Sessions 30 Bond, Yield Curve

Compiled by Prof.
Madhu Iyengar

Bond Prices And Yields
Figuring out the Assured Returns
Compiled by Prof. Madhu Iyengar
OUTLINE

Bond Yields
Risks in Bonds
Rating of Bonds
The Yield Curve
Explaining the Term Structure
Determinants of Interest Rates
Analysis of Convertible Bonds
DETERMINING INTEREST
RATES AND UNDERSTANDING
ITS IMPACT ON MONETARY
POLICY
MACRO VIEW
NET LENDERS NET LENDERS
NET BORROWERS
EXCHANGE
CURRENCY=INTEREST
RATE
Interest Rate Fundamentals
Nominal interest rates - the
interest rate actually observed in
financial markets
directly affect the value (price) of most
securities traded in the market
affect the relationship between spot and
forward FX rates
What are the 3 components of the nominal
interest rate?
ANSWER
The riskless rate- pure time value
Inflation cover related to time
Liquidity, default and interest rate risk cover
USEFUL TIPS
Think interest and think
Time value of money
Lump sum payments upfront or at end of term
Annuities
Time Value of Money and Interest Rates
Assumes the basic notion that a dollar received today is
worth more than a dollar received at some future date
Compound interest
interest earned on an investment is reinvested
Simple interest
interest earned on an investment is not reinvested
Calculation of Simple Interest
Value = Principal + Interest (year 1) + Interest (year 2)

Example:
$1,000 to invest for a period of two years at 12 percent

Value = $1,000 + $1,000(.12) + $1,000(.12)

= $1,000 + $1,000(.12)(2)

= $1,240
Value of Compound Interest
Value = Principal + Interest + Compounded interest

Value = $1,000 + $1,000(.12) + $1,000(.12) + $1,000(.12)

= $1,000[1 + 2(.12) + (.12)
2
]

= $1,000(1.12)
2

= $1,254.40
Present Value of a Lump Sum
PV function converts cash flows
received over a future investment
horizon into an equivalent (present)
value by discounting future cash
flows back to present using current
market interest rate
lump sum payment
annuity

Question
What do you think happens to PVs as
interest rates increase?
ANSWER
PVs decrease as interest rates increase
Loanable Funds Theory
A theory of interest rate determination that views
equilibrium interest rates in financial markets as a result
of the supply and demand for loanable funds
Supply of Loanable Funds
Interest
Rate
Quantity of Loanable Funds
Supplied and Demanded
Demand Supply
Representative study: Funds Supplied
and Demanded by Various Groups (in
billions of dollars) - US

Funds Supplied Funds Demanded Net

Households $34,860.7 $15,197.4 $19,663.3
Business - nonfinancial 12,679.2 30,779.2 -12,100.0
Business - financial 31,547.9 45061.3 -13,513.4
Government units 12,574.5 6,695.2 5,879.3
Foreign participants 8,426.7 2,355.9 6,070.8

TRY AND MAP THIS FOR INDIA..
Determination of Equilibrium Interest
Rates
Interest
Rate
Quantity of Loanable Funds
Supplied and Demanded
D
S
I
H
i
I
L
E
Q
Factors that affect demand and supply
curves of loanable funds to shift
Increase in Affect on Supply Affect on Demand
Wealth & income Increase N/A
As wealth and income increase, funds suppliers are more willing to supply
funds to markets. Result: lower interest rates
Risk Decrease Decrease
As the risk of an investment increases, funds suppliers are less willing to
purchase the claim. All else equal, demanders of funds would be less
willing to borrow as well. Result: likely higher interest rates
Near term spending needs Decrease N/A
As current spending needs increase, funds suppliers are less willing to
invest. Result: higher interest rates

Monetary expansion Increase N/A
As the central bank increases the supply of money in the economy, this directly
increases the supply of funds available for lending. Result: lower interest rates
Economic growth Increase Increase
With stronger economic growth, wealth and incomes rise, increasing the supply of
funds available. As economic strength improves relative to the rest of the world,
foreign supply of funds is also increased. Business demand for funds increases
as more projects are profitable. Result: indeterminate effect on interest rates,
but at more rapid growth rates interest rates tend to rise.
Utility derived from assets Decrease Increase
As utility from owning assets increases, funds suppliers are less willing to invest
and postpone consumption whereas funds demanders are more willing to
borrow. Result: higher interest rates

Restrictive covenants Depends Decrease
As loan or bond covenants become more restrictive, borrowers reduce their demand for
funds. Result: lower interest rates
Taxes Decrease Increase
Taxes on interest and capital gains reduce the returns to savers and the incentive to save.
The tax deductibility of interest paid on debt increases borrowing demand. Result: Higher
interest rates
Currency Increase
Foreign suppliers of funds would earn a higher rate of return if the currency appreciates and a
lower rate of return measured in their own currency if the dollar depreciates. Foreign
central banks often buy U.S. Treasury securities as part of their attempts to prevent their
currency from appreciating against the dollar. Result: Lower interest rates
Expected inflation Decrease Increase
An increase in expected inflation implies that suppliers will be repaid with dollars that will
have less purchasing power than originally anticipated. Suppliers lose purchasing power
and borrowers gain more than originally anticipated. This implies that supply will be
reduced and demand increased. Result: Higher interest rates

QUESTION
Do you think real interest rates are always positive?

What is real interest and nominal interest in what it
represents?
ANSWER
No. They can sometimes be negative because of the
convenience yield of liquidity. They have been negative
recently in Japan and US

The nominal interest rate is the additional dollars earned
from an investment. The real interest rate is the
additional purchasing power earned from an investment.
Effect on Interest rates from a Shift in
the Demand Curve for or Supply curve
of Loanable Funds
Increased supply of loanable funds
Quantity of
Funds Supplied
Interest
Rate
DD
SS
SS*
E
E*
Q*
i*
Q**
i**
Increased demand for loanable funds
Quantity of
Funds Demanded
DD
DD*
SS
E
E*
i*
i**
Q* Q**
Factors Affecting Nominal
Interest Rates-Recap
Inflation
Real Interest Rate
Default Risk
Liquidity Risk
Special Provisions
Term to Maturity
i
j
* = f(Riskless real rate, Expected inflation, Default risk premium, Liquidity risk
premium, Special covenant premium, Maturity risk premium)
Inflation and Interest Rates: The
Fisher Effect
The interest rate should compensate an investor
for both expected inflation and the opportunity
cost of foregone consumption
(the real rate component)

i = RIR + Expected(IP)
or RIR = i Expected(IP)

Example: 3.49% - 1.60% = 1.89%
What is a Yield Curve
A line that plots the interest rates, at a set point in
time, of bonds having equal credit quality, but
differing maturity dates.
The most frequently reported yield curve compares
the three-month, two-year, five-year and 30-year
U.S. Treasury debt.
This yield curve is used as a benchmark for other
debt in the market, such as mortgage rates or
bank lending rates. The curve is also used to
predict changes in economic output and growth.
Term to Maturity and Interest
Rates: Yield Curve
Yield to
Maturity
Time to Maturity
(a)
(b)
(c)
(a) Upward sloping
(b) Inverted or downward
sloping
(c) Flat
INDIAN BOND MARKET
An Overview

The Structure of the Indian Debt Market
Market Segment Issuers Instruments

The
Sovereign
Issuer
Central Govt.
State Govt.
GOI dated securities, T/Bs, State
Govt. securities, zero coupon bonds
(ZCB)

The Public
Sector
Govt. Agencies and
State Bodies
PSUs
Com. Banks/DFIs
Govt. Guaranted Bonds
PSU Bonds, Commercial Paper (CP)
Certificate of deposit (CD), Bond

The Private
sector
Corpotares
Pvt. Sect. banks
Debenture, CP, ZCBs, Floating rate
Notes
Bonds, CPs, and CDs
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.

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

Money Market Instruments

Treasury Bonds (T/B)
Certificates of Deposit (CD)
Commercial Paper

Capital Market Instruments: Bonds
(Debenture)
Straight Bond (Plain Vanilla Bond)

Zero Coupon Bonds

Floating Rate Bond

Bonds with Options:
Convertible Bonds:
Callable Bonds:
Puttable Bonds:


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.

When the yield rates are plotted against different maturity
of the bond, in the following figure, we get the yield
curve.

Yield Rate

Yield curve

Maturity
A positively sloped yield curve
This yield curve indicates that borrowers who wish to
borrow for long periods of time pay a higher rate of interest
than medium-term borrowers who in turn pay, higher rate
of interest than short-term borrowers.

A negatively sloped yield curve
This indicates that borrowers who wish to borrow in short-
term pay a higher rate of interest than long-term
borrowers.

A hump shaped yield curve
Borrowers that borrow medium terms paying higher
interest than those that borrow short-term or long-term.

A relatively flat yield curve with

Borrowers at the short, medium and long term all borrowing
at approximately the same rate of interest.

Illustrative Data For
Government Securities
Face Value I nterest Rate Maturity Current Price Yield to
(years) maturity

100,000 0 1 88,968 12.40
100,000 12.75 2 99,367 13.13
100,000 13.50 3 100,352 13.35
100,000 13.50 4 99,706 13.60
100,000 13.75 5 99,484 13.90

Forward Rates

ONE - YEAR TB RATE
100000
88968 = r
1
= 0.124
(1 + r
1
)
2 - YEAR GOVT. SECURITY
12750 112750
99367 = + r
2
= 0.1289
(1.124) (1.124) (1 + r
2
)
3 - YEAR GOVT. SECURITY
13500 13500 113500
100352 = + +
(1.124) (1.124) (1 .1289) (1.124) (1.1289) (1 + r
3
)
r
3
= 0.1512

Explaining The Term Structure
Expectations Theory
Liquidity Preference Theory
Preferred Habitat Theory
Market Segmentation Theory
Pure Expectations theory

Shape . yield curve depends on .. expectations
those who participate market
(1 +
t
r
n
) = [ (1 +
t
r
1
) (1 +
t+1
r
1
) (1 +
t+n-1
r
n
)]
1/n

yield curve explanation
ascending short-term rates rise in future
descending short-term rates fall in future
humped short-term rates rise . fall
flat short-term rates . . unchanged in
future

Liquidity preference theory
Forward rates should incorporate interest rate expectations as
well as a risk (or liquidity) premium
(1 +
t
r
n
) = [ (1 +
t
r
1
) (1 +
t+1
r
1
+l
2
) (1 +
t+n-1
r
n
+l
n
)]
1/n

an upward-sloping yield curve suggests that future interest rates
will rise (or will be flat) or even fall if the liquidity premium
increases fast enough to compensate for the decline in the future
interest rates
Preferred Habitat theory

Investors prefer to match the maturity of investment to their
investment objective
borrowers . . too
if mismatch inducement to shift
Market segmentation theory

Extreme form of preferred habitat theory

Sessions 30 Bond, Yield Curve

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