BOND PRICES & YIELDS

Bonds
• In India, debt securities issued by the government and public-sector units are generally referred to as Bonds,
while debt securities issued by private-sector joint-stock companies are called as Debentures.

• The two major categories of Bonds are Government Bonds and Corporate Bonds.

• In the case of bonds, both the cash flow streams (interest and principal) and the time-horizon (maturity) are
well-specified and fixed.

• Certain special features of bonds such as Callable, Puttable and Convertible

 Bond Returns
• Coupon rate: It is the nominal rate of interest fixed and printed on the bond certificate. It is calculated on
the face value of the bond.

• For example, if the coupon rate on a bond of face value of Rs. 1000 is 12 percent, Rs. 120 would be payable
by the company to the bondholder annually till maturity.

• Current Yield: The current yield relates the annual interest receivable on a bond to its current market
price.

• Current Yield can be expressed as follows: -

Annual Interest
Current Yield = --------------------------------- x 100
Current Market Price
• For example, if a bond of face value Rs. 1000 and a coupon rate of 12 percent, is currently selling for Rs.
800, the current yield of the bond can be calculated as follows: -
120
Current Yield = --------------------------------- x 100 = 15 percent
800
• The current yield would be higher than the coupon rate when the bond is selling at a discount. Current yield would be lower than the
coupon rate for a bond selling at a premium.

• Zero Coupon bond is a special type of bond which does not pay annual interests. The return on this bond is in the form of a discount on
issue of the bond.

• Spot interest rate is the annual rate of return on a bond that has only one cash inflow to the investor.

• In the case of a two-year bond of face value Rs. 1000, issued at a discount for Rs. 797.19, the spot interest rate would be expressed as
follows: -

1000
797.19 = ---------------------
(1 + K)2

The equation can be rearranged as: -

1000
(1 + K) = ---------------------
2

797.19

Or, (1 + K)2 = 1.2544

Or, (1 + K) = √1.2544 = 1.12

Or, K = 1.12 – 1 = 0.12 or 12 percent

The spot interest rate is 12 percent per annum.

 Yield to Maturity (YTM)
• It may be defined as the compounded rate of return an investor is expected to receive from a bond purchased at the
current market price and held to maturity.
• It is really the internal rate of return earned from holding a bond till maturity.
• YTM is the discount rate that makes the present value of cash inflows from the bond equal to the cash outflow for
purchasing the bond.
• The relation between the cash outflow, the cash inflow and the YTM of a bond can be expressed as: -
Ct TV
MP = ∑ ------------------------ + -------------------------------
(1 + YTM) t (1 + YTM)n

Where, t = 1, 2, 3……...n

Where,
MP = Current market price of the bond
Ct = Cash inflow from the bond throughout the holding period
TV = Terminal cash inflow received at the end of the holding period.

• Through a process of trial and error, the value of YTM that equates the two sides of the equation may be determined.
• Let us consider a bond of face value Rs. 1000 and a coupon rate of 15 percent. The current market price of the
bond is Rs. 900. Five years remain to maturity and the bond is repaid at par.

Then,
150 1000
900 = ∑ ------------------------------- + ------------------------------
(1 + YTM) t (1 + YTM)5

• where, t = 1, 2, 3, 4, 5

What is required is a value of YTM that makes the right-hand side of the equation equal to Rs. 900. Since the
market price is lower than the face value, it indicates that YTM would be higher than the coupon rate.

We may arbitrarily start with 20 percent as the value of YTM. The right-hand side of the equation then becomes:

= Rs. 150 x Present Value Annuity factor (5 years, 20%) + Rs. 1000 x present value factor (5 years, 20%)

= (150 x 2.9906) + (1000 x 0.4019)

= 448.59 + 401.90

= Rs. 850.49
• Since the value obtained at 20 percent is lower than the current market price of Rs. 900, a lower
discount rate has to be tried. Taking YTM as 18 percent, the right-hand side of the equation becomes:

= (150 x 3.1272) + (1000 x 0.4371) = 469.08 + 437.10 = 906.18

• The value obtained is higher than the required amount of Rs. 900. Hence, YTM lies between 18 percent
and 20 percent. It can be estimated using interpolation as shown below: -

906.18 – 900
• YTM = 18 + -------------------------------------- X (20 – 18)
906.18 – 850.49

6.18
= 18 + ------------------------- x 2
55.69

= 18 + 0.22 = 18.22 percent

• The YTM concept is a compound interest concept. It is assumed that all intermediate cash inflows in the form
of interest are reinvested at YTM.

• This is the most widely used measure of return on non-callable bonds.

• The tedious calculations involved in determining YTM can be avoided by using the following formula which
gives an approximate estimate of YTM.
I + [MV – C]/n
• YTM ≈ -------------------------------------------
0.4 MV + 0.6 C
Where,

I = Amount of annual interest

MV = Maturity Value at the end of the holding period

C = Cost or current market price of the bond

n = Holding period till maturity

• This formula was suggested by Gabriel A. Hawawini and Ashok Vora, in an article published in the
Journal of Finance March 1982 issue.
• Using this approximation formula, YTM of a bond in the example given above can be calculated as follows: -

Rs. 150 + (Rs. 1000 – Rs. 900)/5

YTM = --------------------------------------------------------
(0.4 x1000) + (0.6 x 900)

= 0.18085 = 18.085 percent ≈ 18.1 percent (approx.)

• The YTM is the single discount rate at which the present value of payments received from the bond equals
its price. 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 value bond paying an annual coupon of Rs. 90 is bought for Rs.
1,000. 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:
Yield Curve
 Yield to Call (YTC)
• Some bonds may be redeemable before their full maturity period either at the option of the issuer or of the
investor. They are known as Callable Bonds.

• Such option would be exercisable at a specified period and at a specified price.

• The Yield to Call is computed on the assumption that the bond’s cash inflows are terminated at the call date
with redemption of the bond at the specified call price.

• The yield to call is that discount rate which makes the present value of ‘cash flows to call’ equal to the bond’s
current market price or the cost of purchase of the bond.

• If the yield to call is higher than the yield to maturity, it would be advantageous to the investor to exercise the
redemption option at the call date. If, on the other hand, the yield to maturity is higher, it would be better to
hold the bond till final maturity.
• For example, a company may issue 15-year bonds which can be redeemed at the end of 5 years, at the option
of either the investor or the issuer, at a premium of 5 percent on face value.

• In order to calculate the yield on such bonds, two yields may be calculated as follows:

(a) Yield to Maturity, assuming that the bond will be redeemed only at the end of the full maturity period (i. e.
15 years in the given example)

(b) Yield to Call, assuming that the bond will be redeemed at the call date (i. e. 5 years in the given example)

• The yield to call (YTC) is that discount rate which makes the present value of cash flows to call equal to the
debenture’s current market price.

• The relationship between the cash outflow, the cash inflow and the YTC of a debenture can be expressed as
follows:
Ct TV
• MP = ∑ ------------------------ + -------------------------------
(1 + YTC) t (1 + YTC)n

Where, t = 1, 2, 3………n
 BOND PRICING
• The value of a bond is equal to the present value of its expected cash flows. The cash flows from a bond consist of
the annual or semi-annual interest payments as well as the principal repayment at maturity.

• These cash flows have to be discounted at an appropriate discount rate to determine their present values.

• The present value calculations are made with the help of the following equation: -

Ct MV
P0 = ∑ -------------------- + --------------------------
(1+ k) t (1+ k)n

= C x PVIFA (r, n) + MV x PVIF (r, n)

i. e. Current price of bond = Present value of interest payments + Present value of principal repayment

Where,
P0 = Present Value of the Bond
It = Annual Interest payments
MV = Maturity Value of the Bond
 BOND PRICING
• The current market interest rate which investors can earn on other comparable investments is the proper
discount rate to be used in the present value model.
•

• Most bonds pay interest at half-yearly intervals. Where interest payments are semi-annual, the PV equation
has to be modified as follows: -

where, P is the value of the bond, C/2 is the semi-annual interest payment, r/2 is the discount rate applicable to
a half-year period, M is the maturity value, and 2n is the maturity period expressed in terms of half-yearly
periods.
 Rs. 50 Rs. 1000
P0 = ∑ ----------------- + ----------------------- = Rs. 859.20
(1.07) t (1.07)10

Where, t = 1, 2,……,10 [2n = 2 x 5 = 10 years; r/2 = 14/2 = 7%]

OR

Po = 50 x PVIFA (7%, 10 Years) + 1000 x PVIF (7%, 10 Years)

= (50 x 7.024) + (1000 x 0.508)

= 351.20 + 508

= Rs. 859.20
 BOND PRICING THEOREMS
• Bonds are generally issued with a fixed rate of interest known as the Coupon rate. This is calculated on the
face value of the bond and remains fixed till maturity.

• At the time of issue of the bond, its coupon rate will generally be equal to the prevailing market interest rate.

• If the current market interest rate rises above the coupon rate of a bond, the bond provides a lower return and
hence becomes less attractive. The price of the bond declines below its face value.

• If the market interest rate declines below the coupon rate, the bond price will increase and the bond will
begin to be sold at a premium on its face value.

• Bond prices vary inversely with changes in market interest rates.

• The long-term bond is more sensitive to interest rate changes than the short-term bonds, i. e. the long-term
bonds generally have a greater exposure to interest rate risk.

• Bond price volatility is related to the coupon rate, which implies that the percentage change in a bond’s price
due to a change in the market interest rate will be smaller if its coupon rate is higher.
 BOND RISKS
• Two types of risk are associated with investment in bonds, namely default risk and interest rate risk.

• Default risk refers to the possibility that a company may fail to pay the interest or principal on the stipulated
dates.

• Credit rating of debt securities is a mechanism adopted for assessing the default risk involved.

• An investor in bonds faces variations in his returns due to changes in the market interest rate during his
holding period. This is referred to as the interest rate risk.

• If the market interest rate moves up, the investor would be able to reinvest the annual interest received from
the bond at a higher rate than expected. He would gain on his reinvestment activity but loses on selling the
bond.

• When the market interest rate moves down, the investor would be able to reinvest the interest only at a lower
rate than what was expected. However, the bond price will move above its face value as the market interest
rate declines. The investor loses on reinvestment of interest but gains on selling the bond.
 BOND RISKS
• The interest rate risk is composed of two factors: reinvestment risk and price risk.

• The reinvestment risk and the price risk derived from a change in the market interest rate have an opposite
effect on the bond returns.

• For any bond, there is a holding period at which these two effects exactly balance each other.

• This particular holding period at which interest rate risk disappears is known as the duration of the bond.

• An investor can, therefore, eliminate interest rate risk of a bond by holding the bond for its duration.

• Historically, there has been a low correlation between the returns from stocks and corporate bonds. This
implies that combining stocks and bonds in a portfolio can help to reduce the portfolio’s risk as a whole.
Thus, bonds can play a strategic role in portfolio management.
 BOND DURATION
• Duration is the weighted average measure of a bond’s life.

• The formula for computing duration, d is:

d = ---------------------------------------

where,

Ct = Annual cash flow including interest and repayment of principal

n = Holding period

k = Discount rate, i. e. the market interest rate

t = Time-period of each cash flow

 BOND DURATION
• Duration is a key concept in bond analysis for the following reasons:

1. It measures the interest rate sensitivity of a bond.

2. It is a useful tool for immunizing against interest rate risk.
3. Duration reflects coupon, maturity, and yield, the three key variables that determine the response of price to
interest rate changes.

Hence, duration can be used to measure interest rate exposure of a Bond.

• Properties of Duration

The following rules apply to duration:

1. The duration of a zero-coupon bond is the same as its maturity.

2. For a given maturity, a bond’s duration is higher when its coupon rate is lower.

3. For a given coupon rate, a bond’s duration generally increases with maturity.

4. Other things being equal, the duration of a coupon bond varies inversely with its yield to maturity.