Chapter 11 BOND PRICES AND YIELDS Figuring out the Assured Returns

Outline
Changes in Bond Market
Bond Characteristics Bond Prices Bond Yields Risks in Bonds Rating of Bonds The Yield Curve Explaining the Term Structure Determinants of Interest Rates Analysis of Convertible Bonds

Changes In Debt Market

Then
Plain vanilla bonds Stable & administered interest rates Simplistic measures of return & life Rules of thumb Few players Passive approach Illiquid market Absence of a reference rate

Now
Bonds with complex features Volatile & market- determined interest rates Precise measures of return & life Analytical methods More players Relatively more active approach Liquid market ? Emergence of a reference rate

Bond Characteristics
A bond is an IOU. It is described in terms of: Par value Coupon rate Maturity date Government bonds are also called government securities (Gsecs) or gilt-edged securities. These are generally medium to long-term bonds issued by RBI on behalf of the government of India and state governments. Corporate bonds or corporate debentures are debt instruments issued by companies

Types Of Bonds
Straight bonds
Zero coupon bonds. Floating rate bonds Bonds with embedded options Commodity-linked bonds

Bond Pricing (Valuation)

P = n t=1 C + (1+r)t (1+r)n M

2n t=1

C/2 + (1+r/2)t

M (1+r/2)2n

Bond Pricing
A Rs.600 face value bond carries a coupon rate of 12 percent p.a. payable semi-annually. The bond is redeemable at par after 5 years. If investors require a return of 9% per half-year period, what will be the price of the bond. 10 P0 = t=1 = P = (1.09)t 36 + (1.09)10 600

36 x 6.418 + 600 x 0.422 = Rs. 484.25 1 C 1 (1+r)n r F + (1+r)n

36 x 6.418

+ 600 x 0.422 = 484.25

Price-Yield Relationship
Price

Yield

Price changes with time

Value of Bond Premium Bond: rd = 11% A PAR VALUE BOND: rd = 13% B Discount Bond: rd = 15%

Bond Price Theorems

1. Bond prices & yields move in opposite directions.
2. Bond prices are more sensitive to yield changes the longer their maturities. 3. The price sensitivity of bonds to yield changes increases at a decreasing rate with maturity. 4. High coupon bond prices are less sensitive to yield changes than low coupon bond prices. 5. With a change in yield of a given number of basis points, the associated percent gain is larger than the percent loss.

Bond Yields
Current Yield
Annual interest Price

Yield To Maturity
P = C (1+r) 8 t=1 + C (1+r) 90 + (1+r)
t 2

+ .

C (1+r)
n

M (1+r)n

1,000 (1+r)8

800

AT r = AT r =

13% RHS = 808 14% RHS = 768.1 808 - 800 = 13.2% 808 - 768.1

YTM = 13% + (14% - 13%)

YTM Yield to Call

P =

C + (M - P) / n 0.4M + 0.6 P

n* t=1

C + (1+r)t

M* (1+r)n

YTM
Someone who invests in a coupon - paying bond will earn
the YTM promised on the purchase date if and only if all of the following three conditions are fulfilled. The bond is held until it matures rather than being sold at a price which differs from its face value before its maturity The bond does not default All cash flows are re-invested at an interest rate equal to the promised YTM

Realised Yield To Maturity

Future Value of Benefits
INVESTM ENT 150 150 150 150 150 ANNU AL INTEREST RE-INVE STM ENT PERIO D (IN YE ARS) 4 3 2 1 0 CO M PO UND FACTO R (AT 16 PERCENT) 1.81 1.56 1.35 1.161.00 FUTURE VAL UE OF INTERM EDIATE CA SH W S 271.5 234.0 202.5 FLO 174.0 150.0 1000 M ATURITY VALUE TOTAL FUTURE VAL UE = 271.5 + 234.0 + 202.5 + 174.0 + 150.0 + = 2032 0 850 1 2 3 4 5

(1+r*)5 = 2032 / 850 = 2.391 r* = 0.19 OR 19 PERCENT

Realised Yield to Maturity

The realised yield to maturity appears to be conceptually superior to the conventional yield to maturity. However, its appeal seems to be dubious because it is difficult to forecast the future reinvestment rates, given the uncertainty characterising them. While the conventional yields to maturity on coupon bonds are difficult to interpret, realised yields to maturity are difficult to implement.

Stated YTM and Expected YTM

Corporate bonds are subject to default risk. So, you must distinguish

between the bonds stated YTM and the bonds expected YTM. The

stated or promised YTM will be realised only if the issuing firm meets

all the obligations on the bond issue. Thus, the stated YTM is the takes into account the possibility of a default.

maximum possible YTM on the bond. The expected YTM, however,

Expected YTM and Stated YTM

An example may be given to illustrate the difference between the two measures of YTM. Alpha Corporation issued 12 percent coupon bonds 10 years ago. The bonds now have five years left until its maturity. Alpha is experiencing financial difficulties. Bondholders believe that Alpha will meet the remaining interest payments, but at the time of maturity bondholders will receive only 80 percent of par value. The bond is currently selling at Rs 850. The following inputs would be used to calculate YTM: Inputs Coupon payment Number of semiannual periods Final payment Price Expected YTM Rs. 60 10 periods Rs. 800 Rs. 850 Stated YTM Rs 60 10 periods Rs 1000 Rs 850

Using the approximate formula the YTM based on expected payments works out 6.63 percent, whereas the YTM based on promised payments works out to 8.24 percent.

YTM versus Holding Period Return

Dont confuse the yield to maturity (YTM) of a bond with its holding period return. The YTM is the single discount rate at which the present value of payments received from the bond equals its price. It represents the average rate of return from the bond if it is held till maturity. In contrast, the holding period return is the income earned over a given holding period as a percentage of its price at the beginning of the period. For example, if a 10 year Rs. 1000 par bond paying an annual coupon of Rs. 90 is bought for Rs. 1,000, its YTM is 9 percent. If the bond price increases to Rs. 1060 by year end, its YTM will fall below 9 percent (because it is selling at a premium), but its holding-period return for the year exceeds 9 percent: 90 + (1060 1000) Holding period return = 1000 = 0.15 or 15 percent

Risks In Bond Investment

Interest rate risk (market risk) Reinvestment Risk Default risk (credit risk) Inflation risk Call risk Exchange rate risk Liquidity risk Event risk Interest Rate Bond Price Interest rate on Interim cash flow Issuer may default Purchasing power risk Issuer may recall the bonds A non-rupee denominated bond Marketability risk Issuers ability.. Change.. Unexpectedly (a) a natural accident or (b) .. corp. Restrg

Debt Rating
What is it ? probability of timely payment of interest & principal by a borrower What it is not ? Not a recommendation Not a general evaln of the issuing organisation Not a one-time evaluatn credit risk . . valid entire life How is it done ? Industry & bus analysis. Financial analysis Quantitative rating models Value of ratings ? rating scenario ?

Functions Of Debt Rating

Debt ratings (or debt rating firms) are supposed to : provide superior information Offer low-cost information Serve as a basis for a proper risk-return tradeoff. Impose healthy discipline on corporate borrowers. Lend greater credence to financial and other representations. Facilitate the formulation of public policy guidelines on institutional investment.

Credit Rating
Crisils Rating Symbols
AAA AA A BBB BB B C D : Highest Safety : High Safety : Adequate Safety : Low Safety : Inadequate Safety : High Risk : Substantial Risk : In Default

Key factors considered in credit rating

Industry & Business Analysis Growth rate & reln with the economy Industry risk characteristics Structure of industry & nature of competition Competitive position of the issuer Managerial capability of the issuer Financial Analysis Earning power Business & financial risks Asset protection Cash flow adequacy Financial flexibility Quality of accounting

The Yield Curve

The yield curve., Or the term structure of interest rates, shows how YTM is related to term to maturity for bonds that are similar in all respects, expecting maturity.
FACE VALUE 100,000 100,000 100,000 100,000 100,000 INTEREST RATE 0 12.75 13.50 13.50 13.75 MATURITY (YRS) 1 2 3 4 5 CURRENT PRICE 88.968 99,367 100,352 99,706 99,484 YIELD TO MATURITY 12.40 13.13 13.35 13.60 13.90

YIELD CURVE
YIELD TO MATURITY (YTM) 14.0 13.0 12.0

5 TERM TO MATURITY (YRS)

Types Of Yield Curve

YTM A. Upward Sloping YTM B. Downward sloping

Term

Term

YTM C. Flat

YTM

D. Humped

Term

Term

Illustrative Data for Government Securities

Face Value maturity

Interest Rate Maturity (years) 0 12.75 13.50 13.50 13.75 1 2 3 4 5

Current Price

Yield to

100,000 100,000 100,000 100,000 100,000

88,968 99,367 100,352 99,706 99,484

12.40 13.13 13.35 13.60 13.90

Forward Rates
To get forward interest rates, begin with the one-year treasury bill: 88,968 = 100,000 / (1 + r1) where r1 is the one-year spot rate i.e. the discount rate applicable to a riskless cash flow receivable a year hence. Solving for r1 gives r1 = 0.124. Next, consider the two-year government security and split its benefits into two parts, the interest of Rs. 12,750 receivable at the end of year 1 and Rs.112,750 (representing the interest and principal repayment) receivable at the end of year 2. The present value of the first part is: 12,750 = (1+r1) 1.124 12,750

r1

11,343.4

Forward Rates
To get the present value of the second years cash flow of Rs.112,750, discount it twice at r1 (the discount rate for year 1) and r2 (the discount rate for year 2): 112,750 112,750 = (1+r1) (1+r2) (1.124) (1+r2) r2 is called the forward rate for year two, that is, the current estimate of the next years one-year spot interest rate. Since r1, the market price of the bond, and the cash flow associated with the bond are known the following equation can be set up: 12,750 99,367 = (1.124) + (1+r2) 112,750

Forward Rates
Solving this equation gives r2 = 0.1289 To get the forward rate for year 3(r3), set up the equation for the value of the three-year bond: 13,500 13,500 113,500 100,352 = + + (1+r1) (1+r1) (1+r2) (1+r1) (1+r2) (1+r3) 13,500 100,352 = (1.124) + (1.124) (1.1396) 13,500 + (1.124) (1.1396) (1+r3) 113,500

Solving this equation gives r3 = 0.1389. This is the forward rate for year three. Continuing in a similar vein, set up the equation for the value of the four-year bond: 13,500 99,706 = (1+r1) 13,500 = (1.124) + (1.124) (1.1396) 13,500 + (1.124)(1.1396)(1.1389) + (1+r1) (1+r2) 13,500 + (1+r1) (1+r2) (1+r3) 13,500 + (1.124)(1.1396)(1.1389)(1+r4) 13,500 113,500 + (1+r1) (1+r2) (1+r3) (1+r4) 113,500

Solving this equation for r4, leads to r4 = 0.1458. Exhibit 11.7 plots the one-year spot rate and forward rates r2, r3, r4. Notice that while the current spot rate and forward rates are known, the future spot rates are not known - they will be revealed as the future unfolds.

Forward Rates

Forward rate 15.0--

14.0--

13.0--

12.4-1 2 3 4

Year

Explaining The Term Structure

Expectations theory
Liquidity preference theory Preferred habitat theory Market segmentation theory

Expectations Theory
Shape . Yield curve depends on .. expectations those who participate market (1 + tRn) = [ (1 + tR1) (1 + t+1R1) (1 + t+n-1Rn)]1/n

Yield Curve Ascending Descending Humped Flat

Explanation Short-term rates rise in future Short-term rates fall in future Short-term rates rise . fall Short-term rates . . unchanged in future

Liquidity Preference Theory

Forward rates should incorporate interest rate expectations as well as a risk (or liquidity) premium (1 + tRn) = [ (1 + tR1) (1 + t+1R1+L2) (1 + t+n-1Rn +Ln)]1/n

An upward-sloping yield curve suggests that future interest rates will rise (or will be flat) or even fall if the liquidity premium increases fast enough to compensate for the decline in the future interest rates.

Preferred Habitat Theory

Investors prefer to match the maturity of investment to their investment objective Borrowers . . too If mismatch inducement to shift

Market segmentation theory

Extreme form of preferred habitat theory

Determinants Of Interest Rates

Inflation Rate Real Growth Rate Time Preference Short-Term Risk-Free Rate

Maturity Premium Future Expectations Liquidity Preference Preferred Habitat Interest Rate

Default Premium Business Risk Financial Risk Collateral

Special Features Call/Put Feature Conversion Feature Other Features

Valuation Of Convertible Bonds

Value of the Convertible Bond = Max Straight Bond Value , Valuation of Convertible Bonds VA
A. S T R A I G H T
D E B T V A L U E

Conversion Value

Option + Value

Straight Debt Value

C O N V E R S I O N V A L U E

B. Conversion Value

L U E O F C O NV E R T I B L E B O ND S

C. Value of Convertible Bond

Firm Value

Firm Value

Firm Value

Summing Up
The debt market in India has registered an impressive growth
particularly since mid-1990s and has been accompanied by increasing complexity in instruments, interest rates, methods of analysis, and so on . The value of a non callable, nonconvertible bond is: n P= t =1 C + (1+ r)t (1 + r)n M

The commonly employed yield measures are : current yield, yield to maturity (YTM), yield to call, and realised yield to maturity.

The YTM of a bond is the discount rate that makes the

present value of the cash flows receivable from owning the bond equal to the price of the bond. Bonds are subject to diverse risks, such as interest rate risk, inflation risk, real interest rate risk, default risk, call risk, and liquidity risk. Default risk or credit risk is reflected in credit rating of debt instruments.

 yield

The term structure of interest rates, popularly called the curve, shows how yield is related to maturity.

Three principal explanations have been offered to explain the term structure of interest rates : expectations theory,

liquidity preference theory, and preferred habitat theory. The interest rate is determined by four factors : short-term risk-free interest rate, maturity premium, default premium, and special features. Convertible bonds may be viewed as a debenture warrant package.