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Bonds

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Agenda
Bonds
Different Types of Bonds
Basic Terminologies Used
Issuers
Risks
Basics of Pricing
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Making money:
Interest and capital gains
There are two ways to make money from a bond either by
earning interest or capital gains.
Let's say that you have a Rs 1,000 bond that pays 6% interest for
five years. If you hold that bond until the very end of this term
(known as the maturity date), youll collect five interest
payments of Rs 60 for a total of Rs 300.
60.00
Year 1 (6% interest
on 1,000)
Year 2 (6% interest
on 1,000)
60.00
Year 3 (6% interest
on 1,000)
60.00
Year 4 (6%
interest on 1,000)
60.00 60.00
Year 5 (6%
interest on 1,000)
1,300.00
Total principal and
interest (at maturity
date of 5 years)
Principal
amount
Rs 1000.00
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You could also decide to sell that bond to
someone else for $1,100. In that case youd
earn a capital gain of $100 (plus whatever
interest payments you had received in the
meantime).

Now, why would someone pay you $1,100 for
a bond that only cost you $1,000?
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Selling bonds
Your $1,000 bond pays 6% interest. Since you bought that bond,
however, interest rates have gone down. Similar companies are
now only offering a 5% interest rate on their bonds. Your original
rate looks pretty good to another investor. So you can sell that 6%
bond at a higher cost than you paid for it, which is called selling
for a premium.
However, if interest rates have gone up, and similar companies
are now offering 8%, you may have to sell your bond for less
which is known as selling at a discount.
Interest rates and bond prices, then, are like a see-saw when
interest rates go down, bond prices go up (and vice versa).

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Bond Issuers
Government Bonds
Municipal Bonds
Corporate Bonds
International Bonds
Eurobond
Foreign bonds

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Bonds terminology
Issuer
A bond is a debt security, similar to an I.O.U. When you purchase a bond, you
are lending money to a government, municipality, corporation, federal agency
or other entity known as the issuer.
Par Value
It is the value stated on the face of the bond.
It represents the amount the firm borrows and promises to repay at the time of
the maturity.
It is also known as the principal, face value, or par value.
Par value will vary depending on the type of bond. Most corporate bonds
have a Rs 100 face value, sometimes it can be Rs 1000.
It is important to remember that bonds are not always sold at par value. In the
secondary market, a bond's price fluctuates with interest rates. If interest rates
are higher than the coupon rate on a bond, the bond will have to be sold
below par value (at a "discount"). If interest rates have fallen, the price will be
higher.





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Maturity
Maturity is the length of time before the principal is returned on a bond. It is also
called term-to-maturity. At the time of maturity, the issuer is no longer obligated
to make interest payments.
Maturities range significantly, from 1 year to 40+ years for some corporate
bonds.
The bonds of different maturities will behave somewhat differently. For
example, bonds with long-term maturities will be more sensitive to changes in
interest rates. Shorter term bonds are more stable and, because you are more
likely to hold it to maturity, are more predictable. There are some circumstances
where a bond will be "called" before maturity.
Short-term notes: maturities of up to 4 years; Medium-term notes/bonds: maturities of five to 12
years; Long-term bonds: maturities of 12 or more years.


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Coupon
The coupon rate is the interest rate that is paid out to the bond holder.
The name derives from the old system of payment, in which bond holders would need to send
in coupons in order to receive payment.
The coupon is set when the bond is issued and is usually expressed as an annual percentage
of the par value of the bond.
Payments usually occur every six months, but this can vary. If there is a 5% coupon on a Rs
1000 face value bond, the bondholder will receive Rs 50 every year.
There are some bonds that do not pay out any coupons; these are called zero-coupon bonds .
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CREDIT RATINGS
Each of the agencies assigns its ratings based on an in-depth analysis of the issuer's financial condition and
management, economic and debt characteristics, and the specific revenue sources securing the bond.



Credit Risk Moody's
Standard and
Poor's Fitch
Prime Aaa AAA AAA
Excellent Aa AA AA
Upper Medium A A A
Lower Medium Baa BBB BBB
Speculative Ba BB BB
Very Speculative B, Caa B, CCC, CC B, CCC, CC, C
Default Ca, C D DDD, DD, D
Credit Ratings
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Types of Bonds
I. Classification on the basis of Variability of Coupon
Zero Coupon Bonds
Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the
principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and
hence, there are no cash inflows in zero coupon bonds.
The difference between issue price (discounted price) and redeemable price (face value) itself
acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their
maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa.
These types of bonds are also known as Deep Discount Bonds.

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Floating Rate Bonds
In some bonds, fixed coupon rate to be provided to the
holders is not specified. Instead, the coupon rate keeps
fluctuating from time to time, with reference to a
benchmark rate. Such types of bonds are referred to as
Floating Rate Bonds.
For better understanding let us consider an example of
one such bond from IDBI in 1997. The maturity period of
this floating rate bond from IDBI was 5 years. The coupon
for this bond used to be reset half-yearly on a 50 basis
point mark-up, with reference to the 10 year yield on
Central Government securities (as the benchmark). This
means that if the benchmark rate was set at X %, then
coupon for IDBIs floating rate bond was set at (X + 0.50)
%.





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Coupon rate in some of these bonds also have floors and
caps. For example, this feature was present in the same
case of IDBIs floating rate bond wherein there was a floor
of 13.50% (which ensured that bond holders received a
minimum of 13.50% irrespective of the benchmark rate).
On the other hand, a cap (or a ceiling) feature signifies the
maximum coupon that the bonds issuer will pay
(irrespective of the benchmark rate). These bonds are also
known as Range Notes.
More frequently used in the housing loan markets where
coupon rates are reset at longer time intervals (after one
year or more), these are well known as Variable Rate
Bonds and Adjustable Rate Bonds. Coupon rates of some
bonds may even move in an opposite direction to
benchmark rates. These bonds are known as Inverse
Floaters and are common in developed markets.

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Fixed
Stays same until maturity; ie: buy a Rs 1000 bond with 8% fixed interest rate
and you will receive Rs 80 every year until maturity and at maturity you will
receive the Rs 1000 back.

Payable at Maturity
Receive no payments until maturity and at that time you receive principal plus
the total interest earned compounded semi-annually at the initial interest rate.


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II. Classification on the Basis of Variability of Maturity
Callable Bonds
The issuer of a callable bond has the right (but not the obligation) to change
the tenor of a bond (call option). The issuer may redeem a bond fully or partly
before the actual maturity date. These options are present in the bond from
the time of original bond issue and are known as embedded options.
This embedded option helps issuer to reduce the costs when interest rates
are falling, and when the interest rates are rising it is helpful for the holders.
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Puttable Bonds
The holder of a puttable bond has the right (but not an obligation) to seek
redemption (sell) from the issuer at any time before the maturity date.
In riding interest rate scenario, the bond holder may sell a bond with low
coupon rate and switch over to a bond that offers higher coupon rate.
Consequently, the issuer will have to resell these bonds at lower prices to
investors.
Therefore, an increase in the interest rates poses additional risk to the issuer of
bonds with put option (which are redeemed at par) as he will have to lower the
re-issue price of the bond to attract investors.


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Convertible Bonds
The holder of a convertible bond has the option to convert the bond into equity
(in the same value as of the bond) of the issuing firm (borrowing firm) on pre-
specified terms.
This results in an automatic redemption of the bond before the maturity date.
The conversion ratio (number of equity of shares in lieu of a convertible bond)
and the conversion price (determined at the time of conversion) are pre-
specified at the time of bonds issue.
Convertible bonds may be fully or partly convertible. For the part of the
convertible bond which is redeemed, the investor receives equity shares and
the non-converted part remains as a bond.



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III. Classification on the basis of Principal Repayment

Amortizing Bonds
Amortizing Bonds are those types of bonds in which the borrower (issuer)
repays the principal along with the coupon over the life of the bond.
The amortizing schedule (repayment of principal) is prepared in such a
manner that whole of the principle is repaid by the maturity date of the bond
and the last payment is done on the maturity date. For example - auto loans,
home loans, consumer loans, etc.
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Debt Instruments
Type Typical Features
Central Government Securities Medium long term bonds issued by RBI on behalf of GOI.
Coupon payment are semi annually
State Government Securities

Medium long term bonds issued by RBI on behalf of state
govt.
Coupon payment are semi annually

Government Guaranteed Bonds Medium long term bonds issued by govt agencies and
guaranteed by central or state govt.
Coupon payment are semi annually

PSU Medium long term bonds issued by PSU.
51% govt equity stake
Corporate Short - Medium term bonds issued by private companies.
Coupon payment are semi annually

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Risk Associated with Investing in Bonds
Interest Rate Risk
The price of the bond will change in the opposite direction
from the change in interest rate. As interst rate rises the
bond price decreases and vice versa.
If an investor has to sell a bond prior to the maturity date, it
means the realisation of capital loss.
This risk depends on the type of the bond; callable puttable
etc????

Reinvestment Income or Reinvestment Risk
The additional income from such reinvestment called
interest on interest, depends on the prevailing interest rate
levels at the time of reinvestment.



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Call Risk
The issuer usually retains this right in order to have
flexibility to refinance the bond in the future is market
interest rate drops below the coupon rate
Disadvantage for investors for callable bond: cash flow
pattern not known with certainty, interest rate drop, capital
appreciation will reduce.
Credit Risk
If the issuer of a bond will fail to satisfy the terms of the
obligation with respect to the timely payment of interest and
repayment of the amount borrowed.
Yield = market yield + risk associated with credit risk
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Inflation Risk
Purchasing power risk arises because of the variation
in the value of cash flow from the security due to
inflation.
Eg: ???
Exchange Rate Risk
Risk associated with the currency value for non-rupee
denominated bonds. Eg: US treasury bond
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Liquidity Risk
Its depends on the size of the spread between bid and ask
price quoted. Wider the spread is risky.
For investors keeping till maturity, this is uminportant.
Market to market should be calculated portfolio value.

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Bond Pricing
Reason
Indicate the yield received
Should the bond be purchased
Priced at Premium, Discount, or at Par
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Calculating Bond Price
Sum of the present values of all expected coupon payments
plus the present value of the par value at maturity.



C = coupon payment, ordinary annuity
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value
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Question 1
Calculate the Bond price for a 20 year 10% coupon bond
with a par value of Rs 1000. Lets suppose the yield on this
bond is 11%. The cash flows for this bond are as follows:
40 semi anually coupon payment of Rs 50
Rs 1000 to be received 40 six month period from now.

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Solution
50
1-
1 1000
(1.055)
40
+

(1.055)
40

0.055


Rs 50 1- 0.117463 + Rs 100
0.055 8.51332

= Rs 802.31 + 117.46
= Rs 919.77
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Question 2
Calculate the Bond price for a 20 year 10% coupon bond
with a par value of Rs 1000. Lets suppose the yield on this
bond is 6.8%. The cash flows for this bond are as follows:
40 semi anually coupon payment of Rs 50
Rs 1000 to be received 40 six month period from now.


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Solution
50
1-
1 1000
(1.034)
40
+

(1.034)
40

0.034

= Rs 1084.51 + 262.53
= Rs 1,347.04
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Calculate the Bond price for a 20 year 10% coupon bond
with a par value of Rs 1000. Lets suppose the yield on this
bond is 10%. The cash flows for this bond are as follows:
40 semi anually coupon payment of Rs 50
Rs 1000 to be received 40 six month period from now.
Ans Rs 1000

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Price Yield Relationship
When yield increases, investor would not buy the issue
because it offers a below market yield; the resulting lack of
demand would cause the price to fall.
When yield decreases ??????
This is how bond price falls below its par value.
When bond sells below its par value, it is said to be selling
at a discount
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Coupon rate is less than the required yield
Price is less than the par ( Discount Bond)
Coupon rate is equal to the required yield
Price is equal to the par
Coupon rate is more than the required yield
Price is more than the par ( premium Bond)
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A fundamental property of a bond is that its price changes
in the opposite direction from the change in the required
yield
As the required yield increases, the present value of cash
flow decreases; hence the price decreases.
As the required yield decreases, the present value of cash
flow increases; hence the price
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Premium and Discount Bonds
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Bond Basics
Two basic yield measures for a bond are its coupon rate and its
current yield.
10-36
value Par
coupon Annual
rate Coupon =
price Bond
coupon Annual
yield Current =
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Pricing Zero-Coupon Bonds
No coupon payment until maturity. Because of this, the
present value of annuity formula is unnecessary.
Calculate the price of a zero-coupon bond that is maturing
in 5 years, has a par value of $1,000 and required yield of
6%....?
Determine the Number of Periods
Determine the Yield
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Determining Interest Accrued
Accrued interest is the fraction of coupon payment that the
bond seller earns for holding the bond for a period of time
between bond payments
The amount that the buyer pays the seller is the agreed upon
the price plus accrued interest. This is referred as a Dirty
bond prices
The price of a bond without accrued interest is called the
Clean bond prices
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Eg: On March 1, 2003, X is selling a corporate bond with a face
value of $1,000 and 7% coupon paid semi-annually. The next
coupon payment after March 1, 2003, is expected on June 30,
2003.
What is the interest accrued on the bond?
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Yield
Yield is the return you actually earn on the bond--
based on the price you paid and the interest
payment you receive
Two Types of Yields:
Current Yield: annual return on the dollar amount paid for the bond and is
derived by dividing the bond's interest payment by its purchase price
Yield To Maturity: total return you will receive by holding the bond until it
matures or is called.
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Yield
1. Current yield:
Annual coupon receipts/ Market price of the bond

It does not consider:
Time value of money
Complete series of future cash flow

It compares a pre-specified coupon with the current market price,
it is called as current yield.

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Example
The current yield for a 15 years 7% coupon bond with a par
value of Rs 1000, selling for Rs 769.40

Current yield = Rs 70 = 9.10%
Rs769.40
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Yield to Maturity
Given a pre-specified set of cash flows and a price, the YTM of
a bond is that rate which equates the discounted value of the
future cash flows to the present price of the bond.


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YTM
Yield to maturity (YTM) is the interest rate (i) that equates the present
value of cash flow payments received from a debt instrument with its
value today.
It is the most accurate measure of interest rates.
The yield to maturity is the annual return annual rate (discounted)
earned over a bond kept until maturity.
The yield to maturity is the discount rate estimated mathematically that
equals the cash flow of payment of interest and principal received with
the purchasing price of the bond.
This term is also referred to as internal rate of return or as the expected
rate of return of the bond and it is the yield in which most bond
investors are interested in.


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YTM

n
P = C + M

t=1
(1+y)
n
(1+y)
n

P= Price of the bond
C = coupon payment
N = No. of years left to maturity
M = Maturity value
Y = yield to maturity
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Yield of Bond
Eg: You hold a bond whose par value is $100 but has a current yield of
5.21% because the bond is priced at $95.92. The bond matures in 30
months and pays a semi-annual coupon of 5%.

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The yield is the interest rate that will make the present
value of cash flow equals to the bond price.
YTM is calculated same way as IRR, the cash flows are
those that the investor would realized by holding the bond
till maturity.
To compute the YTM requires a trial and error method


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Trial and error method

Annual Interest rate PV of 30 payments
of Rs 35
PV of Rs 1000 30
periods from now
PV of cash flows
9 % 570.11 267 837.11
9.5% 553.71 248.53 802.24
10% 538.04 231.38 769.42
11.5 % 532.04 215.45 738.49
11 % 508.68 200.64 709.32
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Would you prefer to buy a 10-year, 10% annual coupon bond or a 10-
year, 10% semiannual coupon bond, all else equal?
10.25% 1
2
0.10
1 1
m
i
1 EFF%
2 m
Nom
=
|
.
|

\
|
+ =
|
.
|

\
|
+ =
The semiannual bonds effective rate is:




10.25% > 10% (the annual bonds effective rate), so you
would prefer the semiannual bond.
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Calculating Yield for Callable and Puttable Bonds
A callable bond's valuations must account for the issuer's
ability to call the bond on the call date
The puttable bond's valuation must include the buyer's ability
to sell the bond at the pre-specified put date.
The yield for callable bonds is referred to as yield-to-call, and
the yield for puttable bonds is referred to as yield-to-put.
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Yield to Call (YTC)
Yield to call (YTC) is the interest rate that investors would
receive if they held the bond until the call date. The period
until the first call is referred to as the call protection period.
Yield to call is the rate that would make the bond's present
value equal to the full price of the bond. Essentially, its
calculation requires two simple modifications to the yield-to-
maturity formula:
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YTC
When the bond may be called and at what price are
specified at the time the bond is issued.
The price at which bond may be called is referred to as the
call price.
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Example
Consider an 18 years 11% coupon bond payable semi
annually with a maturity value of Rs 1000 selling at Rs
1169. suppose that the first call date is 8 years from now
and that the call price is Rs 1055.
Call price = 1055
N = 8*2 = 16 m
C = 1000*11%/2 = 55
Bond price = 1169
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Solution
1169 = Rs 55
1-
1 1055 1
(1+y)
16
+ (1+y)
16



y



8.54% is the yield to first call

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Yield to Put (YTP)
This mean that the bond holder can force the issuer to buy the
issue at a specified price.
Yield to put (YTP) is the interest rate that investors would receive
if they held the bond until its put date.
To calculate yield to put, the same modified equation for yield to
call is used except the bond put price replaces the bond call
value and the time until put date replaces the time until call date.
M = put price
n = number of periods until assumed put date.

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Example of YTP
Consider an 18 years 11% coupon bond payable semi
annually issue selling Rs 1169. assume that issue is
putable at par (Rs 1000) in five years.
Put price = 1000
N = 5*2 = 10 m
C = 1000*11%/2 = 55
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Solution
1169 = Rs 55
1-
1 1000 1
(1+y)
10
+ (1+y)
10



y



6.94% 7% is the yield to put

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