Juan Manuel de los Ríos, CFA

Fixed Income -
S8
Bonds
Liabilities

Liabilities
Assets

Equity
Liabilities
❖ When a company goes bankrupt and its liquidation is mandated, a
certain order is established whereby stakeholders have claim to
the assets of the firm. This is called the repayment priority or
seniority

❖ In Peru, in very broad terms, the repayment priority is:

1. Workers (wages and social benefits)

2. Government (tributes)

3. Creditors (all debt)

4. Shareholders
What is a bond?
❖ A bond is a security that results from a debt agreement between
an issuer and a group of investors.

Loan

ISSUER INVESTOR

Issuer agrees to pay interest and principal back

at a given maturity
What is a bond?
What is a bond?
❖ “Morgan Stanley made an offer to repurchase its 3.8% bonds
maturing 29/04/2016 at 99.25% of the par value plus accrued
interest. The total amount outstanding is $ 2.5 B. The bonds have
a split rating (A2 by Moody’s, A- by S&P and A by Fitch).”
What is a bond?
❖ Issuer
❖ Maturity / Term
❖ Amount Outstanding
❖ Nominal Value / Face Value
❖ Currency
❖ Structure
❖ Credit Rating
❖ Seniority
What is a bond?

Source: Bloomberg
Pricing

How do we determine a bond’s price?

Pricing: Replication
Rate Price 1st Year 2nd Year 3rd Year 4th Year

BCP Bond 5 5 5 105

Dep. 1 1% 5

Dep. 2 2% 5

Dep. 3 3% 5

Dep. 4 4% 105
Pricing: Replication
Rate Price 1st Year 2nd Year 3rd Year 4th Year

BCP Bond 5 5 5 105

Dep. 1 1% 4.95 5

Dep. 2 2% 4.81 5

Dep. 3 3% 4.58 5

Dep. 4 4% 89.75 105

Pricing: Rates
❖ Why would different terms have differente rates?
❖ Expectation about future short-term interest rates

❖ Expectation about future inflation

❖ Investors’ preference for different terms

Pricing: Spot Rates
❖ We now recognize that every term has a different associated return
❖ Hence, every cashflow should be discounted at the interest rate
relevant for that specific period.

Price 1st Year 2nd Year 3rd Year 4th Year

BCP Bond 5 5 5 105

Rate 1% 2% 3% 4%

5 5 5 105
𝑃= 1
+ 2
+ 3
+
(1 + 1%) (1 + 2%) (1 + 3%) (1 + 4%)4
Pricing: Replication
Rate Price 1st Year 2nd Year 3rd Year 4th Year

BCP Bond 104.09 5 5 5 105

Dep. 1 1% 4.95 5

Dep. 2 2% 4.81 5

Dep. 3 3% 4.58 5

Dep. 4 4% 89.75 105

Pricing: Spot Rates
𝐶 𝐶 𝐶 𝐶+𝑃
𝑉𝑎𝑙𝑢𝑒 = 1
+ 2
+⋯ + 𝑛−1
+
(1 + 𝑟1 ) (1 + 𝑟2 ) 1 + 𝑟𝑛−1 (1 + 𝑟𝑛 )𝑛

𝑛
𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑖
𝑉𝑎𝑙𝑢𝑒 = ෍
(1 + 𝑟𝑖 )𝑖
𝑖=0

❖ We simply take the present value of each cashflow at the relevant

interest rate for each tenor.
What is a Spot Rate?
❖ These are rates that come from zero coupon bonds, which
eliminates the reinvestment risk… The buyer of a zero-coupon
bond will never ask himself about about the rate at which each
coupon payment will be reinvested (coupon = 0).

❖ As these rates eliminate the reinvestment risk, we will use them to

price fixed income securities.
Pricing: YTM
❖ What is the IRR of the bond used in our previous example?
5 5 5 105
104.09 = 1
+ 2
+ 3
+
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)4

𝐼𝑅𝑅 = 3.88%

❖ Then, if I knew that IRR, I could price the bond

5 5 5 105
?= 1
+ 2
+ 3
+
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)4
Pricing: YTM
❖ But … What comes first, the price of the bond or the IRR?
❖ The IRR is nothing more than the another way to state the price
(similar to a mirror); then, if I don’t know the price of the bond, I
won’t be able to find the IRR. This doesn’t imply that I cannot use it
to find the price if I know it.

❖ Then, is it useful? … it is useful to tell the story in an easier way

(easier to communicate). It is easier to say that you are buying a
bond that pays 3.88% thought its life, than to say that the price is
104.09.

IRR = YTM (Yield to Maturity)

Pricing: YTM
𝐶 𝐶 𝐶 𝐶+𝑃
𝑉𝑎𝑙𝑢𝑒 = 1
+ 2
+⋯ + 𝑛−1
+
(1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀) 1 + 𝑌𝑇𝑀 (1 + 𝑌𝑇𝑀)𝑛

𝑛
𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑖
𝑉𝑎𝑙𝑢𝑒 = ෍
(1 + 𝑌𝑇𝑀)𝑖
𝑖=0

❖ The YTM is nothing more than a weighted average (a complicated

one) of the spot rates.
❖ Then, we can say that the YTM “summarizes” the average yield the
bond will pay me.
Pricing: YTM
❖ To summarize, the YTM is just another way to quote the price.
❖ Problems with the YTM:

➡ Assumes a flat yield curve: every tenor in the curve has the
same yield
➡ Assumes that all the intermediate cashflows will be
reinvested at the same rate (YTM)

➡ Different for similar instruments but with different coupons

Let’s summarize everything
5 5 5 105
104.09 = 1
+ 2
+ 3
+
(1 + 1%) (1 + 2%) (1 + 3%) (1 + 4%)4

These are spot rates

5 5 5 105
104.09 = 1
+ 2
+ 3
+
(1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)4

These is the YTM of the bond

Semi-annual Cash Flows
❖ Usually bonds make semi-annual coupon payments and coupon
rates are stated as an “annual rate with semi-annual compounding”
(BEY convention – Bond equivalent yield convention) …

❖ Therefore, how would your answer change if you are presented a

2-year 5% semi-annual coupon paying bond? Assume that the 6m,
12m, 18m and 24m spot rates are 1%, 2%, 3% and 4% (BEY),
respectively.
Semi-annual Cash Flows
5/2 5/2 5/2 5/2+100
P= + + +
(1+ r ) (1+ r ) (1+ r ) (1+ r )
1 2 3 4
6m
/2 12m
/2 18m
/2 24m
/2

P =102.02
Relationship: Price vs. Yield
Price 350%

300%

250%

200%

150%

100%

50%

0%
0% 5% 10% 15% 20% Yield

❖ There is an inverse relationship between the yield and the price of

a bond

❖ Moreover, the relationship is convex. What does this imply?

Relationship: Price vs. Yield
Relationship: Price vs. Yield
❖ An investor buys USD 100 of a bond today to receive USD 110 in a
year. The current interest rate is 10%, which will set the coupon at
10%.

❖ If interest rates fall from 10% to 6% then the price on the bond will
____________ to ____________ . The investor will generate a
____________ of ___________ dollars.

❖ If interest rates increase from 10% to 14% then the price on the
bond will ____________ to ____________ . The investor will
generate a ____________ of ___________ dollars.
Relationship: Price vs. Yield

Gain

Loss

TODAY LATER
Pull to Par
Pull to Par
Why does this occur? Think about 4% semi-annual coupon paying
bond with 4 years to maturity and a YTM of 5%
Time to Change in Coupon
Price Total Gain Gain in %
Maturity Price Received
4.0 96.41 - - -
3.5 96.83 0.41 2.00 2.41 2.5%
3.0 97.25 0.42 2.00 2.42 2.5%
2.5 97.68 0.43 2.00 2.43 2.5%
2.0 98.12 0.44 2.00 2.44 2.5%
1.5 98.57 0.45 2.00 2.45 2.5%
1.0 99.04 0.46 2.00 2.46 2.5%
0.5 99.51 0.48 2.00 2.48 2.5%
0.0 100.00 0.49 2.00 2.49 2.5%

The investor receives a $2 coupon payment every semester (4%/2). Having paid 96.41 this only
represents a 2.07% gain over the invested capital (2/96.41), however the bond was bought assuming a
semi-annual return of 2.5% (YTM of 5%). The price of the bond needs to increase $0.41, which
represents a 0.43% gain (0.41/96.41), thus generating an overall return of 2.5% semi-annually. So the
pull-to-par effect is the capital gain/loss needed to generate the return (YTM) agreed as the periodic
interest payment (coupon) differs from the YTM.
Yield Curve
❖ The yield curve outlines graphically the yields available in the
market for specific maturities.
Yield Curve
Expectations Theory
❖ Assume that the value of short them interest rates will determine
the value of future interest rates (long-term interest rates).

❖ An investor is indifferent between investing for two years or,

investing in one year and, after receiving the proceeds in the
future, reinvesting for another year.
Yield Curve
Liquidity Preferences Theory
❖ Investors are risk averse and will demand for an additional
compensation to lock-up investments in higher maturities.

❖ Investors demand a premium as:

(i) higher maturities create more liquidity risk

(ii) the longer the maturity the bigger the risk of changes in interest
rates

(iii) there is more credit risk over longer time periods

Yield Curve
Segmented Markets Theory
❖ Investors have preferences related to the sectors in the curve
where they invest.

❖ Therefore, different areas in the yield curve are not perfect

substitutes between each other.

❖ This theory explains that investors that are used to investing in a

particular area in the curve will have to be compensated for leaving
its “preferred” sector to move into another one.
Interest Rate Risk

Let’s recall that …

The price of a bond depends on the

interest rates…

… there should be a way to measure how a change in

interest rates will impact the price of the bond
Full-Valuation
❖ Calculate the initial and the final price, if the term structure
changes in the following way:

Price 1st Year 2nd Year 3rd Year 4th Year

BCP Bond ? 5 5 5 105

Initial Rates 1% 2% 3% 4%

Final Rates 2% 3% 4% 5%
Full-Valuation
❖ Calculate the initial and the final price, if the term structure
changes in the following way:

Price 1st Year 2nd Year 3rd Year 4th Year

BCP Bond 5 5 5 105

Initial Rates 104.09 1% 2% 3% 4%

Final Rates 100.44 2% 3% 4% 5%