Module 5

BOND PRICES AND YIELDS

 2017 by Prasanna Chandra

 Outline
• Changes in Bond Market
• Bond Characteristics
• Bond Prices
• Bond Yields
• Risks in Bonds
• Rating of Bonds
[Link]
•
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 2017 by Prasanna Chandra

 Changes In Debt Market
Then Now
• Plain vanilla bonds • Bonds with complex
features
• Stable & administered • Volatile & market- determined
interest rates interest rates
• Simplistic measures of • Precise measures of return & life
return & life
• Rules of thumb • Analytical methods
• Few players • More players
• Passive approach • Relatively more active approach
• Illiquid market • Liquid market ?
• Absence of a reference • Emergence of a reference rate
rate

 2017 by Prasanna Chandra

 Bond Characteristics
• A bond is an debt instrument (IOU). It is described in terms
of:
• Par value
• Coupon rate
• Maturity date

• Government bonds are also called government securities (G-

secs) or gilt-edged securities. These are generally medium to
long-term bonds issued by RBI on behalf of the government of
India and state governments.

• Corporate bonds or corporate debentures are debt

instruments issued by companies
 2017 by Prasanna Chandra
 Types Of Bonds
• Straight bonds or plain vanilla bond

• Zero coupon bonds.

• Floating rate bonds

• Bonds with embedded options (Callable, Puttable, convertible)

• Commodity-linked bonds (Oil bond, Sovereign Gold

Bond)
 2017 by Prasanna Chandra
 Bond Pricing (Valuation)

n C M
P =  +
t=1 (1+r)t (1+r)n

2n C/2 M
P =  +
t=1 (1+r/2)t (1+r/2)2n

 2017 by Prasanna Chandra

 Bond Pricing
Q1. A Rs.1000 face value bond carries a coupon rate of 12 percent
p.a. The bond is redeemable at par after 7 years. If the discount
rate is (a) 14% and (b) 12% p.a, what will be the price of the bond.

 2017 by Prasanna Chandra

 Bond Pricing
Q1. A Rs.1000 face value bond carries a coupon rate of 12 percent
p.a. The bond is redeemable at par after 7 years. If the discount
rate is (a) 14% and (b) 12% p.a, what will be the price of the bond.

(a)P0=514.56+400=914.56

(b)P0=547.68+452=999.68

 2017 by Prasanna Chandra

 Bond Pricing
Q2. Anand owns Rs1000 face vale bond with 5 years to maturity.
The bond has an annual coupoun of Rs75. The bond is currently
priced at Rs970. Given an appropriate discount rate of 10%, should
anand hold or sell the bond?

 2017 by Prasanna Chandra

 Bond Pricing
Q2. Anand owns Rs1000 face vale bond with 5 years to maturity.
The bond has an annual coupon of Rs75. The bond is currently
priced at Rs970. Given an appropriate discount rate of 10%, should
anand hold or sell the bond?

(a)P0=284.31+620.9=905.21, Market price 970>estimated price 905,

Anand can sell and book profit.

 2017 by Prasanna Chandra

 YTM
• YTM of a bond is the discount rate that makes the
present value of the cash flows receivable from
owning the bond equal to the price of the bond.
Someone who invests in a coupon - paying bond will earn
the YTM promised on the purchase date if and only if all
of the following three conditions are fulfilled.
• The bond is held until it matures rather than being sold at
a price which differs from its face value before its maturity
• The bond does not default
• All cash flows are re-invested at an interest rate equal to
the promised YTM

 2017 by Prasanna Chandra

 YTC
Yield to call is the yield up to the date of call

 2017 by Prasanna Chandra

 Bond Yields
• Current Yield
Annual interest
Price
• Yield To Maturity
C C C M
P = + + …. +
(1+r) (1+r) 2
(1+r) n
(1+r)n
8 90 1,000
800 =  +
t=1 (1+r)t (1+r)8
AT r = 13% … RHS = 808
AT r = 14% … RHS = 768.1
808 - 800
YTM = 13% + (14% - 13%) = 13.2%
808 - 768.1
C + (M - P) / n
YTM ≃
0.4M + 0.6 P
• Yield to Call
n* C M*
P =  +
t=1 (1+r)t
(1+r)n
 2017 by Prasanna Chandra
 Bond Pricing
Q3. Prem is considering the purchase of a bond currently selling at
Rs850. The bond has 4 years to maturity, with a face value of Rs1000
and 8 per cent coupon rate. The next annual interest payment is due
after 1 year. The required rate of return is 10%.
(a)Calculate
the intrinsic value of the bond and suggest whether
prem should buy the bond or should not buy?
(b)Calculate the yield to maturity of the bond.

 2017 by Prasanna Chandra

 Bond Pricing
Q3. Prem is considering the purchase of a bond currently selling at
Rs900. The bond has 4 years to maturity, with a face value of Rs1000
and 8 per cent coupon rate. The next annual interest payment is due
after 1 year. The required rate of return is 10%.
(a)Calculate
the intrinsic value of the bond and suggest whether
prem should buy the bond or should not buy?
(a) P0=80*3.1699 + 1000*0.6830=936.59,
Intrinsic value< Market value. Prem should buy
(b)Calculate the yield to maturity of the bond.
(a) P0 at 12%= 242.98+ 635.50=878.48
(b) By Interpolation, P0=10%+(2/58.11)*36.59=11.26%

 2017 by Prasanna Chandra

 Bond Pricing (Valuation)

n C M
P =  +
t=1 (1+r)t (1+r)n

2n C/2 M
P =  +
t=1 (1+r/2)t (1+r/2)2n

 2017 by Prasanna Chandra

 Bond Pricing
Q4. A Rs.600 face value bond carries a coupon rate of 12 percent
p.a. payable semi-annually. The bond is redeemable at par after 5
years. If investors require a return of 9% per half-year period, what
will be the price of the bond.
10 36 600
P0 =  +
t=1 (1.09)t (1.09)10
= 36 x 6.418 + 600 x 0.422 = Rs. 484.25

 2017 by Prasanna Chandra

 Price-Yield Relationship
Price

Yield

Price changes with time

Value of
Bond Premium Bond: rd = 11%

A
PAR VALUE BOND: rd = 13%

B
Discount Bond: rd = 15%

8 7 6 5 4 3 2 1 0
 2017 by Prasanna Chandra YEARS TO MATURITY
 Summing Up

• The debt market in India has registered an impressive growth

particularly since mid-1990s and has been accompanied
by increasing complexity in instruments, interest rates,
methods of analysis, and so on .
• The value of a non callable, nonconvertible bond is:
n C M
P=  +
t =1 (1+ r)t (1 + r)n

 2017 by Prasanna Chandra

• The commonly employed yield measures are : current yield,
yield to maturity (YTM), yield to call, and realised yield
to maturity.

• The YTM of a bond is the discount rate that makes the

present value of the cash flows receivable from owning the
bond equal to the price of the bond.

• Bonds are subject to diverse risks, such as interest rate risk,

inflation risk, real interest rate risk, default risk, call risk,
and liquidity risk.

• Default risk or credit risk is reflected in credit rating of debt

instruments.  2017 by Prasanna Chandra
• The interest rate is determined by four factors : short-
term risk-free interest rate, maturity premium, default
premium, and special features.

• Convertible bonds may be viewed as a debenture –

warrant package.

 2017 by Prasanna Chandra