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

Fixed-rate Bonds
Floating-rate Bonds
Inverse Floaters

Non-convertible
Bonds
Callable Bonds

Asset-backed
Bonds
Catastrophe Bonds
Indexed Bonds
International
Bonds

Puttable Bonds
Zero-coupon Bonds

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

Example-YTM
Coupon Rate : 10%
Time to Maturity: 3 years
Coupon Payment : Half-yearly
FV: Rs.1,000
MV: Rs.1052.42
6

1052.42
t 1

50
1000

(1 ytm)t (1 ytm) 6

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 semiannual
yield is 4% and annual yield is 8%

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

C ( M P) / n
YTM ;
0.4 M 0.6 P
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,

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

Example YTM of Zero

A zero-coupon bond has 12 years to maturity and
is selling for Rs.300.
The ytm is given by:
FV

ytm

1000

300

YTM = 10.3%

1
T

1
24

1
1 0.0515

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

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:
20

40
1,100
1,150

t
20
(1

yc
)
(1

yc
)
t 1
= 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%

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:

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
1
wealth will be Rs.1,210
and the RCY will be:
2
1210

1000

1 0.10

If the interest is reinvested at 8%, the ending

wealth will be Rs.1,208 and the RCY will be:

1, 208
1, 000

1
2

1 0.0991

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 creditrating 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.