Description
explains terms like Bond Indenture, Maturity / term-to-maturity, Par Value/ Face Value, Coupon. It explains classification of bonds based on interest/coupon payment, based on term of maturity, based on options/refunding provisions, based on convertibility.
Fixed Income Securities: Basics and Pricing
Key Terms
• • • • Bond Indenture Maturity / term-to-maturity Par Value/ Face Value Coupon
Classification : based on Issuers
• Government /Treasury Bonds
– Central Government Bonds – State Government Bonds – Municipal Bonds
• PSU Bonds • Bonds Issued by Financial Institutions/Banks • Corporate Bonds
The Topic for Next Discussion
• In India Corporate Bond Market is not as well developed as Equity Market. Why? What can be done to make corporate bonds popular among small investors?
Classification : Based on Interest/Coupon Payment
• Fixed Coupon Bonds • Zero Coupon Bonds
– STRIPS
• Floating Rate Bonds • Inverse Floaters • TIPS (Inflation Protection Bonds)
Classification based on Term-toMaturity
• In context to Treasury Issues • US:
– Bill (up to 1 year) – Note(1-10 year) – Bond(more than 10 year)
• India
– Bill(up to 1 year) – Dated Securities (more than one year)
Classification Based on Options/ Refunding provisions
• Callable Bonds • Putable Bonds • Sinking Fund Provisions
Based on Convertibility
?With option to convert them into equity. • Non-Convertible • Convertible
– Fully Convertible – Partially Convertible
– Why recently FCCB became popular?
Bond Pricing
Price Quotations
• Quoted Price : Clean price is quoted • Clean Price: Does not include interest • Accrued Interest
Annual Coupon Days Since Last Coupen Payment AI ? ? 2 Total Days in Coupon Period
• Invoice Price= Clean Price + Accrued Interest
Day Count Conventions
Basis 0 or omitted 1 2 3 Day count basis US (NASD) 30/360 Actual/actual Actual/360 Actual/365 In India used for T-Bills , CD, CP and Corporate Bonds European 30/360 In India used for Dated Securities Remark February=30
4
February=28/29
Two Parameters of Bond Pricing
• Yield • Price
?Yield (or YTM) is equivalent to IRR ?Price is equivalent to PV. ?Both are two sides of the same coin.
Return on Bond Investment: Yield
• Is it always better to purchase a higher coupon bond (say 12% p.a.) than a low coupon bond (say 3.5% p.a.)?
• What is yield? How is it different from Coupon Rate? • While investing money in fixed income securities, should we give more importance to yield rate or coupon rate?
Why Yield is different from Coupon Rate
• Bonds are not always sold at par. Neither in secondary market, nor always in primary market. • Therefore, yield depends on buying prices. • Where coupon rate is pre-decided (fixed or floating), yield keeps changing according to market conditions.
Current Yield
Annual Coupon Current Yield ? Price
Yield-to-Maturity
• It is IRR of the bond investment, with a assumption that bond is held till maturity.
?It considers the coupon as well as the capital gains. ?It is assumed here that the coupon payments can be reinvested at an interest rate equal to YTM. ?Tip: Price = Par Value: YTM= Current Yield=Coupon Rate Price> Par Value: YTM<Current Yield<Coupon Rate Price < Par Value YTM>Current Yield<Coupon Rate
Yield-to-Call
• In case of a callable bond YTM is not a good indicator of expected bond return. • A bond is likely to be called if current market yield (interest rate) is less then the Coupon Rate. • Yield-to-Call is calculated for a assumed call date; generally for:
– First call date – First par call date.
Example
• A 8.5% Corporate Bond is trading today at 1020 (FV 1000) , It has a exact three years’ term to maturity, but company has an option to call it after 1 year at Rs. 1010. Coupon is paid annually. Find out:
– CY – YTM – YTC
Realized Yield
• YTM analysis is subject to reinvestment risk. • If the bond is not held till maturity, investment is also subject to price risk. • The realized return is the actual rate of return from an investment for a given horizon based on actual reinvestment income and actual selling price of the bond. • Bond investors forecast the possible realized return for different holding periods, or investment horizons. This is called Horizon Analysis.
Example
• An investor purchased 500, 7.5% bond with 3 years’ remaining term-to-maturity at Rs 95. What is its YTM. • He received first coupon after 6 month and reinvested the money for six month at the interest rate of 3.5% p.a. . He also received second coupon after 1 year and sold the investment on the same date at Rs. 96. What is his realized yield.
Yield and Law of One Price
• If two securities are otherwise similar (risk, cash-flow pattern) both should have same yield. • Why : Otherwise, they will provide riskless profit making (arbitrage) opportunity.
…Yield and Law of One Price
• If the yield of security X is higher than that of security Y; it implies that security X has higher risk or some undesirable attributes.
• Higher yield is required to compensate for higher risk or some undesirable attributes.
…Yield and Law of One Price
• Corporate bonds give higher yield than Treasury Bonds. • Corporate Bonds with good credit rating give low yield than Junk Bonds. • Bonds with longer maturity, generally, give higher yield than bonds of shorter maturity. (WHY?) • Ceteris paribus, Bonds with higher coupon rate give lower yield. • A Bond with higher liquidity will give lower yield • A Callable bond will give higher yield
Price of a Bond
doc_615368726.pptx
explains terms like Bond Indenture, Maturity / term-to-maturity, Par Value/ Face Value, Coupon. It explains classification of bonds based on interest/coupon payment, based on term of maturity, based on options/refunding provisions, based on convertibility.
Fixed Income Securities: Basics and Pricing
Key Terms
• • • • Bond Indenture Maturity / term-to-maturity Par Value/ Face Value Coupon
Classification : based on Issuers
• Government /Treasury Bonds
– Central Government Bonds – State Government Bonds – Municipal Bonds
• PSU Bonds • Bonds Issued by Financial Institutions/Banks • Corporate Bonds
The Topic for Next Discussion
• In India Corporate Bond Market is not as well developed as Equity Market. Why? What can be done to make corporate bonds popular among small investors?
Classification : Based on Interest/Coupon Payment
• Fixed Coupon Bonds • Zero Coupon Bonds
– STRIPS
• Floating Rate Bonds • Inverse Floaters • TIPS (Inflation Protection Bonds)
Classification based on Term-toMaturity
• In context to Treasury Issues • US:
– Bill (up to 1 year) – Note(1-10 year) – Bond(more than 10 year)
• India
– Bill(up to 1 year) – Dated Securities (more than one year)
Classification Based on Options/ Refunding provisions
• Callable Bonds • Putable Bonds • Sinking Fund Provisions
Based on Convertibility
?With option to convert them into equity. • Non-Convertible • Convertible
– Fully Convertible – Partially Convertible
– Why recently FCCB became popular?
Bond Pricing
Price Quotations
• Quoted Price : Clean price is quoted • Clean Price: Does not include interest • Accrued Interest
Annual Coupon Days Since Last Coupen Payment AI ? ? 2 Total Days in Coupon Period
• Invoice Price= Clean Price + Accrued Interest
Day Count Conventions
Basis 0 or omitted 1 2 3 Day count basis US (NASD) 30/360 Actual/actual Actual/360 Actual/365 In India used for T-Bills , CD, CP and Corporate Bonds European 30/360 In India used for Dated Securities Remark February=30
4
February=28/29
Two Parameters of Bond Pricing
• Yield • Price
?Yield (or YTM) is equivalent to IRR ?Price is equivalent to PV. ?Both are two sides of the same coin.
Return on Bond Investment: Yield
• Is it always better to purchase a higher coupon bond (say 12% p.a.) than a low coupon bond (say 3.5% p.a.)?
• What is yield? How is it different from Coupon Rate? • While investing money in fixed income securities, should we give more importance to yield rate or coupon rate?
Why Yield is different from Coupon Rate
• Bonds are not always sold at par. Neither in secondary market, nor always in primary market. • Therefore, yield depends on buying prices. • Where coupon rate is pre-decided (fixed or floating), yield keeps changing according to market conditions.
Current Yield
Annual Coupon Current Yield ? Price
Yield-to-Maturity
• It is IRR of the bond investment, with a assumption that bond is held till maturity.
?It considers the coupon as well as the capital gains. ?It is assumed here that the coupon payments can be reinvested at an interest rate equal to YTM. ?Tip: Price = Par Value: YTM= Current Yield=Coupon Rate Price> Par Value: YTM<Current Yield<Coupon Rate Price < Par Value YTM>Current Yield<Coupon Rate
Yield-to-Call
• In case of a callable bond YTM is not a good indicator of expected bond return. • A bond is likely to be called if current market yield (interest rate) is less then the Coupon Rate. • Yield-to-Call is calculated for a assumed call date; generally for:
– First call date – First par call date.
Example
• A 8.5% Corporate Bond is trading today at 1020 (FV 1000) , It has a exact three years’ term to maturity, but company has an option to call it after 1 year at Rs. 1010. Coupon is paid annually. Find out:
– CY – YTM – YTC
Realized Yield
• YTM analysis is subject to reinvestment risk. • If the bond is not held till maturity, investment is also subject to price risk. • The realized return is the actual rate of return from an investment for a given horizon based on actual reinvestment income and actual selling price of the bond. • Bond investors forecast the possible realized return for different holding periods, or investment horizons. This is called Horizon Analysis.
Example
• An investor purchased 500, 7.5% bond with 3 years’ remaining term-to-maturity at Rs 95. What is its YTM. • He received first coupon after 6 month and reinvested the money for six month at the interest rate of 3.5% p.a. . He also received second coupon after 1 year and sold the investment on the same date at Rs. 96. What is his realized yield.
Yield and Law of One Price
• If two securities are otherwise similar (risk, cash-flow pattern) both should have same yield. • Why : Otherwise, they will provide riskless profit making (arbitrage) opportunity.
…Yield and Law of One Price
• If the yield of security X is higher than that of security Y; it implies that security X has higher risk or some undesirable attributes.
• Higher yield is required to compensate for higher risk or some undesirable attributes.
…Yield and Law of One Price
• Corporate bonds give higher yield than Treasury Bonds. • Corporate Bonds with good credit rating give low yield than Junk Bonds. • Bonds with longer maturity, generally, give higher yield than bonds of shorter maturity. (WHY?) • Ceteris paribus, Bonds with higher coupon rate give lower yield. • A Bond with higher liquidity will give lower yield • A Callable bond will give higher yield
Price of a Bond
doc_615368726.pptx