 What is debt?

 It is a financial claim.
 Who issues it?
 The borrower of funds
 For whom it is a liability
 Who holds it?
 The lender of funds
 For whom it is an asset

Bond & Bond Markets

7/3/2017 1 7/3/2017 2

 Difference between debt and equity?

 Debt does not confer ownership rights  Bonds
and debentures are termed as Fixed
 It is merely an IOU Income Securities
 A promise to pay interest at periodic intervals  Once the rate of interest is set at the onset of
And to repay the principal at a pre-specified maturity date.

the period for which it is due
 It usually has a finite life span
 Perpetual debt is rare but happens
 It is not a function of the profitability of the firm
 The interest payments are contractual obligations  Failure to pay the promised interest will
 Borrowers are required to make payments irrespective of their tantamount to default
financial performance

 Interest payments to be made before any dividends

for equity holders.
 In the event of liquidation
 The claims of debt holders must be settled first
 Only then can equity holders be paid.

7/3/2017 3 7/3/2017 4

1
 Bonds may be secured or unsecured
 Unsecured debt securities are termed as
Debentures in the US
 Unsecured means no specific assets have been
earmarked as collateral
 Secured debt requires the firm to earmark
specific assets as collateral
 Secured debt holders enjoy priority from the
standpoint of payments
 Debtsecurities may be negotiable or non-
negotiable
 Negotiable securities can be traded in the
secondary market
 Can be endorsed by one party in favor of another
 Examples of non-negotiable debt securities
 National savings certificates
 Conventional Time or Fixed deposits

7/3/2017 5 7/3/2017 6

 This is true for all securities, not just for bonds.

 The most basic form of a bond is called the
Plain Vanilla version.  More complicated versions are said to have
`Bells and Whistles’ attached.

7/3/2017 7 7/3/2017 8

2
 These bonds are slightly different  Convertible bonds can be converted to shares
 The interest rate does not remain fixed of stock
 It varies each period based on the reference rate  Callable bonds can be prematurely retired by
 Short-term reference rate – maturity < 1 year the issuer
 Floating rate bonds  Putable bonds can be prematurely
 Longer-term reference rate surrendered by the holders
 Variable or adjustable rate bonds

7/3/2017 9 7/3/2017 10

 It is the principal value  Itis the time remaining in the life of the
 Amount payable by the borrower to the last bond.
holder at maturity.  The length of time for which interest has to be
paid as promised.
 Amount on which the periodic interest payments
are calculated.  The length of time after which the face value
will be repaid.
 A.K.A as  A.K.A as
 Par Value  Maturity
 Redemption Value  Term
 Maturity Value  Tenor
 Principal Value  Tenure

7/3/2017 11 7/3/2017 12

3
  The
periodic interest payment that has to be
made by the borrower.
 The coupon rate multiplied by the face value
gives the rupee/dollar value of the coupon.

7/3/2017 13 7/3/2017 14

 Most bonds pays coupons on a semi-annual basis.

 Bond with a face value of $1000.
 True in UK/US/Australia/Japan
 The coupon rate is 8% per annum paid semi-
 In European and Eurobond markets annual
payments are the norm annually.
 So the bond holder will receive
 In earlier days bonds were accompanied by a 1000 x 0.08
booklet of post-dated coupons ___ = $40 every six months.
 Each coupon could be detached and redeemed 2
on the corresponding coupon payment date
 Even today bearer bonds come with coupons
 The certificate number is mentioned on the
coupon
7/3/2017 15 7/3/2017 16

4
 The rate of return if an investor buys the
bond at the prevailing price and holds it
till maturity.
 In order to get the YTM, two conditions
must be satisfied.
 The bond must be held till maturity.
 All coupon payments received before maturity
must be reinvested at the YTM.
 At any point in time the YTM may be
 Greater than
 Less than or
 Equal to the Coupon Rate
 YTM is the IRR of a bond
 Bonds involve pure cash flows
 So only ONE REAL POSITIVE YTM

 Solution to a Non-Linear equation

 Solved iteratively

7/3/2017 17 7/3/2017 18

A holder gets a stream of contractually  It is a chicken and egg story

promised payments.  If we know the yield that is required we can
quote a price
 The value of the bond is the value of this stream
 Once we acquire the asset at a certain price, we
of cash flows. can work out the corresponding yield.
 Cash flows arising at different points in time
cannot be added
 Cash flows have to be discounted

7/3/2017 19 7/3/2017 20

5
A bond will pay identical coupons every
period
 And will repay the face value at maturity.
 The periodic cash flows constitute
an annuity.
 The terminal face value is a lump
sum payment.
 Bond pays a semi-annual coupon of $C/2,
and has a face value of $M.
 Assume there are N coupons left
 And that we are standing on a coupon
date.
 We are assuming that the next coupon is exactly
six months away.
 The required annual yield is y
 Implies that the semi-annual yield is y/2.

7/3/2017 21 7/3/2017 22

 The present value of the coupon stream is:  The present value of the face value is:

7/3/2017 23 7/3/2017 24

6
 So the price of the bond is:  IBM has issued a bond with a face value of
$1,000.
 The coupon is 8% per year to be paid on July
15 and January 15 every year.
 Today is 15 July 2013 and that the bond
matures on 15 January 2033.
 The required yield is 10% per annum.

7/3/2017 25 7/3/2017 26

 JJ – 01/15
 FA – 01/15
 MS – 01/15
 AO – 01/15
 MN – 01/15
 JD – 01/15

7/3/2017 27 7/3/2017 28

7
 In
the example the price is less than the
face value
 Such a bond is called a Discount Bond
 It is trading at a discount from the face value.
 The reason is that
 The yield is greater than the coupon
7/3/2017 29
 As
we move from one coupon date to the
next, if the YTM were to remain constant
 Par bonds would continue to trade at PAR
 Premium bonds will steadily decline in price
 Discount bonds will steadily increase in price
 Thisis called the Pull to Par Effect
 At maturity – ALL BONDS WILL TRADE AT PAR
7/3/2017 31
 If the yield were to equal the coupon
 The bond would sell at PAR
 Such bonds are called PAR Bonds
 If the yield is less than the coupon
 The price will exceed the face value.
 Such bonds are called Premium Bonds
7/3/2017 30
 Aswe approach maturity the number of
coupons reduces
 The contribution of coupons to price reduces
 The contribution of the PV of the face value
increases
 For premium bonds the first effect dominates
 Thus the price steadily declines
 Fordiscount bonds the second effect
dominates
 Thus the price steadily increases
7/3/2017 32
8
A plain vanilla or Bullet Bond pays the entire
face value at maturity in a lump sum
 Amortizing bonds pay the principal in
installments
 The first payment occurs before maturity
 The last payment is made at maturity
7/3/2017 33
 The first two cash flows represent interest on
a principal of $1,000
 The third cash flow is interest on $1,000 plus
a principal payment of $250
 The outstanding principal is $750
 The fourth cash flow is interest on $750 plus
a principal payment of $250
 The outstanding principal is $500
 The final cash flow is interest on $500 plus
the remaining principal of $500
7/3/2017 35
 Consider a 5 year amortizing bond with a
face value of $1,000 and an annual coupon of
8%.
 The annual cash flows are depicted below
Time Cash Flow
1 80
2 80
3 330
4 310
5 540
7/3/2017 34
 Some companies issue such bonds because
the assets being funded have a similar cash
flow profile
 Second the coupon on such a bond may be
lower than that of a bullet bond
 In the case of a bullet bond the entire principal
is due at a single point in time
 There is greater default risk
7/3/2017 36
9
  PlainVanilla bonds pay coupons every
period and repay the face value at
maturity.
 A Zero Coupon Bond does not pay any
coupon interest.
 Issued at a discount from the face value
 Repays the principal at maturity.
 Face Value – Price, constitutes the interest
for the buyer.

7/3/2017 37 7/3/2017 38

 Microsoftis issuing zeroes with 5 years to  This

is to facilitate comparisons with
maturity and a face value of $10,000. conventional bonds
 The required yield is 10% per annum
 What should be the price?
 Price is the PV of the face value
 In practice we discount on a semi-annual basis
 This will give a lower price than if we were to
use annual discounting

7/3/2017 39 7/3/2017 40

10
A zero coupon bond can never sell at a
premium
 It will always trade at a discount prior to
maturity
 At maturity it will trade at par
 If held to maturity a ZCB will always give rise
to a capital gain
 If sold prior to maturity there may be a
capital gain or a capital loss
 Consider a bond with 10 years to maturity
 The YTM at the time of purchase was 10%
 The cost was $376.90
 A year later it is sold at a YTM of 12%
 The corresponding price is $350.35

7/3/2017 41 7/3/2017 42

 For bonds with a given maturity ZCBs have

the highest price sensitivity
 Bullish speculators anticipating a rate decline
will fancy such bonds
 Investors seeking a locked in return over a
long-term – such as Pension Funds
 Like such bonds
 There is an assured return if held till maturity

7/3/2017 43 7/3/2017 44

11
 Fully backed by the federal government of
the issuing nation.
 Consequently they are virtually devoid of
credit risk or the risk of default.
 The yield on such securities is a benchmark
for setting rates on other kinds of debt.
7/3/2017 45
 TheTreasury issues three categories of
marketable securities.
 T-bills are discount securities
 They are zero coupon securities
 T-notes and T-bonds are sold at face value and
pay interest periodically.
 T-bills
are issued with a original time to
maturity of one year or less.
 They are Money market instruments.
 They have maturities of either 1, 3, 6, or 12
months at the time of issue.
7/3/2017 47
 Treasury securities are issued
 To finance expenses in excess of current
revenues
 To pay interest on debt accumulated in earlier
years due to deficits in those years
 To repay past debt issues that are currently
maturing
 The US Treasuries market
 Is the largest bond market in the world
 Is the most liquid bond market in the world
7/3/2017 46
 T-notes and T-bonds have a time to maturity
exceeding one year at the time of issue.
 They are capital market instruments.
 T-notes have maturities ranging from 1-10 years
 T-bonds have an original maturity in excess of 10
years, extending up to 30 years.
 An issue may be followed later by a further issue
 With the same remaining time to maturity and the
same coupon
 The issuance of further tranches is termed as a Re-
opening.
7/3/2017 48
12
 Sixmonths ago a 10-year note was issued
with a coupon of 8% per annum.
 Today if a note with 9 ½ years to maturity
and a coupon of 8% is issued it will add to the
pool that is already trading in the market
 Thus it is a re-opening of an existing issue
7/3/2017 49
 TheTreasury sells bills, notes, and bonds by
7/3/2017 51
 Who is a primary dealer?
 A PD is a dealer who is authorized to deal
directly with the Central Bank of the country
 In the US, a PD is a bank or securities broker-
dealer that directly deals with the FRBNY
 Importance of FRBNY
 In India a PD deals directly with the RBI
7/3/2017 50
way of a competitive auction process.
 Most of the treasury securities are bought by
primary dealers.
 Individual investors submit non-competitive bids
and participate on a much smaller scale.
7/3/2017 52
13
 Bids may be:  Primary dealers bid for their accounts and
 Competitive
 Indicate price & quantity or yield & quantity
on behalf of their clients
 Non-competitive  They usually submit large competitive
Indicate only quantity
bids


 Small investors and individuals
generally submit non-competitive bids
 A non-competitive bidder may not bid for more than
$5MM worth of securities in a bill or bond auction
 Bids indicate the maximum price that the bidder
is prepared to pay if it is a price based auction
 Or the minimum yield that the bidder is
prepared to accept if it is a yield based auction

7/3/2017 53 7/3/2017 54

 The Treasury will net out the total  Assume that the Treasury is offering 25
amount of non-competitive bids billion dollars worth of T-bonds.
 2 billion dollars worth of non-competitive bids
 The balance will be allocated to competitive have been received.
bidders.  So 23 billion dollars worth of bonds are available
 There are two ways in which securities to be offered to the competitive bidders.
can be allotted
 The multiple price/yield auction mechanism  Thereare six competitive bidders who have
 French Auctions submitted the following yields.
 The uniform price/yield auction mechanism  The bids have been arranged in ascending order
 Dutch Auctions
of yield.
 In a price based auction the bids would have
been arranged in descending order of price.
7/3/2017 55 7/3/2017 56

14
  The aggregate demand equals the amount on
Bidder Bid Yield Bid Aggregate offer at a yield of 5.375.
Amount Amount  A multiple yield auction will lead to the

Alpha 5.370 3.0 bn 3.0 bn following allocation.

 Alpha will get 3 bn at a yield of 5.370
Beta 5.372 5.0 bn 8.0 bn  Beta will get 5 bn at 5.372
Gamma 5.373 4.0 bn 12 bn  Gamma will get 4 bn at 5.373

Delta 5.375 8.0 bn 20 bn

Charlie 5.375 12.0 bn 32 bn
Tango 5.380 3.0 bn 35 bn
7/3/2017 57 7/3/2017 58

 At a yield of 5.375 we have only 11 bn left to
allocate.
 There is a demand of 20 bn at this yield
 8 bn from Delta and 12 bn from Charlie.
 Thus we will allocate 11/20 = 55% to each
bidder at this yield
 There will be a pro-rata allocation
 0.55 of 8 bn or 4.40 bn will go to Delta
 0.55 of 12 bn or 6.6 bn will go to Charlie
 The highest accepted yield is called the Stop
Yield or High Yield
 In this case it is 5.375
 Theratio of bids received to the amount
awarded is known as the bid to cover ratio
 The higher the ratio the stronger is the auction

7/3/2017 59 7/3/2017 60

15
 Thesecond type of auction is called a
uniform price/yield auction.
 Aggregate demand is equal to the supply at a
yield of 5.375%.
 Thus everyone who bid less will be allotted
the quantities sought at this yield.
 The two bidders at 5.375 will also be
awarded at this yield but on a pro-rata basis.
7/3/2017 61
 For Plain Vanilla bonds the specified
coupon rate is valid for the life of the
bond.
 In the case of Floaters the rate is reset at
the beginning of every period
 The rate will vary directly with the
benchmark
7/3/2017 63
 Those who bid more than 5.375 will get
nothing and are said to be shutout of the
auction.
 Since 1999 the U.S. Treasury has been
conducting only uniform yield auctions.
 In India, we only have uniform yield
auctions.
7/3/2017 62
 The rate on a Floater is specified as LIBOR
+ 50 b.p.
 The spread is positive.
 If it were specified as LIBOR – 30b.p.
 The spread will be negative
 If
LIBOR rises, the rate will increase,
whereas if LIBOR falls it will decrease
7/3/2017 64
16
 In
the case of such floaters the coupon
varies inversely with the benchmark.
 For instance the rate may be specified as
10% - LIBOR.
 As LIBOR rises, the coupon will decrease,
 As LIBOR falls, the coupon will increase.
 In this case a floor has to be specified
 Coupons cannot become negative
 Consider a bond paying LIBOR and another
paying 10% minus LIBOR
 Assume that LIBOR stays below 10% and the
values are as follows:
Time LIBOR
0 4%
1 5%

2 4.5%

3 6%

7/3/2017 65 7/3/2017 66

 Consider the coupons from a portfolio of one  The portfolio is equivalent to two bonds with
floater and one inverse floater a face value of 1000 each paying 5% coupon
 To rule out arbitrage
 Price of a floater plus price of the inverse = 2 x
price of a plain vanilla bond paying 5% coupon
Time Coupon Coupon Total
from from coupon
Floater Inverse
Floater
1 4% 6% 10%
2 5% 5% 10%
3 4.5 5.5 10%
4 6 4 10%

7/3/2017 67 7/3/2017 68

17
 Theissuer has the right to call back the
bond prematurely.
 They buy back from the holders before maturity
by paying the face value.
 Theoption is with the issuer, and so it has
to pay a price
 This price will manifest itself as a lower price for
the bond as compared to a Plain Vanilla Bond.
A lower price means a higher yield.
 Thus buyers of callable bonds demand a
higher yield
 This is because a buyer of a callable bond is
exposed to cash flow uncertainty.
 He can never be sure as to when a bond will be
recalled.

7/3/2017 69 7/3/2017 70

 When will a callable bond be recalled?
 When interest rates or required yields
are falling.
 The issuer can call back the bonds and
issue fresh bonds with a lower coupon
 In such a scenario holders would like to hold on
 They are getting a higher rate of interest.
 Thecall provision works in favor of the
borrower and against the lender.
 Hence callable bonds command a lower price.
 The way to look at it is as follows
 At the time of issue a callable bond has to carry
a higher coupon
 Subsequently a callable with a given coupon will
have a lower price
 than a Plain Vanilla with the same coupon.

7/3/2017 71 7/3/2017 72

18
A bond may be discretely callable or
continuously callable
 A discretely callable bond may be recalled
only at certain pre-specified dates
 For instance the coupon dates over a period of
the bond’s life
 Bermudan option
A continuously callable bond may be called
at any time after it becomes callable
 Freely callable bonds can be called at any
time.
 Thus they offer the lender no protection.
 Deferred Callable Bonds on the other hand
do offer some protection.
 They have a Call Protection Period

7/3/2017 73 7/3/2017 74

 In practice when a bond is recalled, the
issuer will pay the lender a Call Premium
 This is normally half-year’s or one year’s coupon
 The call premium acts as a sweetener
 That is it makes such bonds more attractive to
potential investors.
 One of the risks in a callable bond is
reinvestment risk
 The bond will be called back when market rates
are low
 And consequently the proceeds will have to be
invested at a lower rate of interest.

7/3/2017 75 7/3/2017 76

19
 The price appreciation potential for a
callable bond
 In a declining interest rate environment is
limited.
 The market will increasingly expect the bond to
be redeemed at the call price as rates fall.
 This is referred to as Price Compression.
A potential buyer will be apprehensive that
the bond may be recalled in a declining
interest rate environment
 And if called he will get the face value plus a
premium and not the market price
 This is the cause of price compression as
compared to a plain vanilla bond that is similar
in other respects.

7/3/2017 77 7/3/2017 78

 Given
the reinvestment risk and price
compression
 Why would any investor want to hold such a
bond?
 If there is sufficient compensation in the form of
a higher yield he may be willing to take the risk.
 Thebondholder has the right to return the
bond prematurely, and take back the face
value.
 The option is with the bondholders and
hence they have to pay an option
premium.
 This will manifest itself as a higher bond price
 As compared to that of an otherwise similar plain
vanilla bond.

7/3/2017 79 7/3/2017 80

20
 When will such a put option be exercised?
 When interest rates are rising.
 Holders can return the bonds and buy
fresh bonds with a higher coupon
 At such times the issuers would prefer that the
holders hold on to the bonds.
7/3/2017 81
 The price at which a bond can be put by the
holder acts as a floor price
 In a rising rate environment
 Since the holders can always surrender the
bonds at this price
 They will never sell at a lower price.
7/3/2017 83
 Since
the put option works in favour of the
holder and against the issuer
 Such bonds are characterized by higher prices or
lower yields.
 At the time of issue a puttable will carry a lower
coupon than an equivalent Plain Vanilla
 Subsequently a puttable will carry a higher price
than a Plain Vanilla with the same coupon.
7/3/2017 82
 Theygrant the holder the right to convert
the bond into a predetermined # of shares
 It is a Plain Vanilla corporate bond with a call
option to buy the common stock of the issuer.
 Thenumber of shares receivable on
conversion is called
 The Conversion Ratio.
 Theconversion privilege may extend for all
or only a portion of the bond’s life.
 The conversion ratio may also decline over time.
 The conversion ratio is adjusted proportionately
for stock splits and stock dividends.
7/3/2017 84
21
 ABCCorporation has issued the following  The conversion price = 1000
bond ------- = $25
 Maturity = 10 years 40
 Coupon rate = 8%  The conversion value of a convertible bond is
 Conversion ratio = 40 the value if it is converted immediately.
 Face value = $1,000  Conversion value = Share price x
Conversion Ratio
 Current market price = $900
 Current share price = $20

7/3/2017 85 7/3/2017 86

 Theminimum price of a convertible bond is  In our case the conversion value is

the greater of:  $20 x 40 = $800
 Its conversion value or  Assume the YTM of a comparable straight
 Its value as a bond without the conversion bond is 10%.
option.  Straight value = 40PVIFA(5,20)+1000PVIF(5,20)
 This is also called the straight value of the bond. = $875.38

 Toestimate the straight value we need the

required yield on a non-convertible bond
 with the same credit rating and similar
investment characteristics.

7/3/2017 87 7/3/2017 88

22
  These are convertible bonds where the holder A bond with a face value of $1,000 is
gets the shares of a different company convertible into 40 shares.
 For instance if IBM were to issue convertible bonds, the
holders would get shares of IBM  If the CMP of the shares is $32 then there is a
 If IBM were to issue exchangeable bonds, the holders probability of conversion.
would get shares of another firm say Hewlett Packard.
 In practice when an exchangeable bond is converted
 Now assume that company announces a 4:1
holders will get shares issued by a subsidiary of the stock split
issuing company
 The share price will decline to approximately $8
 To protect the interest of the bond holder the
 Such bond’s do not lead to dilution for the
conversion ratio will be increased to 4 x 40 = 160
parent company’s shareholders
 Convertible bonds lead to such dilution when
they are converted
7/3/2017 89 7/3/2017 90

 What is risk?
 Risk is the possibility of loss arising due to the
uncertainty regarding the outcome of a transaction.
 All bonds are exposed to one or more sources of
risk.

7/3/2017 91 7/3/2017 92

23
 AKA default risk  Atthe time of issue, the issuer provides
 Refers to the possibility of default by the information
borrower.  About his financial soundness and
creditworthiness.
 The risk that coupon payments and/or
 This is provided in the Offer Document or
principal payments may not be made as
the Prospectus.
promised.
 But
every investor cannot decipher such a
 Treasury securities are backed by the full
document
faith and credit of the Federal government
 Thus in practice we have credit rating
 All other debt securities are exposed to credit
risk of varying magnitudes.
agencies.

7/3/2017 93 7/3/2017 94

 They specialize in evaluating the credit

quality of a bond at the time of issue.
 They also monitor the issuing company,
throughout the life of the bond
 And modify their recommendations if
required.
 The main rating agencies in the U.S. are
 Moody’s Investors Service
 Standard and Poor’s Corporation
 and Fitch Ratings.

7/3/2017 95 7/3/2017 96

24
 Credit Moody’s S&P’s Fitch’s Credit Risk Moody’s S&P Fitch

Risk Ratings Ratings Ratings Somewhat Ba BB BB

Speculative
Highest Aaa AAA AAA Speculative B B B
Quality
Highly Caa CCC CCC
High Aa AA AA Speculative
Quality Most Ca CC CC
Speculative
Upper A A A
Imminent C C C
Medium Default
Medium Baa BBB BBB Default C D D

7/3/2017 97 7/3/2017 98

Credit Risk FITCH CRISIL CARE ICRA

Credit FITCH CRISIL CARE ICRA
Risk Non- BB BB BB LBB
investment
Prime AAA AAA AAA LAAA Grade
Highly B B B LB
High AA AA AA LAA Speculative

Grade Dangerously C C C LC
Speculative
Upper A A A LA Default D D D LD
Medium
Lower BBB BBB BBB LBBB
Medium
7/3/2017 99 7/3/2017 100

25
 Non-investment grade bonds are also known  Ratings can change over the course of time.
as  Ifa rating change is being contemplated, the
 Speculative grade bonds agency will signal its intentions.
 Or High Yield Bonds  S&P will place the security on Credit Watch.
 Or JUNK Bonds  Moody’s on Under Review.
 JUNK bonds may be  Fitch on Rating Watch.
 Original issue junk
 Or Fallen Angels

7/3/2017 101 7/3/2017 102

 It measures the ability of the issuers to meet  Agencies consider the following
its commitments on time  Ability of the issuer to generate cash flows in the
future
 It depends on
 The level and predictability of future cash flows
 Analysis of the issuer’s financial condition and relative to the commitments on debt
management  Survey done by Moody’s using data for the
 The features of the debt security . period 1920 to 2001
 The specified revenue sources backing the issue  Showed that the average one year default rate
for Aaa bonds was zero
 However for B rated bonds it was 6.8%
 In a 10-year period only 0.82% of Aaa bonds
missed a payment
 For B rated bonds however the figure was 43.90%
7/3/2017 103 7/3/2017 104

26
A company can have its issue insured to
enhance its credit quality.
 An insurance premium will have to be paid, but
the coupon rate will come down.
 The insurance company will guarantee the
timely payment of the principal and interest.
 Insured bonds will receive a rating based on
the insurer’s capital and claims-paying
ability.
 In the U.S., the buyer of an uninsured bond
can buy insurance for his portfolio

7/3/2017 105 7/3/2017 106

 The
guarantee provided by insurance  Insurance facilities provide debt market
companies is unconditional and irrevocable access to less well known issuers
 There will be no repercussions if the issue gets
 The broaden the market for issuers with
downgraded subsequently
better credit ratings
 Issuers of insured bonds
 Get funds at reduced rates  They facilitate cross-border fund raising
 Get a diversified pool of investors
 Investors in such bonds
 Get an assurance of timely payments
 Benefit of extensive credit analysis
 Due diligence by the insurer
 Post issuance monitoring by the insurer

7/3/2017 107 7/3/2017 108

27
  The possibility that the market may be
illiquid or thin
 When the asset holder wants to buy or sell the
security.
A liquid market is characterized by a sizeable
number of buyers and sellers

7/3/2017 109 7/3/2017 110

 In illiquid markets, buyers will have to offer

a large premium over the fair value
 Whereas sellers will have to accept large
discounts at the time of sale.
 Illiquid markets are characterized by large
bid-ask spreads
 Because trades will be few and far between.

7/3/2017 111 7/3/2017 112

28
 The interest rate or yield is the key variable of
interest in debt markets.
 Interest rate risk is the risk that rates may move
in an adverse fashion
 Interest rate risk impacts fixed income securities
in two ways.
 All bonds with the exception of zeroes pay coupons
 These have to be reinvested.
 Reinvestment risk is the risk that market rates of
interest may decline before a coupon is received.
 If so, the coupon will have to be reinvested at a lower
than anticipated rate of interest.
7/3/2017 113
7/3/2017 115
 Secondly a bond may not be held to maturity.
 If it is sold prior to maturity, it will have to be at the
prevailing market price
 This will be inversely related to the prevailing yield.
 Market Risk or Price Risk, is the risk that
interest rates may be higher than anticipated
 in which case the bond will have to be sold at a lower
than anticipated price.
 The two risks work in opposite directions.
 Reinvestment risk arises because rates may
fall subsequently
 Market risk arises because rates may rise
subsequently.
7/3/2017 114
 Inflation
is the erosion in the purchasing
power of money.
 Most bonds promise fixed cash flows in dollar
terms.
 Inflation risk is the risk that the purchasing
power may have eroded more than expected
 By the time the cash flow from the bond is
received.
7/3/2017 116
29
 Highinflation will reduce the effective or  From the Fisher Equation:
Real rate of interest. (1+R) = (1+r)(1+)
 The interest rate in monetary terms is called the R  Nominal rate
Nominal Rate of interest.
 The Real Rate, is the nominal rate adjusted for
r  real rate
changes in the purchasing power.   inflation rate

7/3/2017 117 7/3/2017 118

 These are bonds whose coupons are linked to

a price index.
 Price indices are a barometer of changes in the
purchasing power of a currency.
 If inflation is high, so will be the index level and
vice versa.

 Thus indexed bonds will offer higher cash

flows during times of high inflation
 And relatively lower cash flows during
periods of lower inflation
 This will ensure that the cash flow in real terms
is kept at a virtually constant level.
7/3/2017 119 7/3/2017 120

30
 For Plain Vanilla bonds, there is no  Thus
holders of callable bonds will demand a
uncertainty about the timing of inflows premium for bearing this risk.
 However, callable bonds can be recalled
 That is why callable bonds trade at a lower price
than comparable plain vanilla bonds.
at any time.
 For a callable bond holder there is cash
flow uncertainty
 He is unsure as to how many coupons he is going
to get
 And also as to when the face value will be
repaid.

7/3/2017 121 7/3/2017 122

 This risk arises when the cash flows from a

bond are denominated in a foreign currency.
 If the foreign currency depreciates in value
with respect to the home currency
 The returns will be lower than anticipated.

7/3/2017 123 7/3/2017 124

31
A bond promises to pay a coupon of $10  Wehave assumed earlier that we are on a
every six months. coupon payment date.
 It implies that the next coupon is exactly one
 Assume that the rate of exchange is Rs 65 period away.
per dollar.  Howdo we value a bond between two
 So an Indian bondholder will expect to receive Rs coupon dates?
650 every six months.
 However, what if the exchange rate at the
time of the coupon payment is Rs 55.
 If so, he will receive only Rs 550.

7/3/2017 125 7/3/2017 126

 Calculatethe actual no. of days between the  Calculate

date of valuation and the next coupon date.
 Include the next coupon date.
 But do not include the starting date.
 Or vice versa
 Let us call this interval N1.
the actual no. of days between the
preceding coupon date and the next coupon
date.
 Include the ending date but exclude the starting
date or vice versa
 Let us call this time interval as N2.

7/3/2017 127 7/3/2017 128

32
 The
next coupon is then k periods away  There is a Treasury bond with a face value of
where $1,000.
 The coupon rate is 8% per annum, paid on a
semi-annual basis.
 The coupon dates are 15 July and 15 January.
 The maturity date is 15 January 2033.
 Today is 15 September 2013.

7/3/2017 129 7/3/2017 130

Month No. of Days

Month No. of Days July 16
September 15 August 31
October 31 September 30
November 30 October 31
December 31 November 30
January 15 December 31
TOTAL 122 January 15
TOTAL 184
7/3/2017 131 7/3/2017 132

33
K = 122/184 = .6630  Wall
Street professionals will then price the
 This is called the Actual/Actual method and bond using the following equation.
is often pronounced as the Ack/Ack method.
 It is the method used for Treasury bonds in the
U.S.
 It is the method used for Corporate bonds in
India.

7/3/2017 133 7/3/2017 134

 In our example  The Actual/Actual method is applicable

for Treasury bonds in the U.S.
 For corporate bonds in the U.S. we use
what is called the 30/360 NASD method.
 The number of days between successive coupon
dates is always taken to be 180.
 Each month is considered to be of 30 days.

7/3/2017 135 7/3/2017 136

34
 The # of days from the valuation date till the
next coupon date is calculated as:
 The start date is defined as
 D1 = (month1, day1,year1)
 The ending date is defined as
 D2 = (month2,day2,year2)
 If day1 = 31 then set day1 = 30
 If day1 is the last day of February, then set
day1 = 30
 If day1 = 30 or has been set equal to 30, then
if day2 = 31, set day2 = 30

 Thenumber of days is calculated as

360(year2 – year1) + 30(month2 – month1) +
(day2 – day1)

7/3/2017 137 7/3/2017 138

 Assume that the bond considered earlier was

a corporate bond and not a Treasury bond.

7/3/2017 139 7/3/2017 140

35
  Priceof a bond is the PV of all the cash
flows that the buyer will receive
 The seller is compensated for all the cash flows
that he is parting with.
 This includes the amount due to the seller for
parting with the entire next coupon
 Although he has held it for a part of the current
coupon period.
 This compensation is termed as
 Accrued Interest

7/3/2017 141 7/3/2017 142

 Thefraction of the next coupon that is
payable is calculated as per the day-count
convention
 That is for U.S. Treasury bonds the Actual/Actual
method is used
 Whereas for U.S. corporate bonds the 30/360
NASD method is used.
 Why calculate the accrued interest if it is
already included in the price calculation?
 The quoted bond price does not include accrued
interest.
 That is, quoted prices are net of accrued
interest.

7/3/2017 143 7/3/2017 144

36
 The rationale is as follows.  On July 15 the accrued interest is zero.
 On July 15 the price of the Treasury bond  On a coupon payment date, the accrued interest
using a YTM of 10% is $829.83. has to be zero.
 On September 15 the price using a yield of  On September 15 the accrued interest is
10% is $843.5906.
 The yield on both the days is the same
 Hence the increase in price is almost entirely
due to the accrued interest.

7/3/2017 145 7/3/2017 146

 The price net of accrued interest is
$843.5906 - $13.4783 = $830.1123$
 which is very close to the price of $829.83 that
was observed on July 15.
 As the yield changes, so will the price.
 Ifthe accrued interest is not subtracted
from the quoted price we would be
unsure
 Whether the price change is due to a change in
the yield or if it is partly due to accrued interest.
 However if prices are reported net of
accrued interest, then in the short run
 observed price changes will be entirely due to
changes in the yield.
 Consequently bond prices are always reported
after subtracting the accrued interest.

7/3/2017 147 7/3/2017 148

37
 Quoted bond prices are called clean or add-
interest prices.
 When a bond is purchased quoted price plus
the accrued interest has to be paid.
 The total price that is paid is called the dirty
price or the full price or all-in price.
 The yield or the rate of return from a bond
can be computed in various ways.
 Various yield measures have their merits and
demerits.

7/3/2017 149 7/3/2017 150

 This is very commonly reported.  Also known as

 Although it is technically very unsatisfactory.  Flat Yield
 Itrelates the annual coupon payment to the  Interest Yield
current market price.  Running Yield

7/3/2017 151 7/3/2017 152

38
A 15 year 15% coupon bond is currently  Ifthis bond is bought for $800 and held for
selling for $800. one year it will earn an interest of $150.
 The face value is $1,000  So the interest yield is 18.75% for a trader with a
one-year horizon
 The current yield is given by
 However, if it is sold after one year the
trader will make a Capital Gain or Loss.
 The current yield does not take such gains and
losses into account.

7/3/2017 153 7/3/2017 154

 The current yield is used to estimate the cost
of or profit from holding the bond.
 It is a Rough & Ready interest rate
calculation
 If short-term rates are higher than the
current yield
 The bond is said to involve a running cost.
 This is known as negative carry or negative
funding.
 The YTM is the rate that equates the present
value of the cash flows from the bond to its
price
 Assuming that the bond is held to maturity
 Itis analogous to the concept of the IRR
used in project valuation.

7/3/2017 155 7/3/2017 156

39
 Consider a bond that pays an annual coupon  The YTM is the value of y that satisfies the
of C on a semi-annual basis. following equation.
 The face value is M, the price is P, and the
number of coupons remaining is N.

7/3/2017 157 7/3/2017 158

 TheYTM is a solution to a non-linear  TheYTM is easy to compute in the case of

equation. zero coupon bonds.
 We generally require a financial calculator or  Consider a ZCB with a face value of $1,000,
a computer to calculate it. maturing after 5 years.
 The current price is $500.
 However it is fairly simple in two cases
 If we have a coupon paying bond with exactly two  The YTM is the solution to
periods to maturity.
 In such a case it is simply a solution to a quadratic
equation.

7/3/2017 159 7/3/2017 160

40
 The YTM calculation takes into account all
the coupon payments
 As well as any capital gains/losses that
accrue if the bond is held to maturity.
A bondholder can expect to receive income
from the following sources.
 There are coupon payments which are typically
paid every six months.
 There will be a capital gain/loss when a bond is
redeemed
 It may mature or may be called or may be sold before
maturity.

7/3/2017 161 7/3/2017 162

 The YTM calculation assumes that the bond is
held to maturity.
 Finally
when a coupon is received it will
have to be reinvested till redemption
 Once again the YTM calculation assumes that the bond is
held till maturity.
 The reinvestment income is interest on interest.
A satisfactory yield measure should take into
account all the three sources
 The YTM calculation takes into account all
the three sources of income.
 However it makes two key assumptions.
 Firstly it assumes that the bond is held till
maturity.
 Secondly it assumes that all intermediate
coupons are reinvested at the YTM itself.

7/3/2017 163 7/3/2017 164

41
 The
latter assumption is built in to the
mathematics of the calculation.
 The YTM is called a Promised Yield.
 It is Promised because in order to realize it the
holder has to satisfy both the above conditions.
 If either of the two conditions is violated she may not
get what was promised.
 Consider
a bond that pays a semi-annual
coupon of $C/2.
 Let r be the annual rate of interest at which
these coupons can be re-invested.
 r would be dependent on the market conditions
prevailing when the coupon is received
 It need not be equal to y, the YTM, or c, the
coupon rate.

7/3/2017 165 7/3/2017 166

 For ease of exposition we will assume that r is a  The coupon stream is an annuity.
constant for the life of the bond.
 The final payoff from re-investment is the
 In practice, each coupon may have to be future value of this annuity.
reinvested at a different rate of interest.
 The future value is
 Thus each coupon can be re-invested at a rate of
r/2 per six monthly period.

7/3/2017 167 7/3/2017 168

42
 Thefuture value is the sum of all the  The interest on interest is therefore
coupons which are reinvested
 Which in this case is the principal
 Plus the interest from re-investment.
 Thetotal value of coupons that are
reinvested is

The YTM Calculation assumes that r/2 = y/2.

7/3/2017 169 7/3/2017 170

 Consider an L&T bond with 10 years to
maturity.
 The face value is Rs 1,000.
 It pays a semi-annual coupon at the rate of 10%
per annum.
 The YTM is 12% per annum.
 Price can be calculated to be Rs 885.295.
 Assume that the coupons can be reinvested
at a six monthly rate of 6%
 Which corresponds to a nominal annual rate of
12%.
 The total coupon income = 50 x 20 = 1000

7/3/2017 171 7/3/2017 172

43
 Interest on interest gotten by reinvesting the  In the end the holder will get back the face
coupons value of Rs 1,000.
 So the total cash flow at the end
= 1000 + 839.3 + 1000 = 2839.3
 To get this income, the bondholder has to
make an initial investment of 885.295.

7/3/2017 173 7/3/2017 174

 So what is the effective rate of return?  So the rate of return is 6% on a semi-annual

 Itis the value of i that satisfies the following basis or 12% on a nominal annual basis
equation  Which is exactly the same as the YTM.
 So how was this return achieved?
 Only by reinvesting all the coupons at an annual
rate of 12%, compounded on a semi-annual basis.

7/3/2017 175 7/3/2017 176

44
 The reinvestment rate affects only the
interest on interest income.
 The other two sources are unaffected.
 If r > y, then the investor’s interest on
interest income would be higher
 And the return on investment, i, would be
greater than the YTM, y.
7/3/2017 177
 Futurereinvestment rates may be less than
the rate prevailing at the outset
 This risk is called Reinvestment Risk.
 The degree of this risk depends on the time to
maturity as well as the quantum of the coupon.
7/3/2017 179
 Ifr < y, then the interest on interest
income would be lower
 And the rate of return, i, would be less than the
YTM, y.
 So if one buys a bond by paying a price
corresponds to a YTM
 The holder will realize that YTM only if
 The bond is held till maturity
 He is able to reinvest all the intermediate coupons at
the YTM.
7/3/2017 178
 For a bond with a given YTM, and a coupon
rate, the greater the time to maturity
 The more dependent is the total return from the
bond on the reinvestment income.
 Thus everything else remaining constant, the
longer the term to maturity
 The greater is the reinvestment risk.
7/3/2017 180
45
 Fora bond with a given maturity and YTM,
the higher the coupon rate
 The more dependent is the total return on the
reinvestment income.
 Thuseverything else remaining the same, the
larger the coupon rate
 The greater is the reinvestment risk.
 Thus premium bonds will be more vulnerable
to such risks than bonds selling at par.
 Correspondingly, discount bonds will be less
vulnerable than bonds selling at par.
7/3/2017 181
 The Treasury per se does not issue zero
coupon securities.
 But zero coupon securities can be created
which are backed by conventional bonds
 Take a large quantity of a T-note or bond and
separate all the cash flows from each other
 Sell the entitlement to each cash flow
separately.
7/3/2017 183
 If a zero coupon bond is held to maturity,
there will be no reinvestment risk
 Because there are no coupons to reinvest.
 Thus if a ZCB is held to maturity, the actual rate of
return will be equal to the promised YTM.
 This explains the popularity of ZCBs for many
investors, in particular, long-term investors
 They can lock in a compounded rate of return if they
hold the bond till maturity
 Without worrying about the need to reinvest cash
flows periodically
 This explains the popularity of securities such as
STRIPS
7/3/2017 182
 Take the case of a two-year T-note.
 It can be separated into five zero coupon
securities maturing after:
 6 months
 12 months
 18 months
 24 months
7/3/2017 184
46
 Earlier
investment banks used to buy bonds
from the Treasury and separate the cash
flows
 Each cash flow was then sold separately as a zero
coupon bond.
 Such issues are called trademarks.
7/3/2017 185
 What is the motivation to create such
products?
 In practice arbitrage is possible when a
coupon security is purchased at a price
 That is lower than what could be obtained by
selling each cash flow separately.
7/3/2017 187
 Theissue of trademarks has now ceased.
 Because investment banks can now create
such instruments
 In concert with the Treasury itself.
 These ZCBs are known as STRIPS –
 Separate Trading of Registered Interest and
Principal of Securities.
 These are not issued or sold by the Treasury
 The market is made by investment banks.
7/3/2017 186
 Couponstripping reflects a case of financial
engineering
 Creating a risk-return profile that is not
otherwise available
 Aninvestment bank would buy a large
quantity of a Treasury security
 The securities would be placed with an SPV
7/3/2017 188
47
 The SPV is a single-purpose dedicated trust
 Ithas the powers to own the bonds and
collect payments
 It cannot sell or lend the bonds
 It cannot write options on the bonds
 Or use them as collateral for borrowing
 The SPV is empowered to issue zero coupon
bonds
 Where each security represents the ownership of
a single cash flow from the mother bond
 Assume that 100MM USD of 15 year bonds
with a coupon of 8% are placed with the SPV
 The SPV can issue 6M, 12M, 18M, extending up to
14 ½ year zeroes with a total face value of 4MM
USD each
 And 15 year zeroes with a total face value of
104MM


7/3/2017 189 7/3/2017 190

 MerrillLynch pioneered the concept by

introducing TIGRS
 Treasury Investment Growth Receipts
 Salomon followed with CATS
 Certificates of accrual on Treasury securities
 Lehman came up with LIONS
 Lehman Investment Opportunity Notes
 These are known as Animal Products
 This segment of the market was termed as the
Zoo

7/3/2017 191 7/3/2017 192

48
 The Treasury launched this program in 1985
to facilitate the stripping of designated
securities.
 All new T-bonds and notes with a maturity of 10
years or more are eligible.
 The zeroes created in the process are direct
obligations of the U.S. government.
 The mechanism is as follows.
 A dealer who owns a bond or note can ask the
FRB where it is held
 To replace it with an equivalent set of STRIPS
representing each payment as a separate security.
 Each of these securities can be traded independently
of others.

7/3/2017 193 7/3/2017 194

 In 1987 the Treasury started to allow dealers
to reverse the process
 This is called STRIPS RECONSTUTUTION
 If a dealer owns STRIPS representing all the
coupon and principal payments of a bond
The FED can on request convert these holdings into a

single position in the corresponding bond
 Strips are mainly acquired by institutional
investors
 However they are not inaccessible to
individuals
 Strips also constitute a part of the portfolio
held by certain mutual funds
 Consequently this offers an indirect avenue for
investment

7/3/2017 195 7/3/2017 196

49
 There are two types of issues  C-Linkers are like floating rate bonds
 P-Linkers and C-Linkers  The principal is fixed
 In the case of P-Linkers  The coupons are variable and are linked to the
 The coupon rate is fixed CPI
 The principal is linked to changes in an Index like  They are usually issued by commercial banks and
the CPI insurance companies
 Such bonds are usually issued by governments
 TIPS (Treasury Inflation-Protected Securities)
are an example

7/3/2017 197 7/3/2017 198

 Face value = $100

Time CPI INF.Rate Adj.Prin Nominal Real
 Coupon rate = 5% Cash Value
 Payment frequency = annual Flow
0 100 100.00 -100.000 -100.000
 Maturity = 5 years
1 108 8% 108.00 5.400 5.00
2 117.5 8.7963% 117.50 5.875 5.00
3 112.50 -4.2553% 112.50 5.625 5.00
4 120 6.6667% 120.00 6.000 5.00
5 130 8.3333% 130.00 136.500 105.00
Average 6.5082% IRR 10.6814% 5.00%

7/3/2017 199 7/3/2017 200

50
 Ifthe previous issue were to be a C-Linker
the coupon every period will be the Time CPI INF.Rate Coupon Nominal Real
Rate Cash Value
announced rate plus the rate of inflation Flow
 In this case the announced rate is 5% 0 100 -100.000 -100.000
 So if the rate of inflation is 3% 1 108 8% 13.0000% 13.0000 12.0370
 The actual coupon paid will be 8% 2 117.5 8.7963% 13.7963% 13.7963 11.7415
3 112.50 -4.2553% 0.7447% 0.7447 0.6620
4 120 6.6667% 11.6667% 11.6667 9.7223
5 130 8.3333% 13.3333% 113.3333 87.1795
Average 6.5082% IRR 10.5630 4.7423%

7/3/2017 201 7/3/2017 202

 Cash flows on the C-Linker are more – front

loaded- as compared to the P-Linker
 Compensation for inflation on the C-Linker is
paid on realization
 It is mostly deferred till maturity on the P-Linker

7/3/2017 203

51