures
17

 Exp: Rs 1000 Bond , Market Price = Rs 850 , Coupon 8% Maturity 9 years

 What would be the rate of return if investor purchases it and holds till maturity?
 Solution
 n I F
 VO = t + n
 t=1 (1+kd) (1+ kd)
 9 80 1000
 850 = t + 9
 t=1 (1+kd) (1+ kd)
 at 12% - 787
 at 10% - 884
  
 Ans 10.65%

Securities & Portfolio Management 12/07/2021

Yield to maturity
 On exel

 Summary of Bond Yield Relationships

 When the bondholder pays...
 less than par value (discount).  Yield to Maturity >
Nominal Yield
 par value.  Nominal Yield = Yield to Maturity
 more than par value (premium).  Nominal Yield > Yield to
Maturity
 Bond Return and Prices
19

 YIELD TO CALL
 When a Bond is subject to Redemption prior to
Maturity:- yield to call is computed & compared
with yield to maturity
 For a given rate, P.V of assumed cash flow to call
can be determined and yield to call is then defined
as that discount rate which makes this P.V figure
equal to Bonds market Value

Securities & Portfolio Management 12/07/2021

Yield to call
 Example: 30 years maturity 9% Bond sells at
1200 , which is callable at 1150/- in ten years.
coupon is paid semi annually.
 Calculate yield to call and yield to maturity.


Zero Coupon Bond
 Zero Coupon Bonds
are issued at a discount to their face value and at the time of
maturity, the face value is repaid to the holders
 . No interest (coupon) is paid to the holders and hence, there
are no cash inflows
 The difference between issue price (discounted price) and
redeemable price (face value) itself acts as interest to holders.
 The issue price of Zero Coupon Bonds is inversely related to
their maturity period, i.e. longer the maturity period lesser
would be the issue price and vice-versa.
 These types of bonds are also known as Deep Discount Bonds