Introduction to Bonds

Time Value of Money, NPV, IRR

Time Value of Money
A sum of money now is worth more than the same sum of money in future

Net Present Value

The value of all future cash flows (positive and negative) over the entire life of an
investment discounted to the present

Internal Rate of Return

The discount rate at which a project’s returns become
equal to its initial investment i.e. NPV becomes zero
Questions
● Invest 20,000 USD now and receive 3 yearly payments of 5,000 USD each along with 12,000 USD in
the 3rd year. Discount rate is 10%. Is this an investable opportunity?
● A project with a 4 year life and a cost of Rs. 225,000 generates revenue of Rs. 48,000 in year 1,
Rs.67,000 in year 2, Rs. 95,000 in year 3 and Rs. 110,000 in year 4. If the discount rate is 15%, Can be
accepted the project?
● Invest 9,000 USD now and receive three yearly payments of 2,500 USD each along with 4,000 USD in
the 3rd year. What is the IRR?
● Find the IRR of an investment having initial cash outflow of Rs. 280,000. The cash inflows at first,
second, third and fourth years are expected to be Rs. 72,000, Rs. 97,000, Rs.105,000 and Rs, 110,000
respectively.
What are bonds?
● A bond is an instrument that represents a loan made by an investor to a
borrower (typically corporate or governmental). A bond could be thought of as
an I.O.U. between the lender and borrower that includes the details of the loan
and its payments. Bonds are used by companies, municipalities, states, and
sovereign governments to finance projects and operations. Owners of bonds
are debtholders, or creditors, of the issuer.
 How Bonds Work

The interest rate,

These interest
coupon, is typically
The organization, in payments are usually When the bond
When a person buys higher with long-term
return, promises to doled out reaches the date of
a bond, he/she is bonds. The Coupon
pay interest semi-annually, but maturity, the issuer
lending money to the is percentage of the
payments to the they can also be sent repays the principal,
organization that face value of the
bondholder for the out annually, or original amount of
issues it bond which is
length of the loan quarterly or even the loan
generally $100 or
monthly
$1000
Terminology of Bonds
It’s the amount that bond will be Dates on which the bond issuer
Date on which the bond will
worth at its maturity. It is also the will make interest payments.
reference amount the bond issuer mature/end and the bond issuer
Coupon dates are derived based
uses when calculating interest will pay the bond holder the
on coupon frequency and trade
payments. Also known as PAR Value. face value of the bond.
date.

Face value Coupon dates Maturity date

Coupon rate Coupon Frequency Issue price

Rate of interest the bond Number of times coupon paid in

an year, intervals are usually Price at which the bond issuer
issuer will pay on the face
annual or semi-annual. originally sells the bonds.
value of the bond, expressed
as a percentage.
Types of Bonds

•Fixed Interest Bonds : Fixed interest payments till maturity at equal intervals.
•Perpetual bonds : These have no maturity date. Issuers pay coupons on perpetual bonds
forever, and they do not have to redeem the principal to bond holder.
•Floating interest Bonds : Interest paid dependent on a reference benchmark rate.
•Inflation linked bonds : Coupon paid is linked to inflation rate during the period.
•Zero-coupon bonds : No coupon payments, their market price eventually converges to face
value upon maturity. For Zero-coupon bonds, usually, the Issue price ≤ Face Value.
Pricing Bonds
● Bond value is determined by the present value of the coupon payments and
par value.
● The quoted price is for a bond with a face value of 100.
● The quoted price is not the same as the cash price that is paid by the
purchaser.
● Cash price = Quoted price + Accrued Interest since last coupon date
● Quoted price is referred to as Clean Price and Cash price as Dirty Price by the
traders
Example: Bond Price
Suppose that it is May 5, 2020, and the bond under consideration is an 11% coupon bond with semi-annual
coupon maturing on September 10, 2022, with a quoted price of $95.50 on May 5, 2020.

● The most recent coupon date is March 10, 2020, and the next coupon date is September 10, 2020.
● The number of days between March 10, 2020, and May 5, 2020, is 54, and 181 between March 10,
2020, and September 10, 2020
● On a bond with $100 face value, the coupon payment is $5.50 on March 10 and September 10.
● The accrued interest on May 5, 2020, is the share of the September 10 coupon accruing to the
bondholder till May 5, 2020.
● As the day basis type used is actual/actual for Treasury bonds, the AI will be (54/181)*$5.5 = $1.64
● Therefore the cash price per $100 face value bond on May 5, 2020, is $95.5+ $1.64 = $97.14
Questions
Bond Price
● Compute the price of 4-year, 10% annual coupon bond with a par value of $1,000, YTM 11%
● Compute the price of $1,000 par, 4-year bond with a 10% coupon rate paid semi-annually and a
yield-to-maturity of 9%

YTM
● Compute the YTM of a 10-yr, 8% annual bond priced at 925 with a par value of $1,000
● Compute the YTM of a 10-year, $1,000 par bond with an 8% coupon rate that makes semiannual
coupon payments given that its current price is $925
Valuation of a Bond

Bond Price for an Annual Coupon Bond =

Where C = Annual Coupon

y = Yield

N = Number of Coupons

Note: Here the face value of the bond is 100.

Bond Yield
● Bond yield is the return an investor realizes on a bond
● Different ways to define bond yield are:

YTW is the lowest potential yield that

Current Yield is derived by taking YTC assumes that the bond will
can be received on a bond without the
the bond’s coupon yield and be called thus has a shorter
issuer defaulting. YTW is calculated by
dividing it by the bond’s price. cash flow period. assuming worst-case scenario.

Current yield Yield to Call Yield to Worst

Yield to Maturity Yield to Put Discount Margin

YTP is calculated assuming that A discount margin is the average
It is the return a security will
the bond will be put back to the expected return earned in addition to
earn if it is held to the date of the index underlying, or reference
issuer as soon as it is possible
its maturity rate of, the floating rate security
and financially feasible
Yield to Maturity
● A bond's yield to maturity (YTM) is equal to the interest rate that makes the
present value of all a bond's future cash flows equal to its current price
● These cash flows include all the coupon payments and its maturity value.
● Relation of YTM to Coupon Rate and Par value of the bond:
○ When coupon rate = YTM, price = par value
○ When coupon rate > YTM, price > par value (Premium Bonds)
○ When coupon rate < YTM, price < par value (Discount Bonds)
Graphical Representation of YTM and Bond Value
When the YTM < coupon, the
bond trades at a premium.

When the YTM > coupon, the

bond trades at a discount.
Accrued Interest, Dirty Price, Clean Price
A 5% U.S. corporate bond is priced for settlement on July 20, 2015. The bond makes
semiannual coupon payments on April 21 and October 21 of each year and matures on
October 21, 2018. The bond uses the 30/360 day-count convention for accrued interest.

Calculate the full price, the accrued interest, and the flat price per USD 100 of par value
for three stated annual yields-to-maturity: (A) 4.7%, (B) 5.00%, and (C) 5.30%.
Bond Ratings
● A bond rating is a way to measure the
creditworthiness of a bond, which corresponds
to the cost of borrowing for an issuer.
● The higher a bond's rating, the lower the interest
rate it will carry, all else equal.
● Private independent rating services such as
Standard & Poor's, Moody’s Investors Service,
Fitch Ratings Inc., etc. evaluate bond-issuer's
financial strength, or its ability to pay a bond's
principal and interest, in a timely fashion.
● Change in the bond rating will cause the price of
the bond to fluctuate. Increase in bond rating
will increase the bond price and vice versa.
Global Bond Market (By Type of Issuer)

Type of Issuer Amount* ( in billions of USD)

Government 50,315

Financial Institutions 38,573

Corporate Issuers 14,327

International Debt Securities 1,688

Total 104,903

*Data last updated 27/02/2020

Src: http://stats.bis.org:8089/statx/srs/table/c1?f=xlsx
Duration, Modified Duration
● The duration of the bond is a measure of how long the holder of the bond has
to wait before receiving the present value of the cash payments.
● A zero coupon bond that lasts for n years has a duration of n years.
● A coupon bearing bond lasting n years has a duration of less than n years
because the holder receives some of the cash payments prior to year n.
● Also, the higher the duration, the more a bond's price will drop as interest
rates rise.
● Modified Duration – measures the percentage change in bond price for a 1
percentage-point change in yield
Factors Affecting Bond Duration
● Time to maturity: The longer the maturity, the higher the duration, and the
greater the interest rate risk. Accordingly, the shorter-maturity bond would
have a lower duration and less risk
● Coupon rate: Higher the coupon rate, lower will be the duration, and lower
interest rate risk. Lower the coupon rate, higher will be the duration, and
higher interest rate risk.
Source – raymondjames.com
Term Structure of Interest Rates
● The relationship between short-term and long-term interest rates is called the term
structure of interest rates.
● The yield curve shows the relationship between yields-to-maturity and terms-to-maturity
● Spot Rate – Yields on zero-coupon government bonds are spot rates.
● Forward Rate – Forward rates can be described as the market’s current estimate of
future spot rates. The rate of interest on a 1-year loan that would be made two years
from now is a forward rate.
● Expectations Hypothesis - An investor earns the same amount of interest by investing in
two consecutive one-year bond investments versus investing in one two-year bond
today.
Source – masterclass.com
 Yield Curve - Types
● Normal Yield Curve, the yield paid by bonds increases with length. Therefore, a
30-year bond pays more than a 10-year bond, which pays more than a 5-year
bond, which pays more than a 2-year bond, which pays more than a 3-month
bond
● Inverted Yield Curve, the bond market’s short-term rates are higher than its
long-term rates. That means, for instance, that a two-year bond will offer a
higher yield than a five-year bond
● Flat Yield Curve, falls between a normal and an inverted yield curve.

Source – masterclass.com
Thank You