Introduction to Bonds

0 A bond is a formal contract to repay borrowed money

with interest at fixed intervals.

0 A debt investment in which an investor loans money

to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate.

0 Risk 0 default risk almost Nil 0 Decrease in risk greater than decrease in return 0 Interest paid on bonds is tax-deductable expenditure 0 Fixed income returns lock-in income 0 Preference to the bond holders in case of liquidation

Bond Terminology
0 Debenture 0 Non secured debt instruments 0 Face Value / par value 0 Principal amount on which interest is paid

0 Coupon 0 Annual interest paid periodically 0 Maturity Date 0 Date on which bond is repaid 0 Bond Price 0 Price of bond expressed as a percentage of face value

A thought on..
0 A bond of face value of Rs.1000with a 10% coupon

payable semi annually will pay :___________ as interest every 6 months

0 If the bond price of a bond with a face value Rs.5000

is stated as 105 then the bond price is :

0 Basis points 0 One hundredth of one point 0 Redemption Premium 0 Premium paid on maturity date addition to face value 0 Call option 0 Issuer to call back bonds

0 Put option 0 Entitles bond holder to put the bond back for redemption before maturity 0 Yield 0 Current/YTM/Realized 0 Grade /credit rating

0 The yield of high grade bond is 11.5% and low grade

bond is 12.25% , the yield spread is _______ basis points

0 The distinguishing factors of the Debt Instruments

are as follows: -

0 Issuer class 0 Coupon bearing / Discounted 0 Interest Terms [floating vs fixed] 0 Repayment Terms (Including Call / put etc.) 0 Security / Collateral / Guarantee 0 Convertibility

0 The conversion ratio is the ratio at which a

convertible bond can be exchanged for common stock. 0 A company X has outstanding a bond that has a Rs1000 per value and is convertible into 25 equity shares. 0 The bonds conversion ratio is 25. 0 The conversion price for the bond is Rs40 per share (Rs1000/25).

TYPE OF DEBT INSTRUMENTS

They may be classified into two groups according to maturity.

Money Market Instruments: Maturity of one year or less than one year.
Treasury Bonds (T/B) Certificates of Deposit (CD) Commercial Paper

Capital Market Instruments: Bonds (Debenture): Maturity of more than one year.

T/Bs: 91 days, 364 days

They are sold at a discount and redeemed at par value. Yield rate is low; Risk free; Liquidity is very high, Secondary market is very active.
Discount and Finance House of India (DFHI) , and RBI play active role.

Certificates of Deposit (CD):

0 A negotiable receipt of funds deposited in a bank for a

fixed period. 0 CDs are sold at a discount and redeemed at par value. 0 Interest rate is higher than T/B rates.

Commercial Paper:
Short-term unsecured promissory notes issued by firms (financially strong). Maturity period: 90-180 days. It is sold at a discount and redeemed at par. Interest rate of CP>Interest on CD> Interest on T/B.

Capital Market Instruments: Bonds (Debenture)

Straight Bond (Plain Vanilla Bond)

Zero Coupon Bonds

Floating Rate Bond

Straight Bond (Plain Vanilla Bond): This is the most popular bond. It pays a fixed periodic coupon over its life and return the principal on the maturity date.

Zero Coupon Bonds:

It is issued at a discount over its face value and redeemed at par on maturity.

Floating Rate Bond:

Interest rate is linked to a benchmark rate such as T/B rate.

Case:
0 A floating rate instrument has a coupon rate for any

quarter will be 3% above the yield of 91-day T/B. 0 if a T/B yields during a year (4 quarters) 7.88% ,8.12%, 8.45% ,and 8.02%

0 The yield on Floating rate instrument will be _____

The Structure of the Indian Debt Market

Market Segment
The Sovereign Issuer

Issuers

Instruments
GOI dated securities, T/Bs, State Govt. securities, zero coupon bonds (ZCB)

Central Govt. State Govt.

0 Market Segment

Issuers

Instruments

Govt. Agencies and State Bodies The Public Sector PSUs Com. Banks/DFIs

Govt. Guaranted Bonds PSU Bonds, Commercial Paper (CP) Certificate of deposit (CD), Bond

0 Market Segment

Issuers

Instruments

Corpotares The Private sector Pvt. Sect. banks

Debenture, CP, ZCBs, Floating rate Notes

Bonds, CPs, and CDs

The corporate bond market is only an insignificant part of the Indian debt market.

Time Value of Money

Time Value ??
Which would you prefer -- $10,000 today or $10,000 in 5 years? Obviously, $10,000 today.

Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!!

Question?

Would it be better for a company to invest $100,000 in a product that would return a total of $110,000 after one year, or one that would return $120,000 after two years?
Answer !

Answer !!
It depends on the Interest Rate!

Interest Rates: An Interpretation

0 Interpretation of Interest Rates 0 Required Rate of Return 0 Discount Rates 0 Opportunity Cost

0 Composition of Interest Rates: Introduction

to Premiums (Risk Premiums)

0 Equivalence Relationship

0 $9,500 (PV) = $10,000 (FV), or

0 $9,500 (PV) > $10,000 (FV), or 0 $9,500 (PV) < $10,000 (FV) 0 Equivalence relationship is determined using

Interest Rates or Factors or Discount Rate or Opportunity Cost or Rate of Return

0 Interest Rate, denoted by r or R, is a rate of return

that reflects the relationship between differently dated cash flows.

0 $10,000-$9,500=$500 is the required compensation

for receiving $10,000 one year from now, rather than today

0 The interest rate the required compensation stated

as a rate of return

$500(capital appreciation) divided by $9,500(initial investment) = 5.26%

Interpretation of Interest Rates

Interest Rates can be thought of in three ways : 1)Required Rate of Return minimum an investor must receive in order to accept the investment

2)Discount Rates The rate which is used to calculate the present value of a future cash flow. 1 and 2 can be used interchangeably. 3) Opportunity Cost The value that an investor forgoes by choosing a particular course of action. Consuming $ 9,500 today rather than investing has an opportunity cost of 5.26%

Introduction to Premiums
0 From investors perspective the interest rate is

composed of a real risk-free rate plus a set of four premiums. 0 Premium i.e., return over risk-free rate, is demanded by an investor as a compensation for taking risk R or r = Real risk free interest rate + Inflation Premium + Default Risk Premium + Liquidity Premium + Maturity Premium

Real risk free interest rate : Single period interest rate for a completely risk free security if no inflation were expected. The risk free securities issued by the government is composed of Real risk free interest rate and inflation premium.

Inflation Premium
0 All economies face inflation 0 With time inflation increases the price of

commodity 0 Inflation reduces purchasing power (the amount of goods and services one can buy) of a currency. 0 Approximately : Real risk free rate + Inflation Premium = Nominal Risk Free Interest Rate

e.g. Short term treasury bills issued by govt.

Default Risk Premium

0 Compensates an investor for the possibility that the

borrower will fail to make a promised payment at the contracted time and in the contracted amount.

0 Credit Rating

Liquidity Premium
0 Compensates investor for the risk of loss of

capital value if the asset is to be converted to cash. 0 High volumes of T-bills are traded daily on exchange and hence have high liquidity as compared to a debenture issued by a small issuer. 0 These illiquid bonds have to incorporate liquidity premium to lure the investors and compensate them for bearing additional risk.

Maturity Premium
0 Money invested in a bond is locked-in till the

maturity of the instrument. 0 Longer the maturity higher the risk of interest rate movements (price sensitivity) and higher the impact on capital invested. 0 Maturity premium compensates investor for the uncertainty (inflation, business cycles, yield movement) involved for increased time horizon.

Basic Concepts
0 Future Value: compounding or growth over time

0 Present Value: discounting to todays value

0 Single cash flows & series of cash flows can be

considered

Computational Aids
0 Use the Equations 0 Use Spreadsheets 0 Use the Financial Tables 0 Use Financial Calculators

Computational Aids

Computational Aids

Computational Aids

Future Value of a Single Cash Flow

Future Value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate.

FVn = P0(1+r), for period = 1

FVn: Future Value P0: Capital deposited today (t=0) r: Interest Rate per Period

For periods > 1 FVn= PV0(1+r)^N ; where N= number of periods eg; $100 invested for 2 years (assuming annual compounding) @ 5% Coupon Payments Interest on interest Return of Principal

Annuities
0 Annuities Cash flow packets / finite set of level sequential

cash flows

(ImpAnnuities can be Cash Inflows or Cash Outflows)

0 Ordinary Annuity First cash flow occurs one period from

todays investment at t=1

0 Perpetuity Perpetual Annuity (infinite series of cash flows)

starting @t=1

0 Price of the bond at present is

0 PV of payment (cash inflows) +

PV of par value
n V= t =1
=

C F ----------- + ---------------(1+k d)t (1+k d)n

C x PVAkd,n + F x PVkd,n

Models
0 FVn 0 PV0

= =

PV0(1+k)n FVn[1/(1+k)n]

= PV(FVIFk,n) = FV(PVIFk,n)

BOND VALUATION
Let us consider a bond of face value of Rs.1,000 and a coupon rate of 15%. Five years remain to maturity and the bond is repaid at par. If the current rate of interest is 15%,
Then: Price = 5 150 1000 -------------------- + -----------------------t=1 (1+.15)t (1+.15)5

= 1000

0 If current interest rate is 20%

0P=
150 1000 t (1 .20 ) 5 t 1 (1 .20 )
5

0 = 850.5 0 If current interest rate is 10% 0P=

150 1000 t 5 ( 1 . 10 ) ( 1 . 10 ) t 1

0 = 1189.5

Bond Price- Interest rate relationship

Price

IR

0 When you know the basic characteristics of a bond in terms of

coupon, maturity, and par value, the only factor that determines its value is market discount rate i.e. required rate of return

Bond Price- Yield relationship

Price

Yield

0 When you know the basic characteristics of a bond in terms of

coupon, maturity, and par value, the only factor that determines its value is market discount rate i.e. required rate of return

0 A debenture of ` 100 face value ,coupon rate is 14%,

redeemable after 6yrs at a premium of 2%.If there is an required rate of 16%. what is the debenture valued at?

0 a. annually

b. semi annually w/o premium

Ci FV Pm t n (1 i) t 1 (1 i )

Pp Ci 2 Pm t 2n (1 i 2) t 1 (1 i 2)
2n

Current Yield: A bond of face value Rs.100 may be selling at a discount, at say Rs.80 or may be selling at a premium Rs.120. If the coupon rate is 12%, Current Yield = 12/80 x 100 = 15% (sell at discount) or 12/120 x 100 = 10% (sell at premium) 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: Zero coupon bond is a special type of bond which does not pay annual interest. The return on this bond is in the form of a discount on issue of the bond. For example, a 3 month treasury bills of face value `100 may be issued at a discount for `97. The investor who purchases this bond for `97 would receive `100 three months later. This type of bond is also called Pure Discount Bond or Deep Discount Bond.

Spot interest rate. The return received from a zero coupon bond or a pure discount bond expressed on an annualized basis is the spot interest rate. In the above example, the spot interest rate: = (100 - 97)/97 x 4 x 100 = (3 x 4)/97 x 100 = 12.37

Mathematically, the spot interest rate is the discount rate that makes the present value of the single cash inflow to the investor equal to the cost of the bond. Thus, in the case of a two year bond of face value Rs.1,000, issued at a discount for Rs.797.19, the spot interest rate is calculated as follows: 797.19 = 1000/(1+k)2 or (1+k)2 = 1000/797.19 = 1.2544 (1+k) = 1.2544 = 1.12 or k = 0.12 or 12% The spot interest rate is 12% per annum.

Yield to Maturity (YTM): This is the most widely used measure of return on bonds. It is 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: n Ct TV MP = -------------------- + ------------t n (1+YTM) (1+YTM) t=1 Where, MP = Current market price of the bond Ct = Cash inflow from the bond throughout the holding period. TV = The terminal cash inflow received at the end of the holding period.

Example I: Let us consider a bond of face value of Rs.1,000 and a coupon rate of 15%. The current market price of the bond is Rs.900. Five years remain to maturity and the bond is repaid at par. Then: 5 150 1000 900 = -------------------- + -----------------------(1+Y)t (1+Y)5 t=1 Since, the market price is lower than the face value, it indicates that Y would be higher than the coupon rate.

Assumptions
0 All coupons and principals are made according to

schedule

0 The bond is held till maturity

Example: II If, MP = 1000 FV = 1000 Y = 20% Ct = 200 (Interest rate 20%) 200 1000 1000 = -------------------- + -----------------------t 5 (1+Y) (1+Y) t=1
5

= 200 x 2.9906 + 1000 x 0.4019 = 598.12 + 401.9 = 1000.02 Therefore, Y = 20% (at 20% PV of an annuity for 5 years = 2.9906 and PV of Re 1 received at the end of 5th year = 0.4019)

Interest rate risk

Price = 5 150 1000 -------------------- + ----------------t=1 (1+.15)t (1+.15)5 5 150 1000 -------------------- + ----------------t=1 (1+.20)t (1+. 20)5 5 150 1000 -------------------- + ----------------t=1 (1+.10)t (1+.10)5 @ 15% P=1000

Price =

@ 20% P= 850.5

Price =

@ 10% P=1189.5

Duration
0 A measure of the sensitivity of the price (the value of

principal) of a fixed-income investment to a change in interest rates.

0 Duration is expressed as a number of years. 0 Rising interest rates mean falling bond prices, while

declining interest rates mean rising bond prices.

D=

0 Calculate the duration of a 6 percent, $1,000 par bond

maturing in three years if the yield to maturity is 10 percent and interest is paid semiannually.

Points to note:
0 Zero coupon bond has a duration equal to maturity

0 Duration of a bond is proportional to the maturity

0 Duration of bond is inversely related to interest rate in

the market 0 Greater the coupon rate lesser will be the Duration