Bond Basics

By
A.V. Vedpuriswar
 Bond basics
 A bond is an IOU between the Issuer and the investors.
 In most cases, the loan is for a fixed term, so that there is a
specified repayment date.
 There is also (in most cases) a fixed interest rate or
coupon.
 In other words, a bond is a package of cash flows, which
are received by the bondholder at future dates until
repayment.
 The price of a package of future cash flows is its “net
present value”.
 This value will fluctuate with changes in market interest
rates.
 Therefore, during its life the price of the bond will fluctuate,
and will move towards 100 (“par”) on maturity date.
 Basic definitions
 Yield
 The interest rate which can be earned on an investment, currently
quoted by the market or implied by the current market price for the
investment.
 Not to be confused with the coupon paid by an issuer on a security,
which is the coupon rate multiplied by the face value.
 For a bond, it is the yield to maturity unless otherwise specified.
 Yield to maturity
 The internal rate of return of a bond
 The yield necessary to discount all the bond’s cash flows to an NPV
equal to its current price.
 It equals all the interest payments received (and assumes that we will
reinvest the interest payment at the same rate as the current yield on
the bond) plus any gain (if we purchased at a discount) or loss (if we
purchased at a premium).
 Yield to equivalent life
 The same as yield to maturity for a bond with partial redemptions.
 The Yield Curve
 The bond market’s main prediction tool is the yield curve.
 Indeed, the yield curve is probably the only true market
indicator and potential forecaster of the market.
 The shape of the yield curve has correctly predicted every
recession in the US since the war.
 The yield curve plots the yield on a group of bonds against
their maturities.
 Only the same class of bonds can be plotted together (gilts,
Treasuries, AA Sterling Eurobonds, etc)
 The conventional shape of the curve is gently upward
sloping .
 The curve can be inverted if market is expecting recession or
for specific structural factors .
 In the United States, the Treasury yield curve is the first mover of all
domestic interest rates and an influential factor in setting global rates.
 Interest rates on all other domestic bond categories rise and fall with
Treasuries which are the debt securities issued by the U.S.
government.
 To attract investors, any bond or debt security that contains greater
risk than that of a similar Treasury bond must offer a higher yield.
 For example, the 30-year mortgage rate historically runs 1% to 2%
above the yield on 30-year Treasury bonds.
 Normal yield curve

The longer the maturity the higher the yield expected by investors
Historical yield trends in the US
Factors affecting yields
Factors affecting yields
 Useful definitions
 Par yield curve
 A curve plotting maturity against yield for bonds priced at par.
 Asset & Liability Management (ALM)
 The practice of matching the maturity and cash flows of an
organisation’s asset and liability portfolios to maximise returns
and minimise risk.
 Also includes the deliberate mis-matching of cash flows to
take account of views on the short-term yield curve.
 Benchmark
 A bond whose terms set a standard for the market.
 The benchmark usually has the greatest liquidity.
 It also usually trades expensive relative to the yield curve,
due to higher demand for it amongst institutional investors.
 More definitions(Contd)
 Convexity
 A measure of the curvature of a bond’s price/yield curve
(mathematically).
Yield-curve option
 Option that allows purchasers to take a view on a yield
curve without having to take a view about a market’s
direction.
 Yield-curve swap
 Swap in which the index rates of the two interest
streams are at different points on the yield curve.
 Both payments are refixed with the same frequency
whatever the index rate.
 Zero-coupon

 A zero-coupon security is one that does not pay a coupon.

 Its price is correspondingly less to compensate for this.
 A zero-coupon yield is the yield which a zero-coupon
investment for that term would have if it were consistent
with the par yield curve.
 Z-spread

 The z-spread is a spread of a bond yield to a yield curve.

 It is the basis point spread that would need to be added to the
implied spot yield curve such that the discounted cash flows
of a bond are equal to its present value (its current market
price).
 Each bond cash flow would be discounted by the relevant
spot rate for its maturity term.
 This differs from a conventional swap spread which has been
calculated using the bond's yield-to-maturity to discount all its
cash flows.
 Both spreads can be viewed as the coupon of a swap market
annuity of equivalent credit risk of the bond being valued.
 Bond price fluctuations

 A bond's price changes on a daily basis, just like that

of any other publicly traded security.
 Many investors do not hold bonds to maturity.
 At any time, a bond can be sold in the open market,
where the price can fluctuate, sometimes
dramatically.
 Simple Yield calculations

 Yield is a figure that shows the return we get on a bond. The

simplest version of yield is calculated using the following formula:
 Yield = coupon amount/price.
 When we buy a bond at par, yield is equal to the interest rate.
 When the price changes, so does the yield.
 If we buy a bond with a 10% coupon at its $1,000 par value, the
yield is 10% ($100/$1,000).
 But if the price goes down to $800, then the yield goes up to
12.5%.
 Conversely, if the bond goes up in price to $1,200, the yield
shrinks to 8.33% ($100/$1,200).
 Understanding the Link Between Price
and Yield
 When interest rates rise, the prices of bonds in the market fall.
 Thereby raising the yield of the older bonds
 And bringing them into line with newer bonds being issued with
higher coupons.
 When interest rates fall, the prices of bonds in the market rise.
 Thereby lowering the yield of the older bonds.
 And bringing them into line with newer bonds being issued with
lower coupons.
 If we are a bond buyer, we want high yields.
 On the other hand, if we already own a bond, we have locked in
our interest rate, so we hope the price of the bond goes up.
 This way we can cash out by selling our bond in the future.
 Illustration

 A zero coupon bond of redemption value $1,000,000 is

trading at $ 950,000 1 year ahead of maturity. What is the
yield?

Solution
 Price = $ 950,000

 Interest = $ 50,000

 Yield = $ 50,000/$950,000

= 1/19

= .0526
GEN0190n.ppt 16

= 5.26%
 Illustration
 What is the yield to maturity of a bond of face value $ 1000,
redemption period of 3 years, coupon = 4% and the bond is
being traded at $ 950?

GEN0190n.ppt 17
 40 40 1040
950   
(1  r ) (1  r ) 2
(1  r ) 3

 r  .06
 Illustration
 Three month, $ 1 million Eurodollar futures are trading at
89.25. A speculator believes interest rates are   going to
rise. What should he do ? If on the date of settlement,
futures quote 88.75, what is his   gain or loss?
 Solution
 Futures price = 100- yield
                 Sell futures
                100-89.25 = (1,000,000- A)/(1,000,000)x400
                A =  $ 973,125
                100-88.75= (1,000,000-B)/(1,000,000)x400
                B = $ 971,875
                Gain = A - B = 973,125 - 971,875  = 1250
 Illustration
 On January 5, March futures maturing after 77 days on
March 22 are yielding 12.50%.    167 day T Bills are now
yielding 10% while 77 day T Bills are yielding 6%.     The
yields given are actual and based on daily
compounding.    Are there any arbitrage possibilities ?
       Borrow for 77 days, Invest for 167 days, Sell March futures  
        After 77 days, collect money realised against sale of futures  
        Give delivery of T Bill and repay loan.  
        Price of 167 day T Bill = (1,000,000)/(1+.10)167/360
= $ 956,750  
         Borrow $ 956,750 for 77 days.  
        After 77 days, realisation from sale of futures
 = (1,000,000)/(1+.125)90/360 = $ 970,984  
        Repayment of loan  = (956,750)(1+.06)77/360 = $ 968,749  
        Profit = 970,984 - 968,749 = $ 2235
 Illustration
 Repeat previous problem if yield on 77 day T Bills is 8%.
          Buy March futures. Borrow for 167 days. Invest for 77 days
          In March, collect money from maturing 77 day T Bill. Pay and
take delivery against  March futures. Hold till delivery.
          To buy future we need 1,000,000/(1+.125)90/360 = $ 970,984
          Investment today = 970,984/(1+0.08)77/360 = $ 955,131
          Issue 167 day T Bill for $ 955,131
          Buy 77 day T Bill for $ 955,131
          Outflow after 167 days = (955,131)(1+.10)167/360= 988,308
          Gain = 1,000,000 - 998,308 = $1,692
 Government Bonds
 In general, fixed-income securities are classified according to
the length of time before maturity.
 These are the three main categories:

Bills - debt securities maturing in less than one year.

Notes - debt securities maturing in one to 10 years.
Bonds - debt securities maturing in more than 10 years.
 Marketable securities from the U.S. government - known
collectively as Treasuries - follow this guideline and are
issued as Treasury bonds, Treasury notes and
Treasury bills (T-bills).
 All debt issued by the US government is regarded as
extremely safe, as is the debt of any developed country.
 The debt of many developing countries, however, does carry
substantial risk.
 Like companies, countries can default on payments
 Treasury Bills

 A short-term debt obligation backed by the U.S. government with a

maturity of less than one year. 
 T-bills are sold in denominations of $1,000 up to a maximum
purchase of $5 million and commonly have maturities of one month
(four weeks), three months (13 weeks) or six months (26 weeks).
 T-bills are issued through a competitive bidding process at a
discount from par.
 Rather than paying fixed interest payments
like conventional bonds, the appreciation of the bond provides the
return to the holder.
 On the run and Off the run Treasury Bills
 On the run Treasury Bills
 The most recently issued U.S. Treasury bond or note of a
particular maturity.
 Off the run Treasury Bills
 The Treasury bonds and notes issued before the most
recently issued bond or note of a particular maturity.
 Once a new Treasury security of any maturity is issued, the
previously issued security with the same maturity becomes
the off-the-run bond or note.
 Because off-the-run securities are less frequently traded,
they typically are less expensive and carry a slightly greater
yield.
 T Bonds
 A marketable, fixed-interest U.S. government debt security
with a maturity of more than 10 years.
 The bonds make interest payments semi-annually and the
income that holders receive is only taxed at the federal level.
 Treasury bonds are issued with a minimum denomination of
$1,000.
 The bonds are initially sold through auction in which the
maximum purchase amount is $5 million if the bid is non-
competitive or 35% of the offering if the bid is competitive.
 A competitive bid states the rate that the bidder is willing to
accept; it will be accepted depending on how it compares to
the set rate of the bond.
 A non-competitive bid ensures that the bidder will get the
bond but he or she will have to accept the set rate.
 After the auction, the bonds can be sold in the secondary
market.
 Municipal bonds, known as "munis", are the next progression in terms of risk..
 The major advantage to munis is that the returns are free from federal tax.
 Furthermore, local governments will sometimes make their debt non-taxable
for residents, thus making some municipal bonds completely tax free.
 Because of these tax savings, the yield on a muni is usually lower than that of
a taxable bond.

.
 Corporate Bonds
 A company can issue bonds just as it can issue stock.
 Generally, a short-term corporate bond is less than
five years; intermediate is five to 12 years, and long
term is over 12 years.
 Corporate bonds are characterized by higher yields
because there is a higher risk of a company defaulting
than a government.
 The company's credit quality is very important: the
higher the quality, the lower the interest rate the
investor receives.
 Other variations on corporate bonds include
convertible bonds which the holder can convert into
stock, and callable bonds which allow the company to
redeem an issue prior to maturity