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Fixed Income Securities Bond Prices and Yields: Figuring out the Assured Returns

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Title: Fixed Income Securities Bond Prices and Yields: Figuring out the Assured Returns


1
Fixed Income Securities Bond Prices and Yields
Figuring out the Assured Returns
  • Rishit Shah

2
What 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.

3
Making 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.

4
Bond 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

5
Changing 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
6
Types of Bonds
  • Government Bonds
  • Corporate Bonds
  • Straight Bonds (Plain Vanilla Bond)
  • Zero Coupon Bonds
  • Floating Rate Bonds
  • Convertible Bonds
  • Callable Bonds
  • Puttable Bonds

7
Bond Prices
  • Bond value with Semi-annual interest

8
Example
  • 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

9
Price-Yield Relationship
Price
Yield
10
Bond 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
11
Price-Time Relationship
12
Relationship 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

13
Bond 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

14
Bond 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.

15
Risks in Bonds
  • Interest Rate Risk
  • Inflation Risk
  • Real Interest Rate Risk
  • Default Risk
  • Call Risk
  • Liquidity Risk
  • Reinvestment Risk
  • Foreign Exchange Risk

16
Rating 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

17
Key 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

18
Types of Yield Curve
19
Types of Yield Curve
20
Types of Yield Curve
21
Types of Yield Curve
22
Term Structure Theory
  • Expectations Theory
  • Liquidity Premium Theory
  • Preferred Habitat Theory
  • Segmented Markets Theory

23
Term 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

24
The 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

25
Expectation 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
26
Liquidity 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.

27
Liquidity 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)
28
Preferred 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.

29
Segmented 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.

30
Thank You
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