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
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
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
Price-Yield Relationship
Price
Yield
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
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
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.
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.
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 ?
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
YIELD CURVE
YIELD TO MATURITY (YTM) 14.0 13.0 12.0
Term
Term
YTM C. Flat
YTM
D. Humped
Term
Term
Current Price
Yield to
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
14.0--
13.0--
12.4-1 2 3 4
Year
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
Explanation Short-term rates rise in future Short-term rates fall in future Short-term rates rise . fall Short-term rates . . unchanged in future
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.
Maturity Premium Future Expectations Liquidity Preference Preferred Habitat Interest Rate
Conversion Value
Option + 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
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.
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.