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Fixed Income Securities Bond Prices and Yields: Figuring out the Assured Returns. Rishit Shah. What is a Bond?.
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Fixed Income SecuritiesBond Prices and Yields: Figuring out the Assured Returns Rishit Shah
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 he’ll 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.
Total principal andinterest (at maturitydate of 5 years) Principalamount Year 1 (6% intereston $1,000) Year 2 (6% intereston $1,000) Year 3 (6% intereston $1,000) Year 4 (6%interest on $1,000) Year 5 (6%interest on $1,000) $1000.00 $60.00 $60.00 $60.00 $60.00 $60.00 $1,300.00 Making money:Interest 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), you’ll collect five interest payments of $60 for a total of $300.
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
Types of Bonds • Government Bonds • Corporate Bonds • Straight Bonds (Plain Vanilla Bond) • Zero Coupon Bonds • Floating Rate Bonds • Convertible Bonds • Callable Bonds • Puttable Bonds
Bond Prices • Bond value with Semi-annual interest
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%
Price-Yield Relationship Price Yield
Relationship among Yield Measures • For premium bonds: • Coupon rate > Current yield > YTM • For discount bonds: • Coupon rate < Current yield < YTM • For par value bonds: • Coupon rate = Current yield = YTM
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
Bond Yields Price of One-Year 5 percent Coupon Bond = • The value of ithat 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.
Risks in Bonds • Interest Rate Risk • Inflation Risk • Real Interest Rate Risk • Default Risk • Call Risk • Liquidity Risk • Reinvestment Risk • Foreign Exchange Risk
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
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
Term Structure Theory • Expectations Theory • Liquidity Premium Theory • Preferred Habitat Theory • Segmented Markets Theory
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
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
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.
Liquidity Premium Theory EQ: = Actual long term rate n = term to maturity (in years) = Current one year rate = Expected one-year rate (i=2,…,n-1) = Risk premium (i=2,…,n)
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.
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.
