Fixed Income Markets

Fixed Income Markets
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Part-06
Part-02
An Introduction to Fixed Income
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Securities 2
Basics
What is debt?
It is a financial claim.
Who issues it?
The borrower of funds
For whom it is a liability
Who holds it?
The lender of funds
For whom it is an asset
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Basics (Cont…)
What is the difference between debt and

equity?
Debt does not confer ownership rights on the
holder.
It is merely an IOU
A promise to pay interest at periodic intervals
And to repay the principal at a pre-specified maturity
date.
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Basics (Cont…)
It usually has a finite life span
The interest payments are contractual
obligations
Borrowers are required to make payments
irrespective of their financial performance
Interest payments have to be made before any
dividends can be paid to equity holders.
In the event of liquidation
• The claims of debt holders must be settled first
• Only then can equity holders be paid.
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Fixed Income – Instruments
Fixed Deposits
Banks
Companies
Post Office Deposits
Bonds/ Debentures
Money Market Instruments
Debt Mutual Funds
Structured Products
Fixed Income Securities
Are All Instruments Securities?
What is Difference?
A security is an instrument which can be

traded ( bought & sold) in the market.
Why are bonds and debentures termed as

Once the rate of interest is set at the onset of
the period for which it is due
It is not a function of the profitability of the firm
Thus even floating rate bonds are fixed
income securities
Failure to pay the promised interest will
tantamount to default
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Basics (Cont…)
Bonds may be secured or unsecured

Unsecured debt securities are termed as
Debentures in the US
Unsecured implies that no specific assets have
been earmarked as collateral
Secured debt issues require the firm to earmark
specific assets as collateral
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Basics (Cont…)
Debt securities may be negotiable or non-

negotiable
Negotiable securities can be traded in the
secondary market
Can be endorsed by one party in favor of another
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Markets for Fixed Income Securities
 Markets Prior to 1980s
 Dominated by plain vanilla bonds with simple cash flow
structures
 Valuation was simple and straightforward
 Markets After 1980s
 Complex cash flow structures
 A variety of securities
 Derivative products to facilitate portfolio strategies to
control interest rate risk and to enhance return
 Wider range of investors
Markets for Fixed Income Securities
 Two thirds of the market value of all the securities outstanding in
world classified as fixed income
 Most participants in the corporate and financial sectors
participate in this market
 Federal governments, state governments, and municipalities
have not choice but to issue fixed income securities
 Therefore, a need to have well informed participants so that they
understand
 the forces that drive the bond market
 The valuation of complex cash flow structures
 Portfolio management strategies
Participants in Debt Markets
 Issuers
 Government
 Government Companies /agencies
 State governments
 Municipalities
 Banks and other Financial Institutions
 Corporates
 Objectives
 To receive a fair value for their securities
 Be able to issue securities that best fit their needs
 Investors
 Pension / Provident Funds
 Insurance companies
 Commercial banks
 Mutual funds
 Central banks
 Corporates
 Individual investors
 Objectives
 Safety
 Fixed Income
 Buy/Sell at a fair market price
 Intermediaries
 Help issuers in the initial offering of the security
 Assist in pricing and distribution of the securities
 Make a secondary market, provide liquidity
 Engage in proprietary trading activities
 Produce information about credit quality of different issuers
 Provide liquidity
Plain Vanilla & Bells and Whistles
 The most basic form of a bond is called the
Plain Vanilla version.
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Plain Vanilla (Cont…)
 This is true for all securities, not just for bonds.
 More complicated versions are said to have
`Bells and Whistles’ attached.
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Plain Vanilla (Cont…)
Floating rate bonds are similar to

conventional bonds
The difference is that the interest rate does not
remain fixed
It varies from period to period based on the
benchmark to which it is linked
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Bonds With Embedded Options
Convertible bonds can be converted to

shares of stock
Callable bonds can be prematurely retired
by the issuer
Putable bonds can be prematurely
surrendered by the holders
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Face Value
It is the principal value underlying the

bond.
It is the amount payable by the borrower to the
last holder at maturity.
It is the amount on which the periodic interest
payments are calculated.
A.K.A as
Par Value
Redemption Value
Maturity Value
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Principal Value 21
Term to Maturity
It is the time remaining in the life of the

bond.
It represents the length of time for which
interest has to be paid as promised.
It represents the length of time after which the
face value will be repaid.
A.K.A as
Maturity
Term
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Coupon
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Coupon
The coupon payment is the periodic
interest payment that has to be made by
the borrower.
The coupon rate when multiplied by the face
value gives the dollar value of the coupon.
Most bonds pays coupons on a semi-annual basis.
In the earlier days bonds were accompanied by
a booklet of post-dated coupons
Each coupon could be detached and redeemed on
the corresponding coupon payment date
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Example of Coupon Calculation
Consider a bond with a face value of Rs

1000.
The coupon rate is 8% per annum paid
semi-annually.
So the bond holder will receive
1000 x 0.08
___ = 40 every six months.
2
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Yield to Maturity (YTM)
 Yield to maturity is the rate of return for an
investor if he buys the bond at the prevailing
market price and holds it till maturity.
 In order to get the YTM, two conditions must be
satisfied.
The bond must be held till maturity.
All coupon payments received before maturity must be
reinvested at the YTM.
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YTM (Cont…)
At any point in time the YTM may be

Greater than
Less than or
Equal to the Coupon Rate
YTM is the IRR of a bond
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Value of a Bond
 A bond holder gets a stream of contractually
promised payments.
 The value of the bond is the value of this stream
of cash flows.
 However you cannot simply add up cash flows
arising at different points in time.
Cash flows have to be discounted before being added.
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Price versus Yield
Price versus yield is a chicken and egg
story
We cannot say which comes first.
If we know the yield that is required we can
quote a price accordingly.
Similarly, once we acquire the asset at a certain
price, we can work out the corresponding yield.
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Bond Valuation
A bond is an instrument that will pay

identical coupons every period, usually
every six months
And will then repay the face value at
maturity.
The periodic cash flows obviously
constitute an annuity.
The terminal face value is a lump sum
payment.
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Bond Valuation (Cont…)
 Consider a bond that pays a semi-annual
coupon of C/2, and which has a face value of M.
 Assume that there are N coupons left, and that
we are standing on a coupon payment date.
That is, we are assuming that the next coupon is exactly
six months away.
 The required annual yield is y, which implies that
the semi-annual yield is y/2.
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Illustration
IBM has issued a bond with a face value

of Rs 1,000.
The coupon is 8% per year to be paid on
July 15 and January 15 every year.
Assume that today is 15 July 2012 and
that the bond matures on 15 January
2032.
The required yield is 10% per annum.
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Par, Discount & Premium Bonds
 In the above example, the price of the bond is
less than the face value of Rs1,000.
 Such a bond is called a Discount Bond, since it
is trading at a discount from the face value.
 The reason why it is trading for less than the
face value is because the required yield of 10%
Is greater than the rate of 8% that the bond is paying by
way of interest.
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Par, Discount & Premium Bonds
(Cont…)
 If the required yield were to equal the coupon
rate, the bond would sell for Rs1,000.
 Such bonds are said to be trading at Par.
 If the required yield were to be less than the
coupon rate the price will exceed the face value.
Such bonds are called Premium Bonds, since they are
trading at a premium over the face value.
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Par Discount and Premium (Cont…)
If c = y, P = M
Thus if the coupon is equal to the YTM, the
bond will always sell at Par
It can be shown that the bond price is a
monotonically increasing function of the
coupon
Obviously if the coupon is less than the YTM
the price will be less than the face value
If the coupon is greater than the YTM the price
will be in excess of the face value
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Par Premium and Discount (Cont…)
Why would a bond trade at a premium or a

discount?
The price of a bond is the PV of all the cash
flows emanating from it
If YTM = coupon the return demanded by
investors will be equal to the rate offered by the
issuer
Obviously the bond will sell at PAR
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What if the YTM is less than the coupon

Assume c = 10% while YTM = 8%
An investor will be willing to pay more than the
face value
The price would be bid up to a level where the
YTM is equal to 8%
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On the other hand what if YTM is greater

than the coupon
Assume coupon = 8% while YTM = 10%
Investors will only pay less than the face value
The price will be driven down to a level where
the yield is exactly 10%
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Evolution of The Price
Consider the change in price of a bond

from one coupon date to another
assuming that the YTM is constant
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Evolution (Cont…)
If y = c, then ΔP = 0
Thus if the YTM remains constant, the
price of a par bond will remain at par as
we go from one coupon date to the next
If the YTM > Coupon, ΔP > 0
Thus a discount bond will steadily increase in
price as we go from one coupon date to another
If YTM < Coupon ΔP < 0
A premium bond will steadily decline in price as
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we go from one coupon date to another
Illustration
Consider a bond with 10 years to maturity

and a par value of 1,000
YTM is 8% per annum
Coupon = 6% per annum
Price = 864.10
If we move 6-M ahead the price will be
868.66 if the YTM were to remain constant
Obviously since it is a discount bond the price
has increased
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Illustration (Cont…)
Now consider a bond with 10 years to

maturity and a face value of 1,000
YTM = 8%
Coupon = 10%
Price = 1135.90
Six months later if the yield were to remain
constant the price will be 1131.34
Obviously the price has declined
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Zero Coupon Bonds
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Zero Coupon Bonds
 A Plain Vanilla bond pays coupon interest every
period, typically every six months, and repays
the face value at maturity.
 A Zero Coupon Bond on the other hand does
not pay any coupon interest.
 It is issued at a discount from the face value and
repays the principal at maturity.
 The difference between the price and the face
value constitutes the interest for the buyer.
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Illustration
Microsoft is issuing zero coupon bonds
with 5 years to maturity and a face value
of Rs10,000.
If you want a yield of 10% per annum,
what price will you pay?
The price of the bond is the present value
of a single cash flow of Rs10,000,
discounted at 10%.
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In practice, we usually discount the face

value using a semi-annual rate of y/2,
where y in this case is 10%.
This is to facilitate comparisons with
conventional bonds which pay coupon
interest every six months.
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Zero Coupon Bonds (Cont…)
Zero coupon bonds are called Zeroes by
traders.
They are also referred to as Deep
Discount Bonds.
They should not be confused with
Discount Bonds
Which are Plain Vanilla bonds which are trading
at a discount from the face value.
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A zero coupon bond can never sell at a

premium
It will always trade at a discount prior to
maturity
At maturity it will trade at par
Can a zero coupon bond give rise to a
capital gain or a loss?
If it is bought and held to maturity there will
obviously be a capital gain
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If a zero coupon bond is sold prior to

maturity there may be a capital gain or a
capital loss
Consider a bond with 10 years to maturity
The YTM at the time of purchase was 10%
The cost was 376.90
A year later it is sold at a YTM of 12%
The corresponding price is 350.35
Obviously there is a capital loss
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Treasury Securities
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Treasury Securities
They are fully backed by the federal
government of the issuing nation.
Consequently they are devoid of credit risk
or the risk of default.
The interest rate on such securities is
used as a benchmark for setting rates on
other kinds of debt.
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U.S. Treasury Securities
The Treasury issues three categories of

marketable securities.
T-bills are discount securities
They are issued at a discount from their face
values and do not pay interest.
T-notes and T-bonds are sold at face
value and pay interest periodically.
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U.S. Treasury Securities (Cont…)
T-bills are issued with a original time to

maturity of one year or less.
Consequently they are Money market
instruments.
They have maturities of either 1, 3, 6, or 12
months at the time of issue.
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US. Treasury Securities (Cont…)
T-notes and T-bonds have a time to

maturity exceeding one year at the time of
issue.
They are therefore capital market instruments.
T-bonds have an original maturity in excess of
10 years, extending up to 30 years.
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U.S. Treasury Securities (Cont…)
T-notes are similar to T-bonds except that

their terms to maturity range from one to
ten years.
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Primary Dealers
 Who is a primary dealer?
A PD is a bank or securities broker-dealer that directly
deals in government securities with the Reserve Bank of
India.
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Primary Dealers (Cont…)
The FED requires primary dealers to

participate meaningfully in both open
market operations
as well as Treasury Auctions.
The current list of primary dealers is as
follows.
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List of Primary Dealers
 Bank of Nova Scotia, New  Jefferies & Company, Inc.
York Agency  J.P. Morgan Securities LLC
 BMO Capital Markets Corp.  Merrill Lynch
 BNP Paribas Securities  Mizuho Securities USA Inc.
 Barclays Capital Inc.  Morgan Stanley & Co.
Incorporated
 Cantor Fitzgerald & Co.
 Nomura Securities
 Citigroup Global Markets International, Inc.
 Credit Suisse Securities  RBC Capital Markets
 Daiwa Capital Markets  RBS Securities Inc.
America  SG Americas Securities
 Deutsche Bank Securities  UBS Securities LLC.
 Goldman, Sachs & Co.
 HSBC Securities (USA)
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Primary Dealers in India
 Deutsche Securities  Royal Bank of Scotland
 ICICI Securities Primary  Bank of America
Dealership
 IDBI Bank  Bank of Baroda
 Morgan Stanley India Primary  Canara Bank
Dealer  Citibank
 Nomura Fixed Income
Securities
 Corporation Bank
 PNB Gilts  HDFC Bank
 SBI DFHI  STCI Primary Dealer
 Kotak Mahindra Bank  HSBC
 Standard Chartered Bank
 JP Morgan Chase
 Axis Bank
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 Goldman Sachs 59
Treasury Auctions
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Treasury Auctions
The U.S. Treasury sells bills, notes, and
bonds by way of a competitive auction
process.
Most of the treasury securities are bought
by primary dealers.
Individual investors who submit non-
competitive bids participate on a much
smaller scale.
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Treasury Auctions (Cont…)
The auction process begins with a public
announcement by the Treasury giving the
following information.
Offering amount
Description of the offering
Strips information
Is the security eligible for stripping
Procedures for submission of bids; minimum
bid amount; and payment terms
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 Primary dealers who bid for their accounts or on
behalf of their clients usually submit large
competitive bids
These bids indicate not only the quantity that is sought
But also the maximum price that the bidder is prepared
to pay if it is a price based auction
Or the minimum yield that the bidder is prepared to
accept if it is a yield based auction
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Bids are submitted in terms of discount
rates for bills
Stated in 3 decimal places
In 0.005 percent increments
In note and bond auctions
They are expressed as yields up to 3 decimal
places
In 0.001 percent increments
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When Issued (WI) Trading
The when issued market is a market for

forward trading of a bond
Whose issue has been announced but has not
yet taken place
Trades take place from the date of
announcement until the actual issue date
Helps bidders to gauge the market’s
interest before the actual auction
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WI Trading (Cont…)
WI trading has ramifications for the bidding

strategies of market participants
It has a bearing on the outcome of the
auction
Traders can take both long and short
positions
Settlement is scheduled for the issue date
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Coupon Stripping
 The process of separating each coupon payment as well
as the principal and selling securities backed by them is
referred to as Coupon Stripping.
 The receipts issued in the process are not created by the
Treasury.
But the underlying asset in the bank custody account is
an obligation of the Treasury.
Thus the cash flows from the underlying asset are
guaranteed.
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Treasury Strips
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STRIPS
The Treasury launched this programme in

1985 to facilitate the stripping of
designated Treasury securities.
All new T-bonds and notes with a maturity of 10
years or more are eligible.
The zeroes created in the process are direct
obligations of the U.S. government.
They are cleared through the Federal Reserve’s
book-entry system.
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STRIPS (Cont…)
On dealer quote sheets and vendor

screens, STRIPS are identified as
follows.
Cash Flow Source Symbol
Coupon ci
Principal from T-bond bp
Principal from T-note np
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STRIPS (Cont…)
The mechanism of issue is as follows.

A dealer who owns a bond or note can ask the
FRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate security.
Each of these securities can be traded independently
of others.
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STRIPS (Cont…)
Most coupon and principal payments fall
on the same set of dates
These are
15 February
15 May
15 August
15 November
So a lot of bonds would have coupons on
the same date.
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STRIPS (Cont…)
All interest payments falling due on a

given date would be converted in to the
same security
Regardless of the bond they were stripped from
Consequently coupon payments are said to be
fungible
Principal payments falling on the same date are
not fungible
They have different CUSIP numbers
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STRIPS (Cont…)
In 1987 the Treasury started to allow

dealers to reverse the process
This is called STRIPS RECONSTUTUTION
How does this work?
If a dealer owns STRIPS representing all the
coupon and principal payments of a bond
The FED can on request convert these holdings into
a single position in the corresponding bond
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Floating Rate Bonds
 In the case of a Plain Vanilla Bond, the coupon
rate that is specified at the outset, is valid for the
life of the bond.
 In the case of a Floating Rate bond, the coupon
rate is reset at the beginning of every period
And is therefore valid for only the next six months.
 Thus when you buy such a bond, the coupon will
be known only for the first six months.
Subsequent coupons will be unknown.
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Floaters (Cont…)
 For instance the rate on a floating rate bond,
also called a Floater, may be specified as LIBOR
+ 50b.p. in which case the spread is positive.
 Or it may be specified as LIBOR – 30b.p., in
which case the spread is negative.
 The rate of interest on a floater will move directly
with changes in the benchmark.
 Thus if LIBOR rises, the rate will increase,
whereas if LIBOR falls, the rate will decrease.
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Inverse Floaters
 In the case of an inverse floater the coupon
varies inversely with the benchmark.
 For instance the rate on an inverse floater may
be specified as 10% - LIBOR.
 In this case as LIBOR rises, the coupon will
decrease, whereas as LIBOR falls, the coupon
will increase.
In this case a floor has to be specified for the coupon.
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Inverse Floaters (Cont…)
In the absence of a floor the coupon can

become negative in principle.
In the above case, if LIBOR were to exceed
10%, then we would be confronted with the
spectre of a negative coupon.
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Callable Bonds
 In the case of such a bond, the issuer has the
right to call back the bond prematurely.
He can buy it back from the holder before maturity by
paying him the face value.
 In this case the option is with the issuer, and so
he has to pay a price for it.
This compensation will manifest itself as a lower price
for the bond as compared to a Plain Vanilla Bond.
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Callable Bond (Cont…)
Since prices and yields are inversely

related a lower price means a higher yield.
Thus buyers of callable bonds demand a
higher yield from them as compared to buyers
of otherwise similar plain vanilla bonds.
This is because a buyer of a callable bond is
exposed to cash flow uncertainty.
He can never be sure as to when a bond will be
recalled.
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Callable Bonds (Cont…)
When will a callable bond be recalled?

Obviously when interest rates or required
yields are falling.
Under such conditions, the issuer can call
back the bonds and issue fresh bonds with a
lower coupon.
However this is precisely the scenario when a
holder would like to hold on to his bonds, since
they are yielding a higher rate of interest.
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 Thus the call provision works in favour of the
borrower and against the lender.
Hence it is not surprising that callable bonds command
a lower price.
 The way to look at it is as follows
At the time of issue a callable bond has to carry a higher
coupon than an equivalent Plain Vanilla Bond
Subsequently a callable with a given coupon will have a
lower price than a Plain Vanilla with the same coupon.
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A bond may be discretely callable or

continuously callable
A discretely callable bond may be recalled
only at certain pre-specified dates
For instance the coupon dates over a period of
the bond’s life
A continuously callable bond may be
called at any time after it becomes callable
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Freely callable bonds can be called at any

time.
Thus they offer the lender no protection.
Deferred Callable Bonds on the other
hand do offer some protection.
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This is because they have a Call

Protection Period during which they
cannot be recalled.
For instance if a bond with 20 years to maturity
has a call protection period of 10 years, then it
cannot be recalled for the first 10 years.
After that, it will of course become freely callable.
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In practice when a bond is recalled, the
issuer will pay the lender not just the face
value, but usually also one year’s coupon.
This additional amount is called the Call
Premium.
The call premium acts as a sweetener
That is it makes such bonds more attractive to
potential investors.
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One of the risks in a callable bond is

therefore reinvestment risk
The bond will be called back when market rates
are low
And consequently the proceeds will have to be
invested at a lower rate of interest.
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Second, the price appreciation potential

for a callable bond in a declining interest
rate environment is limited.
This is because the market will increasingly
expect the bond to be redeemed at the call
price as rates fall.
This is referred to as Price Compression.
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Given the reinvestment risk and price

compression why would any investor want
to hold such a bond.
If he receives sufficient compensation in the
form of a higher yield he may be willing to take
the risk.
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Puttable Bonds
Such bonds give the lender or the

bondholder, the right to return the bond
prematurely, and take back the face value.
The option in such cases is with the
bondholders or the lenders, and consequently
they have to pay an option premium.
This will manifest itself as a higher bond price, as
compared to that of an otherwise similar plain vanilla
bond.
8/11/2019 90
Puttable Bonds (Cont…)
A higher bond price obviously means a
lower yield.
When will such a put option be exercised?
Obviously when interest rates are rising.
Under such conditions holders can return the
bonds and buy fresh bonds with a higher
coupon rate.
This is precisely the scenario when the issuers
would prefer that the holders hold on to the
bonds.
8/11/2019 91
Since the put option works in favour of the

holder and against the issuer
Such bonds are characterized by higher prices
or lower yields.
At the time of issue a puttable will carry a lower
coupon than an equivalent Plain Vanilla
Subsequently a puttable will carry a higher price
than a Plain Vanilla with the same coupon.
8/11/2019 92
The price at which a bond can be sold

back by the holder acts as a floor price for
the bond when interest rates rise.
Since the holders can always return the
bonds at this price, they will never sell to
anyone else at a lower price.
8/11/2019 93
Convertible Bonds
A conversion provision, if present in the

bond, grants the bondholder the right to
convert the bond into a predetermined
number of shares
It is therefore a Plain Vanilla corporate bond
with a call option to buy the common stock of
the issuer.
8/11/2019 94
Convertible Bonds (Cont…)
 The number of shares of common stock that a
bondholder will receive if he converts the bond is
called the Conversion Ratio.
The conversion privilege may extend for all or only some
portion of the bond’s life.
The stated conversion ratio may also decline over time.
The conversion ratio is always adjusted proportionately
for stock splits and stock dividends.
8/11/2019 95
Illustration
 ABC Corporation has issued the following bond
Maturity = 10 years
Coupon rate = 8%
Conversion ratio = 40
Face value = $1,000
Current market price = $900
Current share price = $20
Dividends per share = $1
8/11/2019 96
The conversion price = 1000
------- = $25
40
The conversion value of a convertible
bond is the value if it is converted
immediately.
Conversion value = Share price x
Conversion Ratio
8/11/2019 97
Convertible Bond (Cont…)
The minimum price of a convertible bond

is the greater of:
Its conversion value or
Its value as a bond without the conversion
option .
This is also called the straight value of the bond.
8/11/2019 98
To estimate the straight value we must

determine the required yield on a non-
convertible bond
with the same credit rating and similar
investment characteristics.
8/11/2019 99
In our case the conversion value is

$20 x 40 = $800
To determine the straight value we have to
obtain the YTM of a comparable straight
bond.
Assume it is 10%.
 Straight value = 40PVIFA(5,20)+1000PVIF(5,20)
= $875.38
8/11/2019 100
Exchangeable Bonds
 These are a category of convertible bonds where the
holder gets the shares of a different company when he
converts the bonds.
 For instance if IBM were to issue convertible bonds, the holders
would get shares of IBM if they were to convert.
 On the other hand, if IBM were to issue exchangeable bonds, the
holders would get shares of another company, say Hewlett
Packard.
8/11/2019 101
Exchangeable Bonds (Cont…)
Exchangeable bonds may be issued by

firms which own blocks of shares of
another company and intend to sell them
eventually.
They may like to defer the sale and issue such
bonds, because they may perceive a rise in the
value of the shares.
It may also be the case that they desire to defer
their capital gains tax liability.
8/11/2019 102
Exchangeable Bonds (Cont…)
An advantage for the issuer is that they do

not lead to dilution for the parent
company’s shareholders
Convertible bonds lead to such dilution when
they are converted
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Risks Inherent in Bonds
What is risk?
Risk is the possibility of loss arising due to
the uncertainty regarding the outcome of a
transaction.
All bonds are exposed to one or more
sources of risk.
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Credit Risk
8/11/2019 105
Credit Risk
 This risk refers to the possibility of default by the
borrower.
 That is, it refers to the risk that coupon payments
and/or principal payments may not be
forthcoming as promised.
 Except for Treasury securities - which are
backed by the full faith and credit of the Federal
government - all debt securities are exposed to
credit risk of varying magnitudes.
8/11/2019 106
Credit Evaluation
 At the time of issue, it is the issuer’s
responsibility to provide accurate information
about his financial soundness and
creditworthiness.
 This is provided in the Offer Document or the
Prospectus.
 But every potential investor cannot be expected
to be able to properly evaluate the
creditworthiness of a borrower.
 Thus in practice we have credit rating agencies.
8/11/2019 107
Rating Agencies
8/11/2019 108
Credit Rating Agencies
 Such agencies specialize in evaluating the credit
quality of a bond at the time of issue.
 They also monitor the issuing company,
throughout the life of the bond, and modify their
recommendations if required.
 The main rating agencies in the U.S. are
 Moody’s Investors Service
 Standard and Poor’s Corporation
and Fitch Ratings.
8/11/2019 109
Rating Criteria
Ratings are based on an in-depth analysis

of the issuer’s financial condition and
management
And the specific source of revenue that
has been specified as collateral for the
bond.
8/11/2019 110
Investment Grade Ratings
Credit Moody’s S&P’s Fitch’s

Risk Ratings Ratings Ratings
Highest Aaa AAA AAA
Quality
High Aa AA AA
Quality
Upper A A A
Medium
Medium Baa BBB BBB
8/11/2019 111
Non Investment Grade Ratings
Credit Risk Moody’s S&P Fitch
Somewhat Ba BB BB
Speculative
Speculative B B B
Highly Caa CCC CCC

Speculative
Most Ca CC CC
Speculative
Imminent C C C
Default
Default C D D
8/11/2019 112
Junk Bonds
Non-investment grade bonds are also

known as
Speculative grade bonds
Or JUNK Bonds
JUNK bonds may be
Original issue junk
Or Fallen Angels
8/11/2019 113
Changes in Ratings
Ratings can change over the course of

time.
If a rating change is being contemplated,
the agency will signal its intentions.
S&P will place the security on Credit Watch.
Moody’s on Under Review.
Fitch on Rating Watch.
8/11/2019 114
Bond Insurance
A company can have its issue insured in

order to enhance its credit quality.
An insurance premium will have to be paid, but
the coupon rate will come down.
The insurance company will then guarantee
the timely payment of the principal and interest.
8/11/2019 115
Insured Bonds
Insured bonds receive the same rating as

the insurance company, which is based on
the insurer’s capital and claims-paying
ability.
In the U.S., the buyer of an uninsured
bond can separately buy insurance for it
on his own.
8/11/2019 116
Liquidity Risk
8/11/2019 117
Liquidity Risk
This risk refers to the possibility that the

market may be illiquid or thin at a time
when the asset holder wants to buy or sell
the security.
A liquid market is characterized by the
presence of a sizeable number of buyers
and sellers at any point in time.
8/11/2019 118
Illiquid Markets
In illiquid markets, potential buyers will

have to offer a large premium over the fair
value of an asset in order to acquire it
whereas potential sellers will have to accept
large discounts at the time of sale.
Illiquid markets are characterized by large
bid-ask spreads, because trades will be
few and far between.
8/11/2019 119
Interest Rate Risk
8/11/2019 120
Interest Rate Risk
The interest rate or yield is the key
variable of interest in debt markets.
The yield is the fundamental variable that
drives the market.
Interest rate risk refers to the fact that
rates may move in an adverse fashion
from the standpoint of the holder of the
debt instrument.
8/11/2019 121
Interest Rate Risk
Interest rate risk impacts fixed income
securities in two ways.
Firstly, all bonds with the exception of zeroes
pay coupons
These have to be reinvested.
Reinvestment risk is the risk that market
rates of interest may decline by the time a
coupon is received.
8/11/2019 122
Interest Rate Risk (Cont…)
If so, the coupon will have to be reinvested

at a lower than anticipated rate of interest.
Secondly a bond may not be held to
maturity.
If it is sold prior to maturity, it will have to be at
the prevailing market price
This will be inversely related to the prevailing yield.
8/11/2019 123
Interest Rate Risk (Cont…)
Market Risk or Price Risk, is the risk that
interest rates may be higher than
anticipated at the time of sale
in which case the bond will have to be sold at a
lower than anticipated price.
The two risks work in opposite directions.
Reinvestment risk arises because rates may
fall subsequently
Market risk arises because rates may rise
subsequently.
8/11/2019 124
Inflation Risk
8/11/2019 125
Inflation Risk
Inflation refers to the erosion in the
purchasing power of money.
Most bonds promise fixed cash flows in
dollar terms.
Inflation risk is the risk that the purchasing
power of money may have eroded by
more than what was anticipated
 By the time the cash flow from the bond is
received.
8/11/2019 126
Inflation Risk (Cont…)
High inflation will reduce the effective or

Real rate of interest.
The interest rate in monetary terms is
called the Nominal Rate of interest.
The Real Rate, on the other hand, is the
nominal rate adjusted for changes in the
purchasing power.
8/11/2019 127
Inflation Risk (Cont…)
From the Fisher Equation:

(1+R) = (1+r)(1+)
R  Nominal rate
r  real rate
  inflation rate
8/11/2019 128
Indexed Bonds
These are bonds whose coupons are

linked to a price index.
Price indices are used as barometers of
changes in the purchasing power of a
currency.
If inflation is high, so will be the index level
and vice versa.
8/11/2019 129
Indexed Bonds (Cont…)
Thus indexed bonds will offer higher cash

flows during times of high inflation
And relatively lower cash flows during
periods of lower inflation
This will ensure that the cash flow in real terms
is kept at a virtually constant level.
8/11/2019 130
Timing Risk
8/11/2019 131
Timing Risk
 In the case of Plain Vanilla bonds, there is no
uncertainty regarding the times to receipt of the
cash flows.
 However, callable bonds can be recalled at any
time.
 For a callable bond holder there is cash flow
uncertainty
He is unsure as to how many coupons he is going to get
and also as to when the face value will be repaid.
8/11/2019 132
Timing Risk (Cont…)
Thus holders of callable bonds will

demand a premium for bearing this risk.
That is why callable bonds trade at a lower
price than comparable plain vanilla bonds.
8/11/2019 133
FOREX Risk
8/11/2019 134
Foreign Exchange Risk
This risk arises when the cash flows from

a bond are denominated in a foreign
currency.
If the foreign currency depreciates in value
with respect to the home currency, the
returns will be lower than anticipated.
8/11/2019 135
Illustration
 A bond promises to pay a coupon of $10 every
six months.
 Assume that the rate of exchange is Rs 50 per
dollar.
So an Indian bondholder will expect to receive Rs 500
every six months.
 However, what if the exchange rate at the time
of the coupon payment is Rs 45.
If so, he will receive only Rs 450.
8/11/2019 136
Valuation in between
Coupon Dates
While valuing a bond we assumed that we
were standing on a coupon payment date.
This is a significant assumption because it
implies that the next coupon is exactly one
period away.
What should be the procedure if the
valuation date is in between two coupon
payment dates?
8/11/2019 137
The Procedure
for US Treasury Bonds
Calculate the actual number of days
between the date of valuation and the next
coupon date.
Include the next coupon date.
But do not include the starting date.
Or vice versa
Let us call this interval N1.
8/11/2019 138
Treasury Bonds (Cont…)
Calculate the actual number of days

between the coupon date preceding the
valuation date and the following coupon
date.
Once again include the ending date but exclude
the starting date or vice versa
Let us call this time interval as N2.
8/11/2019 139
The next coupon is then k periods away

where
8/11/2019 140
Illustration
There is a Treasury bond with a face value
of $1,000.
The coupon rate is 8% per annum, paid on
a semi-annual basis.
The coupon dates are 15 July and 15
January.
The maturity date is 15 January 2032.
Today is 15 September 2012.
8/11/2019 141
No. of Days Till the
Next Coupon Date
Month No. of Days
September 15
October 31
November 30
December 31
January 15
TOTAL 122
8/11/2019 142
No. of Days between
Coupon Dates
Month No. of Days

July 16
August 31
September 30
October 31
November 30
December 31
January 15
8/11/2019
TOTAL 184 143
K = 122/184 = .6630
This method is called the Actual/Actual
method and is often pronounced as the
Ack/Ack method.
It is the method used for Treasury bonds
in the U.S.
8/11/2019 144
The Treasury Method
There is a difference between the Wall

Street approach and the approach used by
the Treasury to value T-bonds.
The difference is that the Treasury uses a
simple interest approach for the fractional first
period.
8/11/2019 145
The Treasury Method (Cont…)
The Treasury approach will always give a

lower price because
For a fractional period the simple interest
approach will always give a larger discount
factor than the compound interest approach.
8/11/2019 146
The 30/360 NASD Approach
 The Actual/Actual method is applicable for
Treasury bonds in the U.S.
 For corporate bonds in the U.S. we use what is
called the 30/360 NASD method.
In this method the number of days between successive
coupon dates is always taken to be 180.
That is each month is considered to be of 30 days.
8/11/2019 147
The 30/360 Approach (Cont…)
The number of days from the date of

valuation till the next coupon date is
calculated as follows.
The start date is defined as
D1 = (month1, day1,year1)
The ending date is defined as
D2 = (month2,day2,year2)
8/11/2019 148
The 30/360 Approach (Cont…)
The number of days is then calculated as

360(year2 – year1) + 30(month2 – month1)
+ (day2 – day1)
8/11/2019 149
Additional Rules
If day1 = 31 then set day1 = 30

If day1 is the last day of February, then set
day1 = 30
If day1 = 30 or has been set equal to 30,
then if day2 = 31, set day2 = 30
8/11/2019 150
Examples of Calculations
Start Date End Date Actual Days Days Based

on 30/360
Jan-01-86 Feb-01-86 31 30
Jan-15-86 Feb-01-86 17 16
Feb-15-86 Apr-01-86 45 46
Jul-15-86 Sep-15-86 62 60
Nov-01-86 Mar-01-87 120 120
Dec-15-86 Dec-31-86 16 16
Dec-31-86 Feb-01-87 31 31
Feb-01-88
8/11/2019
Mar-01-88 29 30 151
Pricing of A Corporate Bond
Let us assume that the bond considered

earlier was a corporate bond rather than a
Treasury bond.
8/11/2019 152
30/360 European Convention
In this convention, if day2 = 31, then it is

always set equal to 30.
So the additional rules are:
This is the convention used in India for
Treasury securities
8/11/2019 153
Examples of Calculations
Start Date End Date Actual Days
Days Based on
30/360E
Mar-31-86 Dec-31-86 275 270
Dec-15-86 Dec-31-86 16 15
8/11/2019 154
Actual/365 Convention
The difference between this and the

Actual/Actual method is that the
denominator in this convention will consist
of 365 even in leap years.
8/11/2019 155
Actual/365 Japanese
This is used for Japanese Government

Bonds (JGBs)
It is similar to the Actual/365 method.
The only difference is that in this case, the
extra day in February is ignored in leap
years
While calculating both the numerator and the
denominator.
This is the convention for corporate bonds
8/11/2019 156
in India
Actual/365 ISDA
 This day count convention is identical to the Actual/365
convention for a coupon period that does not include
days falling within a leap year.
 However for a coupon period that includes days falling
within a leap year, the day count is given by:
#of days falling within the leap year
______________________________ +
366
#of days not falling within the leap year
_________________________________
365
8/11/2019 157
Actual/360 Convention
This is a simple variant of Actual/365.

This is the convention used for money
market instruments in most countries.
8/11/2019 158
Global Conventions
Country Security Convention

Japan T-bills Act/365 Japanese
Japan JGBs Act/365 Japanese
Japan Other Bonds Act/365 Japanese
UK Fixed rate gilts Act/Act
UK Index linked gilts Act/Act
UK Strips Act/Act
US T-bills Act/360
US T-notes and T-bonds Act/Act
US Other bonds 30/360 NASD
India Government bonds 30E/360
8/11/2019 159
India Corporate bonds Act/Act
Accrued Interest
8/11/2019 160
Accrued Interest
 The price of a bond is the present value of all the
cash flows that the buyer will receive when he
buys the bond.
Thus the seller is compensated for all the cash flows
that he is parting with.
 This compensation includes the amount due for
the fact that the seller is parting with the entire
next coupon, although he has held it for a part of
the current coupon period.
8/11/2019 161
Accrued Interest (Cont…)
This compensation is called Accrued

Interest.
Let us denote the sale date by t; the
previous coupon date by t1; and the
following coupon date by t2
The accrued interest is given by
8/11/2019 162
Accrued Interest (Cont…)
Both the numerator and the denominator

are calculated according to the
conventions discussed above.
That is for U.S. Treasury bonds the
Actual/Actual method is used
 Whereas for U.S. corporate bonds the 30/360
NASD method is used.
8/11/2019 163
Why Accrued Interest?
Why should we calculate the accrued

interest if it is already included in the price
calculation?
The answer is that the quoted bond price does
not include accrued interest.
That is, quoted prices are net of accrued
interest.
8/11/2019 164
Why Accrued Interest? (Cont…)
The rationale is as follows.
On July 15 the price of the Treasury bond
using a YTM of 10% is $829.83.
On September 15 the price using a yield of
10% is $843.5906.
Since the required yield on both the days is the
same, the increase in price is entirely due to the
accrued interest.
8/11/2019 165
Why Accrued Interest (Cont…)
On July 15 the accrued interest is zero.

On a coupon payment date, the accrued
interest has to be zero.
On September 15 the accrued interest is
8/11/2019 166
 The price net of accrued interest is
$843.5906 - $13.4783 = $830.1123$
which is very close to the price of $829.83 that was
observed on July 15.
 We know that as the required yield changes, so
will the price.
 If the accrued interest is not subtracted from the
price before being quoted then we would be
unsure
Whether the observed price change is due to a change
in the market yield or is entirely due to accrued interest.
8/11/2019 167
However if prices are reported net of

accrued interest, then in the short run
observed price changes will be entirely due to
changes in the market yield.
Consequently bond prices are always reported
after subtracting the accrued interest.
8/11/2019 168
Clean versus Dirty Prices
Quoted bond prices are called clean or

add-interest prices.
When a bond is purchased in addition to
the quoted price, the accrued interest has
also to be paid.
The total price that is paid is called the
dirty price or the full price.
8/11/2019 169
Negative Accrued Interest
 One logical question is
Can the accrued interest be negative?
That is, can there be cases where the seller of the bond
has to pay accrued interest to the buyer.
 The answer is yes.
In markets where bonds trade ex-dividend the dirty price
will fall by the present value of the next coupon on the
ex-dividend date and the dirty price will be less than the
clean price.
8/11/2019 170
Ex-dividend Date
It is actually a misnomer for bonds do not

pay interest.
Till this date the buyer will get the
forthcoming coupon
Starting from this date, the next coupon
will go to the seller.
8/11/2019 171
Example
Take a T-bond that matures on 15 July
2031.
It pays a 9% coupon semi-annually on 15
January and 15 July every year.
The face value is 1000 and the YTM is
8%.
Assume that we are on 5 January 2012
which is the ex-dividend date.
8/11/2019 172
Example (Cont…)
 Using the Actual/Actual convention we can

calculate k to be 0.0543.
8/11/2019 173
Example (Cont…)
The moment the bond goes ex-dividend

the dirty price will fall
By the present value of the forthcoming coupon,
because the buyer will be no longer entitled to
it.
8/11/2019 174
Example (Cont…)
 Thus the ex-dividend dirty price is
8/11/2019 175
Example (Cont…)
This is the amount payable by the person
who buys the bond an instant after it goes
ex-dividend.
The accrued interest an instant before the
bond goes ex-dividend is:
0.09x1000 174
________ x ____ = $ 42.5543
2 184
8/11/2019 176
Example (Cont…)
 Thus the clean price at the time of the bond
going ex-dividend is
1140.4910 – 42.5543 = $1097.9367
 The clean price is therefore greater than the ex-
dividend dirty price.
This represents the fact that the seller has to
compensate the buyer
 because while the buyer is entitled to his share of the next
coupon the entire amount will be received by the seller.
8/11/2019 177
Example (Cont…)
The fraction of the next coupon that is
payable to the buyer is
0.09x1000 10
_________ x ____ = $2.4457
2 184
Hence the buyer has to pay
1097.9367 – 2.4457 = $1095.4910 which
is the ex-dividend dirty price.
8/11/2019 178
Yield Measures
The yield or the rate of return from a bond

can and is computed in various ways.
We will discuss various yield measures
and their relative merits and demerits.
8/11/2019 179
The Current Yield
This is very commonly reported.

Although it is technically very
unsatisfactory.
It relates the annual coupon payment to
the current market price.
8/11/2019 180
Example of the Current Yield
A 15 year 15% coupon bond is currently

selling for $800.
The face value is $1,000
The current yield is given by
8/11/2019 181
Current Yield (Cont…)
If you buy this bond for $800 and hold it for
one year you will earn an interest income
of $150.
So your interest yield is 18.75%
However, if you sell it after one year you
will either make a Capital Gain or a Capital
Loss.
8/11/2019 182
What is a Capital Gain?

If the price at the time of sale is higher than the
price at which the bond was bought, the profit is
termed as a Capital Gain.
Else if there is a loss, it is termed a Capital
Loss.
The current yield does not take such gains
and losses into account.
8/11/2019 183
 One question is:
Should the current yield be based on the dirty price or
the clean price
 The advantage of using the clean price is that the current
yield will stay constant till the yield changes.
However if the dirty price is used it will give rise to a
sawtooth pattern.
8/11/2019 184
The current yield is used to estimate the

cost of or profit from holding the bond.
If short-term rates are higher than the
current yield, the bond is said to involve a
running cost.
This is known as negative carry or negative
funding.
8/11/2019 185
Simple YTM
This yield measure attempts to rectify the

shortcomings of the current yield by taking
into account capital gains and losses.
The assumption made is that capital gains
and losses accrue evenly over the life of
the bond.
8/11/2019 186
Simple YTM (Cont…)
The formula is:

Simple YTM = C M-P
__ + ____
P PXN/2
8/11/2019 187
For the 15 year bond that we considered

earlier
Simple YTM = 150 1000-800
_____+_________ = 20.42%
800 15 x 800
8/11/2019 188
The problem with the simple YTM is that it

does not take into account the compound
interest that can be earned by reinvesting
the coupons.
This will obviously increase the overall
return from the bond.
8/11/2019 189
Yield to Maturity (YTM)
The YTM is the interest rate that equates

the present value of the cash flows from
the bond (assuming that the bond is held
to maturity), to the price of the bond.
It is exactly analogous to the concept of
the Internal Rate of Return (IRR) used in
project valuation.
8/11/2019 190
YTM (Cont…)
Consider a bond that pays an annual

coupon of C on a semi-annual basis.
The face value is M, the price is P, and the
number of coupons remaining is N.
8/11/2019 191
YTM (Cont…)
The YTM is the value of y that satisfies the

following equation.
8/11/2019 192
YTM (Cont…)
 The YTM is a solution to a non-linear equation.
 We generally require a financial calculator or a
computer to calculate it.
 However it is fairly simple to compute the YTM in
the case of a coupon paying bond with exactly
two periods to maturity.
In such a case it is simply a solution to a quadratic
equation.
8/11/2019 193
YTM for a Zero Coupon Bond
The YTM is easy to compute in the case of

zero coupon bonds.
Consider a ZCB with a face value of
$1,000, maturing after 5 years.
The current price is $500.
The YTM is the solution to
8/11/2019 194
Features of YTM
The YTM calculation takes into account all

the coupon payments
As well as any capital gains/losses that
accrue to an investor who buys and holds
a bond to maturity.
8/11/2019 195
Sources of Returns From a Bond
A bondholder can expect to receive

income from the following sources.
Firstly there are coupon payments which
are typically paid every six months.
There will be a capital gain/loss when a
bond matures or is called before maturity
or is sold before maturity.
8/11/2019 196
Returns From a Bond (Cont…)
 The YTM calculation assumes that the bond is
held to maturity.
 Finally when a coupon is received it will have to
be reinvested till the time the bond eventually
matures or is sold or is called.
Once again the YTM calculation assumes that the bond
is held till maturity.
The reinvestment income is nothing but interest on
interest.
8/11/2019 197
YTM
A satisfactory measure of the yield should

take into account all the three sources of
income.
The current yield measure considers only
the coupon for the first year.
All the other factors are totally ignored.
8/11/2019 198
YTM (Cont…)
The YTM calculation takes into account all

the three sources of income.
However it makes two key assumptions.
Firstly it assumes that the bond is held till
maturity.
Secondly it assumes that all intermediate
coupons are reinvested at the YTM itself.
8/11/2019 199
YTM (Cont…)
The latter assumption is built in to the
mathematics of the YTM calculation.
The YTM is called a Promised Yield.
It is Promised because in order to realize it
you have to satisfy both the above
conditions.
If either of the two conditions is violated you
may not get what was promised.
8/11/2019 200
The Re-investment Assumption
Consider a bond that pays a semi-annual
coupon of $C/2.
Let r be the annual rate of interest at which
these coupons can be re-invested.
r would be dependent on the market rate
of interest that is prevailing when the
coupon is received
It need not be equal to y, the YTM, or c,
the coupon rate.
8/11/2019 201
Reinvestment (Cont…)
For ease of exposition we will assume that

r is a constant for the life of the bond.
However, in practice, it is likely that each
coupon may have to be reinvested at a
different rate of interest.
Thus each coupon can be re-invested at a
rate of r/2 per six monthly period.
8/11/2019 202
The coupon stream is an annuity.

The final payoff from re-investment is the
future value of this annuity.
The future value is
8/11/2019 203
The future value represents the sum of all

the coupons which are reinvested (which
in this case is the principal)
Plus the interest from re-investment.
The total value of coupons that are
reinvested is
8/11/2019 204
Re-investment (Cont…)
The interest on interest is therefore
The YTM Calculation assumes that r/2 = y/2.

8/11/2019 205
Reinvestment in Action
Consider an L&T bond with 10 years to

maturity.
The face value is Rs 1,000.
It pay a semi-annual coupon at the rate of
10% per annum.
The YTM is 12% per annum.
Price can be calculated to be Rs 885.295.
8/11/2019 206
Reinvestment in Action (Cont…)
Assume that the semi-annual interest

payments can be reinvested at a six
monthly rate of 6%, which corresponds to
a nominal annual rate of 12%.
The total coupon income = 50 x 20 = 1000
8/11/2019 207
Interest on interest gotten by reinvesting

the coupons
8/11/2019 208
Finally in the end you will get back the

face value of Rs 1,000.
So the total cash flow at the end
= 1000 + 839.3 + 1000 = 2839.3
To get this income, the bondholder has to
make an initial investment of 885.295.
8/11/2019 209
So what is the effective rate of return?

It is the value of i that satisfies the
following equation
8/11/2019 210
So the rate of return is 6% on a semi-

annual basis or 12% on a nominal annual
basis,
Which is exactly the same as the YTM.
So how was this return achieved?
Only by being able to reinvest all the coupons
at a nominal annual rate of 12%, compounded
on a semi-annual basis.
8/11/2019 211
The Significance of the Reinvestment
Rate
The reinvestment rate affects only the
interest on interest income.
The other two sources are unaffected.
If r > y, then the investor’s interest on
interest income would be higher
And the return on investment, i, would be
greater than the YTM, y.
8/11/2019 212
The Reinvestment Rate (Cont…)
 On the contrary, if r < y, then the interest on
interest income would be lower
And the rate of return, i, would be less than the YTM, y.
 So if you buy a bond by paying a price which
corresponds to a given YTM, you will realize that
YTM only if
You hold the bond till maturity
You are able to reinvest all the intermediate coupons at
the YTM.
8/11/2019 213
Reinvestment Risk
One faced by an investor is that future
reinvestment rates may be less than the
rate prevailing when the bond was bought
This risk is called Reinvestment Risk.
The degree of reinvestment risk depends on the
time to maturity as well as the quantum of the
coupon.
8/11/2019 214
Reinvestment Risk (Cont…)
For a bond with a given YTM, and a

coupon rate, the greater the time to
maturity
The more dependent is the total return from the
bond on the reinvestment income.
Thus everything else remaining constant,
the longer the term to maturity
The greater is the reinvestment risk.
8/11/2019 215
For a bond with a given maturity and YTM,

the higher the coupon rate
The more dependent is the total return on the
reinvestment income.
Thus everything else remaining the same,
the larger the coupon rate
The greater is the reinvestment risk.
8/11/2019 216
Thus premium bonds will be more

vulnerable to such risks than bonds selling
at par.
Correspondingly, discount bonds will be
less vulnerable than bonds selling at par.
8/11/2019 217
Zero Coupon Bonds
and Reinvestment Risk
 If a zero coupon bond is held to maturity, there
will be no reinvestment risk, because there are
no coupons to reinvest.
Thus if a ZCB is held to maturity, the actual rate of
return will be equal to the promised YTM.
 If the risk is lower or absent, the return should
also be less.
Thus a ZCB will command a higher price than an
otherwise similar Plain Vanilla bond.
8/11/2019 218
The Realized Compound Yield
 We will continue with the assumption that the
bond is held till maturity.
 But we will make an explicit assumption about
the rate at which the coupons can be reinvested.
 That is, unlike in the case of the YTM, we will no
longer take it for granted
That intermediate cash flows can be reinvested at the
YTM.
8/11/2019 219
Illustration
Let us reconsider the L&T bond.

Assume that intermediate coupons can be
reinvested at 7% for six months, or at a
nominal annual rate of 14%.
The total coupon income and the final face
value payment will remain the same
But the reinvestment income will change.
8/11/2019 220
The interest on interest
8/11/2019 221
So the final amount received

= 1000 + 1049.75 + 1000 = 3049.75
The initial investment is once again
885.295
Therefore, the rate of return is given by
8/11/2019 222
This is the rate of return for six months.

The nominal annual return is 6.38 x 2 =
12.76%
Which is greater than the YTM of 12%.
The RCY is greater than the YTM,
because we assumed that
The reinvestment rate was greater than the
YTM.
8/11/2019 223
Had we assumed the reinvestment rate to
be less than the YTM
The RCY would have turned out to be less than
the YTM.
The RCY can be an ex-ante or an ex-post
measure.
Ex-ante means that we make an assumption
about the reinvestment rate and calculate the
RCY.
8/11/2019 224
Ex-post means that we take into account

the actual rate at which we have been able
to reinvest and calculate the RCY.
8/11/2019 225
The Horizon Return
Let us now relax both the assumptions

which were used to calculate the YTM.
Firstly the investor need not hold the bond
until maturity.
Secondly he may not be able to reinvest
the coupons at the YTM.
8/11/2019 226
The Horizon Return (Cont…)
Now the return will depend on three

sources
 the coupons received
the reinvestment income
 and the price at which the bond is sold prior to
maturity.
The sale price of the bond would depend
on the prevailing market yield at that point
in time
And need not equal the face value.
8/11/2019 227
Illustration
Assume that an investor with a 7 year
investment horizon buys the L&T bond
that we discussed earlier.
He will get coupons for 14 periods (not 20).
The total coupon income will be
50x14 = 700
We will assume that the reinvestment rate
is expected to be 7% per six monthly
period.
8/11/2019 228
We will also assume that the investor

expects the YTM after 7 years to be 12%
per annum.
The first step is to calculate the expected
price at the time of sale.
At that point in time the bond will have 3 years
to maturity.
8/11/2019 229
The price using a YTM of 12% can be

shown to be Rs 950.865.
The interest on interest
8/11/2019 230
The total terminal cash flow

= 700 + 427.50 + 950.865 = 2,078.365
 The initial investment as before is 885.295
8/11/2019 231
The nominal annual rate of return is

6.29x2 = 12.58%
This is the Horizon Yield.
It is also known as the Holding Period Yield
Once again, it can be calculated ex-post or
ex-ante.
8/11/2019 232
Yield to Call (YTC)
This measure of the rate of return is used

for callable bonds.
The YTC is the yield that will make the
present value of the cash flows from the
bond equal to the price
Assuming the bond is held till the call date.
In principle a bond can have many
possible call dates.
8/11/2019 233
YTC (Cont…)
In practice the cash flows are usually

taken only till the first call date
Although they can easily be taken to any
subsequent call date.
The YTC is given by the equation
8/11/2019 234
YTC (Cont…)
 N* is the number of coupons till the call date.
 M* is the price at which the bond is expected to
be recalled.
 M* need not equal the face value.
 In practice companies pay as much as one
year’s coupon as a Call Premium at the time of
recall.
 If so, M* = M + C
8/11/2019 235
Let us assume that the L&T bond is a

callable bond and that the first call date is
7 years away.
Assume that a call premium of Rs 100 will
be paid if the bond is recalled.
8/11/2019 236
The YTC is the solution to the following

equation
8/11/2019 237
The solution comes out to be 6.74%.
So the YTC on an annual basis is 13.48%.
The YTC is very important for Premium
Bonds.
The very fact that a bond is selling at a
premium, indicates that the coupon is
greater than the yield
And that therefore there is a greater chance of
recall.
8/11/2019 238
The Yield to Worst
In practice the investors compute the YTC

for every possible call date.
They then compute the YTM as well.
The lowest of all possible values is called
the Yield to Worst.
8/11/2019 239
Portfolio Yield
Consider a case where you hold a portfolio

or a collection of bonds.
You cannot simply calculate the yield from
the portfolio as a weighted average of the
YTMs of the individual bonds.
8/11/2019 240
Portfolio Yield (Cont…)
You have to first compute the cash flows

from the portfolio, and then find that
interest rate
Which will make the present value of the cash
flows equal to the sum of the prices of the
component bonds.
In other words you need to calculate the
Portfolio IRR
8/11/2019 241
Illustration
Consider a person who buys a TELCO

bond and a Ranbaxy bond.
The TELCO bond has a time to maturity of
5 years, face value of 1000, and pays
coupons semi-annually at the rate of 10%
per annum.
8/11/2019 242
The Ranbaxy bond has a face value of

1000, time to maturity of 4 years, and pays
a coupon of 10% per annum semi-
annually.
Consider a portfolio consisting of one bond
of each company.
What is the portfolio yield?
8/11/2019 243
The first step is to calculate the two prices.

The price of the TELCO bond can be
shown to be 926.405.
The price of the Ranbaxy bond can be
shown to be 827.63.
The total initial investment is therefore
1,754.035
8/11/2019 244
The Cash Flow Table
Period Investment Inflow from Inflow from Total

TELCO Ranbaxy
0 (1754.035) (1754.035)
1 50 50 100
2 50 50 100
3 50 50 100
4 50 50 100
5 50 50 100
6 50 50 100
7 50 50 100
8 50 1050 1100
9 50 50
8/11/2019 245
10 1050 1050
Using a financial calculator or a spread

sheet, the portfolio yield can be calculated
to be 13.76%.
8/11/2019 246
Taxable Equivalent Yield (TEY)
Certain bonds are tax exempt

In the US both federal and state
governments can levy income tax
To compare a normal bond with a tax-free
bond we need to compute the TEY of the
tax-free bond
8/11/2019 247
TEY (Cont…)
The method of calculation depends on the

applicable taxes
Let us consider a Municipal bond which is
yielding 6%
It is obviously exempt from Federal IT
Assume the Federal tax rate is 25%
TEY = 6.00/(1-0.25) = 8%
8/11/2019 248
TEY (Cont…)
The implication is the following

An investor should be indifferent between
a taxable bond yielding 8% and the tax-
free Muni
If a taxable bond yields more than 8% go for it
If it yields less than 8% choose the Muni
8/11/2019 249
TEY (Cont…)
To be more precise we need to account

for the fact that both bonds attract state
income tax
This may not appear to warrant an adjustment
since both bonds will be impacted
However an adjustment is required because
State taxes can be deducted while computing the
Federal tax bill
8/11/2019 250
TEY (Cont…)
 Assume the Federal rate is 25% while the state tax rate
is 8%
 The adjusted federal rate is:
25 - 0.25x0.08 = 0.23
 TEY = 6.00/(1-0.23) = 7.7922%
 That is if a person earns $100 he will have to pay $8 to
the state
Federal tax is applicable only on $92
Thus the effective Federal rate is
0.92x0.25 = 0.23  23%
8/11/2019 251
TEY (Cont…)
What if the Muni is exempt from both

Federal and State Taxes
We need to compute the combined tax rate for
a taxable bond
In this case it is 23 + 8 = 31%
TEY = 6.00/(1-0.31) = 8.6957%
Sometimes the taxable bond maybe
subject to Federal tax but not to state tax
If so we need to compare the TEY for both
bonds
8/11/2019 252
TEY (Cont…)
Assume that a taxable bond which is

subject only to Federal tax yields 6.90%
Its TEY = 6.90/(1-0.08) = 7.50%
This should be compared with the TEY of
the Muni
The bond offering a higher TEY is superior
8/11/2019 253
Duration
Long term bonds are more susceptible to

changes in yield than shorter term bonds
Take two bonds with a face value of 1,000
Both pay a 10% coupon on a semi-annual
basis
YTM is 10% in both cases
Bond A has a time to maturity of 5 years
Bond B has a time to maturity of 10 years
8/11/2019 254
Duration (Cont…)
Both bonds will obviously sell at par

Since coupon = YTM = 10%
Now assume that the YTM increases to
12%
Price of bond A = 926.40
Price of bond B = 885.30
Price of A has declined by 7.34%
Price of B has declined by 11.47%
8/11/2019 255
Duration (Cont…)
 The longer term bond is more impacted by the
price change
 Why?
The PV of a cash value is
8/11/2019 256
Duration (Cont…)
The larger the value of t, the greater is the

impact of a change in the YTM
A 10 year bond has most of its cash flows
coming in at later points as compared to a 5
year bond
Thus its price is more vulnerable to changes in
the yield
8/11/2019 257
Duration (Cont…)
However the issue is not so simple.

Consider a 5 year Zero with a face value
of $1,000
At 10% price = 613.91
At 12% price = 558.39
The price decline is 9.04%
Why is a 5 year Zero more price sensitive
than a 5 year coupon bond?
8/11/2019 258
Duration (Cont…)
A coupon paying bond is

A series of cash flows arising at 6 monthly
intervals
It is a portfolios of Zeroes
Time to maturity only takes cognizance of the
last cash flow
The effective time to maturity
Should be an average of the times to maturity of the
component zeroes
8/11/2019 259
Duration (Cont…)
What about a 5 year Zero?

It gives rise to a single cash flow
Its stated time to maturity is the same as its
effective time to maturity
It is obvious why the 5 year Zero is more
price sensitive
Its effective time to maturity is greater
8/11/2019 260
Duration (Cont…)
Duration is a measure of the effective term

to maturity of a Plain Vanilla bond
It is a weighted average of the terms to maturity
of the component cash flows
The weight attached to a cash flow is the
fraction of the total present value of the bond
contributed by the cash flow
8/11/2019 261
Illustration
Consider a 5 year 10% coupon paying

bond
With a face value of $1,000
YTM = 10%
8/11/2019 262
8/11/2019 263
The weighted average time to maturity is

8.1078 semi-annual periods
Or 4.0539 years
The weighted average time to maturity of a
5 year Zero is 5 years
Thus a 5 year Zero is more price sensitive
8/11/2019 264
Duration (Cont…)
 The relationship between the duration of a bond
and the rate of change of the percentage change
in price is
8/11/2019 265
Duration (Cont…)
D
________
(1+ y/2) is known as the Modified Duration.
Thus the rate of the %age change in the
price wrt. the yield is equal to the modified
duration of the bond.
8/11/2019 266
Duration (Cont…)
Thus the rate of change of the percentage

change in price is a function
Of the duration of the bond
And not its time to maturity
Thus it is duration and not time to maturity
that accurately captures the relationship
Between the change in yield and the
corresponding price change.
8/11/2019 267
Duration (Cont…)
A concise formula can be derived

Define c as the semi-annual coupon rate
And y as the semi-annual YTM
8/11/2019 268
Dollar Duration
The dollar duration is the product of the

modified duration of a bond and its price
Consider a bond with a price of $920.8728
And a modified duration of 4.0851 years
The dollar duration is:
920.8728x4.0851 = 3,761.8574
8/11/2019 269

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Fixed Income Markets

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Fixed Income Markets

What is the difference between debt and

Are All Instruments Securities?

A security is an instrument which can be

Why are bonds and debentures termed as

Bonds may be secured or unsecured

Debt securities may be negotiable or non-

Floating rate bonds are similar to

Convertible bonds can be converted to

It is the principal value underlying the

It is the time remaining in the life of the

Consider a bond with a face value of Rs

At any point in time the YTM may be

A bond is an instrument that will pay

IBM has issued a bond with a face value

Why would a bond trade at a premium or a

What if the YTM is less than the coupon

On the other hand what if YTM is greater

Consider the change in price of a bond

Consider a bond with 10 years to maturity

Now consider a bond with 10 years to

In practice, we usually discount the face

A zero coupon bond can never sell at a

If a zero coupon bond is sold prior to

The Treasury issues three categories of

T-bills are issued with a original time to

T-notes and T-bonds have a time to

T-notes are similar to T-bonds except that

The FED requires primary dealers to

The when issued market is a market for

WI trading has ramifications for the bidding

The Treasury launched this programme in

On dealer quote sheets and vendor

The mechanism of issue is as follows.

All interest payments falling due on a

In 1987 the Treasury started to allow

In the absence of a floor the coupon can

Since prices and yields are inversely

When will a callable bond be recalled?

A bond may be discretely callable or

Freely callable bonds can be called at any

This is because they have a Call

One of the risks in a callable bond is

Second, the price appreciation potential

Given the reinvestment risk and price

Such bonds give the lender or the

Since the put option works in favour of the

The price at which a bond can be sold

A conversion provision, if present in the

The minimum price of a convertible bond

To estimate the straight value we must

In our case the conversion value is

Exchangeable bonds may be issued by

An advantage for the issuer is that they do

Ratings are based on an in-depth analysis

Credit Moody’s S&P’s Fitch’s

Credit Risk Moody’s S&P Fitch