Bonds

Bond


Bonds are debt instruments that are issued by companies, municipalities and governments to raise funds for financing their capital expenditure. By purchasing a bond, an investor loans money for a fixed period of time at a predetermined interest rate. While the interest is paid to the bond holder at regular intervals, the principal amount is repaid at a later date, known as the maturity date. While both bonds and stocks are securities, the principle difference between the two is that bond holders are lenders, while stockholders are the owners of the organization.

Bond Terminology


There are several terms with which you must be familiar to solve bond valuation problems:


Coupon Rate - This is the stated rate of interest on the bond. It is fixed for the life of the bond. Also, this rate time the face value determines the annual interest payment amount. Face Value - This is the principal amount (nominally, the amount that was borrowed). Interest amount to be paid is computed on this value only. Maturity Date - This is the date after which the bond no longer exists. It is also the date on which the loan is repaid and the last interest payment is made.

Types of Bonds
        

Registered Bonds and Bearer Forms Secured Bonds and Unsecured Bonds Senior Vs Subordinate Bonds Convertible and Non-convertible Bonds Junk Bonds Callable and Puttable Bonds Index Bonds Floating rate Bonds Zero Coupon Bonds

Zero Coupon Bonds



 

Make no periodic interest payments (coupon rate = 0%) The entire yield-to-maturity comes from the difference between the purchase price and the par value Cannot sell for more than par value Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs) Treasury Bills and principal-only Treasury strips are good examples of zeroes

Floating-Rate Bonds
 

Coupon rate floats depending on some index value Examples adjustable rate mortgages and inflationlinked Treasuries There is less price risk with floating rate bonds


The coupon floats, so it is less likely to differ substantially from the yield-to-maturity

Coupons may have a collar the rate cannot go above a specified ceiling or below a specified floor

Differences Between Debt and Equity

Debt
 

Equity
 

Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax deductible Creditors have legal recourse if interest or principal payments are missed Excess debt can lead to financial distress and bankruptcy

Ownership interest Common stockholders vote for the board of directors and other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid An all equity firm can not go bankrupt merely due to debt since it has no debt

Are Bonds Risk Free???



Bonds are among the safest investment instruments in the world. But no instruments is actually risk free. Types of Risk in Bonds:
     

Interest Rate Risk Reinvestment Risk Inflation risk Credit/Default Risk Call risk Liquidity Risk

Value of a Bond


Value of a Bond = (Annual Interest payable x Present Value annuity factor) + (Redemption Value x Discount factor) V = I ( PVAF k,n) + F(DFk,n)

Bond Values


Assume that you are interested in purchasing a bond of Rs.1000, with 5 years to maturity and a 10% coupon rate. If your required return is 12%, what is the highest price that you would be willing to pay?
100 0 1 100 2 100 3 100 4 1,000 100 5

V = Int x {(1+r)n 1 /(1+r)nr} + Redemption Value x {1/(1+r)n}

= 100x{((1.12)5 - 1)/((1.12)5x.12)} + 1000{1/(1.12)5} = 927.90

Valuing a Discount Bond with Annual Coupons



Consider a bond with a coupon rate of 8% and annual coupons. The par value is Rs.1,000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond?


Using the formula:

 

B = PV of annuity + PV of lump sum B =295.67 + 593.45 = 889.12

Valuing a Premium Bond with Annual Coupons



Suppose you are looking at a bond that has a 12% annual coupon and a face value of Rs.1500. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond?

Ans = 2089

Some Notes About Bond Valuation



The value of a bond depends on several factors such as time to maturity, coupon rate, and required return We can note several facts about the relationship between bond prices and these variables (ceteris paribus):


Higher required returns lead to lower bond prices, and vice-versa Higher coupon rates lead to higher bond prices, and vice versa Longer terms to maturity lead to lower bond prices, and vice-versa

Graphical Relationship Between Price and Yield-to-maturity (YTM)

1500 1400

Bond Price

1300 1200 1100 1000 900 800 700 600 0% 2% 4% 6% 8% 10% 12% 14%

YTM

Bond Yields


There are several ways that we can describe the rate of return on a bond:
   

Coupon rate Current yield Yield to maturity Realized Yield

The Coupon Rate

 

The coupon rate of a bond is the stated rate of interest that the bond will pay The coupon rate does not normally change during the life of the bond, instead the price of the bond changes as the coupon rate becomes more or less attractive relative to other interest rates The coupon rate determines the dollar amount of the annual interest payment:
Annual Pmt ! Coupon Rate v Face Value

The Current Yield



 

The current yield is a measure of the current income from owning the bond It is calculated as: CY = Annual Interest rate/Current Market price

The Yield to Maturity



The yield to maturity is the average annual rate of return that a bondholder will earn under the following assumptions:
 

The bond is held to maturity The interest payments are reinvested at the YTM

The yield to maturity is the same as the bonds internal rate of return (IRR) MP = Int x PVIFA(YTM,N) + RVxPVIF(YTM,N)

Approximation to YTM


YTM = 1+[MV C]/n [MV + C]/2 I = Interest Amount MV= Maturity Value C = Current Market price n = Holding period

Bond Prices: Relationship Between Coupon and Yield

 

If YTM = coupon rate, then par value = bond price If YTM > coupon rate, then par value > bond price
 

Why? The discount provides yield above coupon rate Price below par value, called a discount bond Why? Higher coupon rate causes value above par Price above par value, called a premium bond

If YTM < coupon rate, then par value < bond price
 

The Yield to Call



Most corporate bonds, and many older government bonds, have provisions which allow them to be called if interest rates should drop during the life of the bond Normally, if a bond is called, the bondholder is paid a premium over the face value (known as the call premium) The YTC is calculated exactly the same as YTM, except:
 

The call premium is added to the face value, and The first call date is used instead of the maturity date

The Realized Yield

 

The realized yield is an ex-post measure of the bonds returns The realized yield is simply the average annual rate of return that was actually earned on the investment If you know the future selling price, reinvestment rate, and the holding period, you can calculate an ex-ante realized yield which can be used in place of the YTM (this might be called the expected yield)

Calculating Bond Yield Measures



As an example of the calculation of the bond return measures, consider the following:


You are considering the purchase of a 2-year bond (semiannual interest payments) with a coupon rate of 8% and a current price of $964.54. The bond is callable in one year at a premium of 3% over the face value. Assume that interest payments will be reinvested at 9% per year, and that the most recent interest payment occurred immediately before you purchase the bond. Calculate the various return measures. Now, assume that the bond has matured (it was not called). You purchased the bond for $964.54 and reinvested your interest payments at 9%. What was your realized yield?

Calculating Bond Yield Measures (cont.)

-964.54 Timeline if not called 0

40 1

40 2

40 3

1,000 40 4

-964.54 Timeline if called 0

40 1

1,030 40 2

Calculating Bond Yield Measures (cont.)



The yields for the example bond are:

  

 

Current yield = 8.294% YTM = 5% per period, or 10% per year Modified YTM = 4.971% per period, or 9.943% per year YTC = 7.42% per period, or 14.84% per year Realized Yield:
 

if called = 7.363% per period, or 14.725% per year if not called = 4.971% per period, or 9.943% per year

Bond Pricing Theorems

 

A Bonds price is inversely proportional to its YTM For a given difference between the YTM and the coupon rate of the bonds, the longer the term to maturity, the greater will be the change in price with change in the YTM. Given the maturitys the change in bond price will be greater with a decrease in the bonds YTM than the change in bond price with an equal increase in the bonds YTM. That is for equal fixed increase and decrease in the YTM, price movements are not symmetrical. A change in the YTM affects the bonds with a higher YTM more than it does the bond with a lower YTM.

The Term Structure of Interest Rates



Interest rates for bonds vary by term to maturity, among other factors The yield curve provides describes the yield differential among treasury issues of differing maturities Thus, the yield curve can be useful in determining the required rates of return for loans of varying maturity

Types of Yield Curves

Rising Declining

Flat

Humped

Explanations of the Term Structure



There are three popular explanations of the term structure of interest rates (i.e., why the yield curve is shaped the way it is):
  

The expectations hypothesis The liquidity preference hypothesis The market segmentation hypothesis (preferred habitats)

Note that there is probably some truth in each of these hypotheses, but the expectations hypothesis is probably the most accepted

Bond Price Volatility



Bond prices change as any of the variables change:

 

Prices vary inversely with yields The longer the term to maturity, the larger the change in price for a given change in yield The lower the coupon, the larger the percentage change in price for a given change in yield Price changes are greater (in absolute value) when rates fall than when rates rise

Measuring Term to Maturity



It is difficult to compare bonds with different maturities and different coupons, since bond price changes are related in opposite ways to these variables Macaulay developed a way to measure the average term to maturity that also takes the coupon rate into account This measure is known as duration, and is a better indicator of volatility than term to maturity alone

Duration


Duration is calculated as:

D!

t !1

Pmt t t

1  i

Bond Pr ice

So, Macaulays duration is a weighted average of the time to receive the present value of the cash flows The weights are the present values of the bonds cash flows as a proportion of the bond price

Calculating Duration


Recall our earlier example bond with a YTM of 5% per six-months:

-964.54 0 40 1 40 2 40 3 1,000 40 4
3636.76 ! 3.77 964.54

D!

40 40 40 1040 4 1  2  3  2 3 4  . 105 . . . 105 105 105 964.54

Note that this is 3.77 six-month periods, which is about 1.89 years

Notes About Duration



   

Duration is less than term to maturity, except for zero coupon bonds where duration and maturity are equal Higher coupons lead to lower durations Longer terms to maturity usually lead to longer durations Higher yields lead to lower durations As a practical matter, duration is generally no longer than about 20 years even for perpetuities

Modified Duration


A measure of the volatility of bond prices is the modified duration (higher DMod = higher volatility) Modified duration is equal to Macaulays duration divided by 1 + per period YTM
D Mod D ! 1  i

Note that this is the first partial derivative of the bond valuation equation wrt the yield

Why is Duration Better than Term?



Earlier, it was noted that duration is a better measure than term to maturity. To see why, look at the following example: Suppose that you are comparing two five-year bonds, and are expecting a drop in yields of 1% almost immediately. Bond 1 has a 6% coupon and bond 2 has a 14% coupon. Which would provide you with the highest potential gain if your outlook for rates actually occurs? Assume that both bonds are currently yielding 8%.

Why is Duration Better than Term? (cont.)



Both bonds have equal maturity, so a superficial investigation would suggest that they will both have the same gain. However, as well see bond 2 would actually gain more.
60 t  1000 5 1.08t 1.085 D1 ! t !1 ! 4.44 920.15 D Mod ,1 ! 4.30 ! 3.98 1.08 5 120 1000 1.08t t  1.085 5 D 2 ! t !1 ! 4.11 1159.71 D Mod , 2 ! 4.11 ! 3.81 1.08
5

Why is Duration Better than Term? (cont.)



Note that the modified duration of bond 1 is longer than that of bond two, so you would expect bond 1 to gain more if rates actually drop.
 

Pbond 1, 8%= 920.15; Pbond 1, 7%= 959.00; gain = 38.85 Pbond 2, 8%= 1159.71; Pbond 2, 7%= 1205.01; gain = 45.30

Bond 1 has actually changed by less than bond 2. What happened? Well, if we figure the percentage change, we find that bond 1 actually gained by more than bond 2. %(bond 1 = 4.22%; %(bond 2 = 3.91% so your gain is actually 31 basis points higher with bond 1.

Why is Duration Better than Term? (cont.)



Bond price volatility is proportionally related to the modified duration, as shown previously. Another way to look at this is by looking at how many of each bond you can purchase. For example, if we assume that you have $100,000 to invest, you could buy about 108.68 units of bond 1 and only 86.23 units of bond 2. Therefore, your dollar gain on bond 1 is $4,222.14 vs. $3,906.15 on bond 2. The net advantage to buying bond 1 is $315.99. Obviously, bond 1 is the way to go.

Convexity


Convexity is a measure of the curvature of the price/yield relationship

DMod = Slope of Tangent Line

Convexity

Note that this is the second partial derivative of the bond valuation equation wrt the yield

Yield

Calculating Convexity


Convexity can be calculated with the following formula:

C! 1 2  i 1

1  i 
CFt
2 t t !1

t t

VB

For the example bond, the convexity (per period) is: 40  1 40  2 40  3 1040  4 1 2 3 4   
2 2 2 2

. 105

. 105

C!

. 105 . 105
2

. 105

964.54

17,820.73 16,163.93 . ! 11025 ! ! 16.758 964.54 964.54

Calculating Convexity (cont.)



To make the convexity of a semi-annual bond comparable to that of an annual bond, we can divide the convexity by 4 In general, to convert convexity to an annual figure, divide by m2, where m is the number of payments per year

Calculating Bond Price Changes



We can approximate the change in a bonds price for a given change in yield by using duration and convexity:
(VB !  D Mod v (i v VB  0.5 v C v VB v (i

If yields rise by 1% per period, then the price of the example bond will fall by 33.84, but the approximation is:

(VB ! 3.59 v 0.01 v 964.54  0.5 v 16.75 v 964.54 v 0.01 ! 34.63  0.81 ! 33.82

Solved Examples (on a payment date)

Bond 1 Term (years) Yield Coupon Face Value Value Duration Mod. Duration Convexity 2 3% 100 1000 1133.94 1.91 1.86 5.33 Bond 2 3 5% 80 1000 1081.70 2.79 2.66 9.88 Bond 3 4 7% 60 1000 966.13 3.67 3.43 15.54 Bond 4 5 9% 40 1000 805.52 4.58 4.20 22.46 Bond 5 6 11% 20 1000 619.25 5.62 5.06 31.24 Bond 6 7 13% 0 1000 425.06 7.00 6.19 43.86