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BOND YIELDS AND PRICES

Fixed Income Securities


A debt security is a claim on a specified periodic stream of
income.

Debt securities are often called fixed income securities

These securities are easy to understand and are relatively less
risky.

A bond is a security that is issued in connection with a
borrowing arrangement.
Bonds
Three basic characteristics of a bond are:
Face Value,
Coupon Rate and
Maturity.

The bond prices that are quoted in the financial pages are not
actually the prices that the investors pay for the bond.
The quoted price (called the clean price) does not include the
interest that accrues between coupon payment dates.
The price including the accrued interest is called the dirty
price.

Types Of Bonds
Govt. Bonds
Corporate Bond
Convertible Bonds
Non-convertible Bonds
Callable Bonds
Puttable Bonds
Zero-coupon Bonds

Fixed-rate Bonds
Floating-rate Bonds
Inverse Floaters
Asset-backed Bonds
Catastrophe Bonds
Indexed Bonds
International Bonds
Bond Pricing
Given the market rate of interest equal to r, the value of a
bond with maturity of T years can be written as:

Bond Value =

= Coupon*Annuity Factor (r, T) + Par Value * PV Factor (r, T)

=
1
(1 ) (1 )
T
t T
t
Coupon ParValue
r r
=
+
+ +

1 1 1
1
(1 ) (1 )
T T
Coupon ParValue
r r r
| |
+
|
+ +
\ .
Bond Prices and Interest Rates

There is an inverse relationship between bond prices and
yields.


Bond Price









The relationship between bond prices and yields is convex.




















Interest Rate
Bond Yields

Current Yield is the ratio of the coupon interest to current
market price.

Yield to Maturity (YTM) is defined as the compound rate of
return an investor will receive from a bond purchased at the
current market price and held to maturity.

YTM makes the present value of a bonds payments equal to
its price.





Yield to Maturity



Where P = the current price of the bond
T = the number of semi-annual periods to maturity
ytm = the semi-annual yield to maturity to be solved
for
c = the semiannual coupon in amount
FV = the face value (or maturity value or par value)

The annual YTM (bond equivalent yield) is equal to 2 x ytm


1
(1 ) (1 )
T
t
t T
t
c FV
P
ytm ytm
=
= +
+ +

Example-YTM
Coupon Rate : 10% Time to Maturity: 3 years
Coupon Payment : Half-yearly FV: Rs.1,000
MV: Rs.1052.42



Since the bond is selling at a premium , ytm is lower than the
coupon rate.

With a 4% discount rate the PV is Rs.1052.10. The semi-annual
yield is 4% and annual yield is 8%
6
6
1
50 1000
1052.42
(1 ) (1 )
t
t
ytm ytm
=
= +
+ +

YTM-An Approximation
YTM can be approximated using the following equation:





Where C is the coupon payment per period,
M is the maturity value of the bond ,
P is the present price of the bond and
n the number of coupon payments,
( ) /
0.4 0.6
C M P n
YTM
M P
+
+
YTM of Zero-Coupon Bond
The yield to maturity of a zero-coupon bond is given by:




For a premium bond, Coupon Rate > Current Yield > YTM


1
[ / ] 1
n
ytm FV P =
Example YTM of Zero
A zero-coupon bond has 12 years to maturity and is selling for
Rs.300.
The ytm is given by:



=

YTM = 10.3%
1
1
T
FV
ytm
P
| |
=
|
\ .
1
24
1000
1 0.0515
300
| |
=
|
\ .
Yield to Call
The yield to call is the expected yield to the end of the
deferred call period when a bond can first be called.
















where
fc = the number of semiannual periods until the first call date
yc = the yield to first call on a semiannual basis
CP = the call price to be paid by the issuer if the bond is called




1
(1 ) (1 )
fc
t
t fc
t
c CP
P
yc yc
=
= +
+ +

Example Yield to Call


An 8% coupon , 30 year maturity bond sells for Rs.1,150 and is
callable in 10 years at a call price of Rs.1,100.
Its Yield to Call will be:



= 6.64%

PV at discount rate of 3.5% = Rs.1121.32
PV at a discount rate of 3% = Rs. 1204.4
By interpolation, discount rate =3.32%

20
20
1
40 1,100
1,150
(1 ) (1 )
t
t
yc yc
=
= +
+ +

Realized Compound Yield


Realized compound yield measures the compound yield on
the bond investment actually earned over the investment
period, taking into account all intermediate cash flows and
reinvestment rates.
It cannot be determined until the investment is concluded
and all of the cash flows are known.
The semi-annual realized compound yield can be calculated
using the following formula:




1/
1.0
T
Total ending wealth
RCY
Purchase priceof bond
(
=
(

Example-RCY
An investor invested Rs.1,000 two years ago in a 10% bond
with a two year maturity. The promised YTM is 10%.

If the reinvestment rate is 10%, the ending wealth will be
Rs.1,210 and the RCY will be:


If the interest is reinvested at 8%, the ending wealth will be
Rs.1,208 and the RCY will be:



1
2
1210
1 0.10
1000
| |
=
|
\ .
1
2
1, 208
1 0.0991
1, 000
| |
=
|
\ .
Bond Prices, Coupon Rates and
Interest Rates
A bond will sell at par value when the coupon rate equals
market interest rate.
When the coupon rate is lower than the market interest rate,
the bond has to be sold below par value to provide a capital
gain on the investment.
When the coupon rate exceeds the market interest rate, the
bond would sell at a premium. The extra cash flows from
coupons are offset by capital losses at maturity.
Although the capital gain and income components differ, each
bond is priced to offer the same rate of return to investors.
Bond Prices over Time

Prices of zero-coupon bonds rise exponentially over time, providing a
rate of appreciation equal to the rate of interest.

Though, at maturity, all bond prices converge to their face value, but
before maturity date, bond prices are continually changing with
changes in interest rates and yields.

The two bond variables of major importance in assessing the change
in the price of a bond, given a change in interest rates, are its coupon
and its maturity.

A decline (rise) in interest rates will cause a rise (decline) in bond
prices, with most volatility in bond prices occurring in longer
maturity bonds and bonds with low coupons.
Bond Prices over Time

In order to receive the maximum price impact of an expected
change in interest rates, a bond buyer should purchase low-
coupon, long maturity bonds.

If an increase in interest rates is expected (or feared), an
investor contemplating a bond purchase should consider
those bonds with large coupons or short maturities or both.

Treasury Strips

Longer term zero-coupon bonds are commonly created from
coupon bearing notes and bonds with the help of treasury.
The treasury breaks down the cash flows to be paid by be the
bond into a series of independent securities where each
security is a claim to one of the payments of the original
bond.
The treasury program under which coupon stripping is
permitted is called STRIPS (Separate trading of registered
interest and principal of securities).

Default Risk and Bond Pricing

When bonds are subject to default, the promised yield will
not be realized.
To compensate bond investors for default risk, bonds must
offer default premiums, that is promised yield in excess of
those offered by default-free government securities.
The default premiums depend on rating by credit-rating
agencies.
Higher rated bonds are considered investment grade and
lower-rated bonds are classified as speculative-grade or junk
bonds.

Determinants of Bond Safety

Bond safety is often measured using financial
ratios such as liquidity ratios, coverage ratios,
leverage ratios, profitability ratios and cash
flow ratios.

Discriminant analysis can be used to predict
bankruptcy.

Bond Indentures

Bond Indentures are a safeguard to protect the claims of debenture
holders.

Common , indentures specify :

Sinking fund requirements,

Collateralization of the loan,

Dividend restrictions and

Subordination of future debt.

Collateralized Debt Obligations

CDOs are used to reallocate the credit risk of a pool of loans.

The pool is sliced into tranches, with each tranche assigned a
different level of security in terms of its claims on the cash
flow from the underlying loans.

High seniority tranches are usually quite safe, with credit risk
concentrated on the lower level tranches.

Each tranche can be sold off as a stand alone security.