Title: Fixed Income Securities Bond Prices and Yields: Figuring out the Assured Returns
1Fixed Income Securities Bond Prices and Yields
Figuring out the Assured Returns
2What is a Bond?
- You've just loaned your neighbour 1,000 so that
he can renovate his home. He's promised to pay
you 6 interest each year for the next 5 years,
and then hell give you back your money. - A bond works much the same way you give a
company 1,000 and they pay you a fixed rate of
interest for a specified period of time, after
which they return your principal. Governments
(federal, provincial and municipal) and
corporations use bonds to raise the capital they
need to expand.
3Making moneyInterest 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 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 60 for a total of 300.
4Bond Characteristics
- Par value is the value stated on the face value
of the bond. It represents the amount the issuer
promises to pay at the time of maturity - Coupon rate is the interest rate payable to the
bondholder - Maturity date is the date when the principal
amount is payable to the bondholder - Bond indenture is the contract between the issuer
and the bondholder, specifies the par value,
coupon rate and maturity date
5Changing complexion of Bond Market in India
Pre-liberalisation Scenario Post-liberalisation Scenario
Instruments Plain vanilla bond Bonds with complex features
Interest rates Stable administered Volatile Market-determined
Number of players Few players Many players
Reference rate No reference rate Gradually emerging
Methods of analysis Used simplistic measures Use scientific methods like YTM and Duration
Nature of market High illiquid Liquid
Approach to portfolio management Investors followed passive approach Investors follow active approach
6Types of Bonds
- Government Bonds
- Corporate Bonds
- Straight Bonds (Plain Vanilla Bond)
- Zero Coupon Bonds
- Floating Rate Bonds
- Convertible Bonds
- Callable Bonds
- Puttable Bonds
7Bond Prices
- Bond value with Semi-annual interest
8Example
- A Rs.100 par value bond bearing a coupon rate of
12 will mature after five years. What is the
value of the bond, if the discount rate is 15? - An eight-year, 12 coupon bond with a par value
of Rs.1000 on which interest is payable
semi-annually. The required return on this bond
is 14
9Price-Yield Relationship
Price
Yield
10Bond Prices And Yields
if Bond YTM is then Bond Price is (Assume par 1,000)
higher than coupon rate less than 1,000 discount bond
equal to coupon rate 1,000 par bond
less than coupon rate more than 1,000 premium bond
11Price-Time Relationship
12Relationship among Yield Measures
- For premium bonds
- Coupon rate gt Current yield gt YTM
- For discount bonds
- Coupon rate lt Current yield lt YTM
- For par value bonds
- Coupon rate Current yield YTM
13Bond Yields
- Current yield Coupon
- Market Price
- Example Find current yield of 10 year, 12
coupon bond with a par value of Rs.1000 and
selling for Rs.950. - Yield to Maturity (YTM)-
- It is discount rate that makes the present value
of the cash flows receivable from owning the bond
equal to the price of the bond
14Bond Yields
- Price of One-Year 5 percent Coupon Bond
- The value of i that solves this equation is the
yield to maturity - Yield to Call (YTC)-
- Redemption before maturity
- Usually at Premium
- Yield to call is often compared with Yield to
Maturity.
15Risks in Bonds
- Interest Rate Risk
- Inflation Risk
- Real Interest Rate Risk
- Default Risk
- Call Risk
- Liquidity Risk
- Reinvestment Risk
- Foreign Exchange Risk
16Rating of Bonds
- Functions of Debt Ratings
- Provide superior information
- Offer low-cost information
- Serve as a basis for a proper risk-return
tradeoff - Impose healthy discipline on corporate borrower
- Lend greater credence to financial and other
representations - Facilitate the formulation of public policy
guidelines on institutional investment
17Key Financial Ratios
- Coverage ratios such as time-interest-earned
ratio and fixed charged coverage ratio - Leverage ratios such as debt-equity ratio
- Liquidity ratios such as current ratio and quick
ratio - Profitability ratios such as return on capital
employed and returned on equity - Turnover ratios such as inventory turnover and
total assets turnover ratio - Cash flow to debt ratio
18Types of Yield Curve
19Types of Yield Curve
20Types of Yield Curve
21Types of Yield Curve
22Term Structure Theory
- Expectations Theory
- Liquidity Premium Theory
- Preferred Habitat Theory
- Segmented Markets Theory
23Term Structure Theory
- Expectations Theory-
- This theory holds that the shape of the yield
curve can be explained by the interest rate
expectations of those who participate in the
market. - Limitations-
- Neglects the risks inherent in investing in bonds
(because forward rates are not perfect predictors
of future rates) - Interest rate risk
- Reinvestment rate risk
24The Term Structure of Interest Rates
Upward- Sloping Yield Curve
Downward- Sloping Yield Curve
- Expected higher interest rate levels
- Expensive monetary policy
- Expanding economy
- Expected lower interest rate levels
- Tight monetary policy
- Recession soon
25Expectation Theory
Yield Curve Explanation
Ascending Short-term rates are expected to rise in future
Descending Short-term rates are expected to fall in future
Humped Short-term rates are expected to rise for a while and then fall
Flat Short-term rates are expected to remain unchanged in future
26Liquidity Premium Theory
- Investors are Risk averse
- Long-term bonds are more risky
- Investors will hold on only for a premium
-
- Forward rates contain a liquidity premium and
interest rate.
27Liquidity Premium Theory
EQ
Actual long term rate
n
term to maturity (in years)
Current one year rate
Expected one-year rate (i2,,n-1)
Risk premium (i2,,n)
28Preferred Habitat Theory
- Long term investors would like to invest in
instruments of longer maturities. - Short term investors would like to invest in
instruments of shorter maturities. - Investors may buy bonds that do not have their
preferred maturity if there is demand-supply
mismatch. - Clearly, all types of yield curves, viz. upward
sloping, downward sloping, flat or humped, are
possible.
29Segmented Markets Theory
- An extreme form of preferred habitat theory.
- Investors as well as borrowers are unwilling to
shift from their preferred maturity range. - Hence, according to this theory the shape of the
yield curve is determined entirely by the supply
and demand forces within each maturity range.
30Thank You