Annual Refresher Program in Teaching (ARPIT)

through
National Resource Centres (NRCs)

Date
Basics of
Bonds

Dr. Kapil Sharma

Learning Objectives

1 To become aware of the recent trends of bond market

To understand key dimensions related to bonds like yield, convexity

2 immunization etc.
 • In August 2016, a committee headed by former Reserve Bank of India Deputy Governor H R
Khan had made a series of recommendations for the domestic debt market
• The rapid growth of Bond Market in India has lead to an increase in manpower which is
equipped with the skills of understanding the bonds particularly bond valuation
Growth
• The bond market average daily trading has almost doubled in the past five years, with the
Trends in
exception of certificates of deposit (CDs), where it has declined due to lower supply
Bond Market
• With out banks already overstretched and burdened with non-performing assets, there lies
of India
scope for the Indian corporate bond market to further grow rapidly and offer extensive
investing opportunities
• By 2023, CRISIL expects corporate bond outstanding to be around Rs 55-60 lakh crore, driven
by large infrastructure investment requirements, lowering of interest rates in economy and
the inability of banks to meet up corporate lending because of their capital constraint
Current Yield and its Significance
Current Yield is a relationship between the current market price of a bond and it’s coupon payments.
It represents the prevailing return that a bond is delivering to its owners.
Formula to Annual Coupon Payments
= Current Yield
Calculate Current Yield Current Market Price of Bond

Example :

• A bond with a face value of Rs. 1,000/- is currently trading at Rs. 950/-. The bond carries a coupon rate of 12% and is issued for
a period of 10 years. Then the current yield of the bond will be Rs 120 / Rs 950 which is 0.1263 or 12.63 %
• However if the market price of the bond is Rs. 1,100/- then the current yield will Rs 120 / Rs 1,100 which turns out to be
0.1090 or 10.90%

Note: The stated coupon rate usually remain the same during the entire life of the bond. However, the interest rates in the market
fluctuates, leading to a change in the market price of the bond and thus resulting into change in the current yield. As a result, investors
will trade in bond at a higher or lower price until the Current Yield on that bond is equivalent to the current yield of other securities with
similar risk profiles.
Yield to maturity (YTM) and its use
Yield to Maturity or YTM is a very important measure for analyzing a bonds performance.
• It is the discount rate that makes the present value of cash inflows from the bond equal to the cash outflow
done for purchasing the bond
• It is purely based on face value of bond and ignores time value of coupon payments and redemption price
• In other words, it is the IRR earned from a bond if it is held till maturity

Example:
• Let there be a bond with a face value of Rs. 1,000/- having tenure of 2 years and coupon rate of 5% annually. The bond is
available at Rs 946.93 in secondary market
• An investor pays Rs. 946.93 to acquire the bond and intends to hold it till maturity
• The bondholder is entitled for Rs. 50/- at the end of first year and Rs. 50 plus Rs 1,000 at the end of second year
• To find out the YTM of the bond we need to calculate that rate at which the present value of cash outflow that is purchase
price of bond is equal to the present value of cash inflow that is coupon payments for the 2 years and redemption value

Therefore we have the 50 1,050

946.63 = +
equation: (1+x)1 (1+x)2
On solving the equation x turns out to be 7.99% which is the YTM of the bond
Relation between Intrinsic Value of a Bond and YTM
Intrinsic value of bond and YTM are inversely proportional to each other. It implies that if YTM increases value
of bond will decrease and vise versa
Example:
• Let us consider a bond with a face value of Rs. 1,000/- having a coupon rate of 12% where payments are made semi annually
and the term to maturity of 8 years
• Let the indicative YTM for such a bond in the market be 13%. Then the value of bond arrived after calculation will be Rs. 951.16
60 60 1,060
Price = + + = 951.16
(1+0.065)1 (1+0.065)2 (1+0.065)16
Using 13% as indicative YTM the value of bond is Rs. 951. 16

Value of bond by changing the YTMs: • Since YTM is the denominator, the value of the bond
YTM Price Decrease in Price increases when YTM decreases and the value
decreases when YTM increases
12.0% 1,000
12.5% 975.16 24.84 • An increase in price for a given level of decrease in
13.5% 927.96 23.20 YTM is less than the decrease in price for the same
level of increase in YTM
14.0% 905.53 22.43
How both coupon rate and YTM effect a bonds premium or discount?
Whether a bond is at a premium or discount depends upon the relationship between the coupon rate of the
bond and its YTM
Example:
• Let us consider a bond having face value of Rs. 1,000/- maturing after 5 years with a coupon rate of 10% paid semi annually.
The table below represents the variation of price with YTM
Calculating Value of bond by changing the YTMs:

Face Value Coupon Rate YTM Discounted Price Premium / Discount

1,000 10 % 8% 1081.11 + 81.11 Premium
100 10 % 12 % 926.40 - 73.60 Discount
100 10 % 10 % 1000 0 At Par
1,000 10 % 8% 1081.11 + 81.11 Premium
From above we can infer that:
• In case YTM < Coupon Rate, the bond is at Premium

• In case YTM > Coupon Rate , the bond is at Discount

• In caes YTM = Coupon Rate, bond is at Par

Effect of Term of Maturity and Bond Price
Assuming that YTM will remain constant during the term to maturity, there are 2 types of effects of term to
maturity on value of bond :
1. The size of premium or discount decreases as the bond approaches its maturity
2. The size of premium or discount decreases at an increasing rate as bond approaches its maturity
Example:
• Let’s consider 5 year bond with a face value of Rs. 1,000 and coupon rate of 14% paid semi annually. Let YTM of the bond be
13.5% for the entire term of the bond
Changing price of bonds with the change in the term to maturity:

Face Value Term Bond Value Premium / Discount Fall in Premium

1,000 5 1,017.76 + 17.76 Premium
1,000 4 1,015.07 + 15.07 - 2.69
1,000 3 1,012.01 + 12.01 - 3.06
1,000 2 1,008.52 + 08.52 - 3.49
From above we can infer that:
• As the term to maturity reduces from 5 to 4 there is a reduction in premium by Rs 2.69 which goes further from 4 to 3 and so on
• Moreover, this decrease is at increasing rate as term to maturity reduces. Similar phenomenon can be observed in case of discounts also.
Yield to call
Many companies which issue bonds with an option to call back or repurchase them before their term to
maturity. The yield on such type of bonds is called Yield to Call (YTC)
Note: The call period is different from the maturity period and the call value could be different from the maturity value

Example:
• Suppose a bond with face value of 1,000/- bearing a coupon rate of 10% per annum and tenure of 10 years has call option at the
end of 5th year with a redemption value of Rs. 1,050/-. Currently the bond is selling for Rs. 950/- in market and an investor
purchases it
• To calculate yield to call we assume X to be value of Yield to Call and apply the below mentioned formula

100 1,050 In this case yield to call come out

950 = + to be 12.7 %.
(1+X)1 (1+X)5

Now, if we calculate YTM for the same bond assuming the same redemption value of Rs 1,050 but tenure of 10 years we will get 10.9% as YTM

100 1,050 In this case yield to call come out

950 = + to be 10.9%
(1+X)1 (1+X)10
Duration
• Duration is a measure of a bond's sensitivity to interest rate changes. It is an approximate measure of a
bond's price sensitivity to changes in interest rates
• The measure of duration is in years, months or days
• Duration gives a measure of the extent of change that would occur in the value of a bond for a given
change in its YTM
Formula to calculate Duration (D):
∑ PV(Ct) X t PV(FV) X T T = Term to Maturity ; t = Time points at which coupon payments are made
Duration (D) = +
∑ PV(Ct) PV(FV) Ct = Coupon Payments at t; FV = Face Value; PV = Present Value

Example:
• Let’s calculate duration of a bond maturing after 3 year, with face value of Rs. 1,000 and yearly coupon payments of Rs. 80.
Let’s assume YTM to be 10%
Time Amount of Cash Flow PV of Cash Flow PV x Time of Cash Flow • Putting values in the formula duration turns out to
be 2,639.23 / 950.27 that is 2.78 years
1 80 72.73 72.73 • The higher the bond's duration, the greater its
2 80 66.12 132.24 sensitivity to changes in interest rates and vice
3 1080 811.42 2434.26 versa. In nut shell duration measure the level of
interest rate risk of a bond
950.27 2639.23
Convexity
• A bond’s Convexity measures the sensitivity of a bond’s duration due to changes in yield
• It measures the degree of the non-linear relationship between the bond price and yield of the bond

Positive Convexity Negative Convexity

• A bond is said to have positive convexity if duration rises as

the yield declines • It indicate that duration rises as yields increase and this can
• Such bonds will have larger price increases due to a decline work against an investor’s interest.
in yields than price declines due to an increase in yields
Immunization
• The strategy to protect a bond portfolio from adverse changes in interest rates is called Immunization
• A bond is said to be immunized if it is not much affected by the adverse changes in the interest rates
• To immunize the bond portfolio one must know the duration of bonds in the portfolio
• As bond immunization strategy attempts to minimize the interest rate risk of a bond investment by adjusting the portfolio
duration to match with the investor’s time horizon
• By doing so, Immunization locks in a fixed rate of return during the amount of time an investor plans to keep the bond without
encashing it
• However, there are difficulties in immunizing the bond portfolio such as it is necessary to rebalance the portfolio from time to
time since the duration depends on yield and yield can keep on changing
• Moreover, the immunization method assumes that all yields are equal which is not quite realistic that bonds with different
maturities have the same yield

Example:
• Let’s assume an investor needs to pay Rs 10,000 at the end of 5th years. To immunize against this definite cash outflow, the
investor can purchase a five-year zero-coupon bond with a redemption value of Rs.10,000
Summary

• Bond is the safest investment tool which gives a fixed return to its
investors. But it is necessary to be aware about the bond
terminologies like current market price, bond interest rate, yield,
maturity period etc.

Summary

• Duration, convexity and immunization are most important tools, the

investors must be aware about so that they can do the analysis of
interest rate fluctuations which will definitely affect the current yield
of the bonds.