Fixed Income Securities: Lecture Note 2: Valuation

Fixed Income Securities
Lecture Note 2: Valuation
Apoorva Javadekar
Indian School of Business
December 11, 2019
Apoorva Javadekar (Indian School of Business) Fixed Income Securities December 11, 2019 1 / 35
Value the ZCB (And everything else follows!)
Recall: ZCB a non-coupon paying bond ⇒ pays face value at the maturity
What’s the Yield on your ZCB? Consider 1-year ZCB with fv of 100$ and
issue price of 98 $. If you invest in this ZCB, what’s your return?
100
Dollar Income = 2 $ y= − 1 = 2.04%
98
Annual Yield: Suppose above was a 2 year bond instead of 1 year
⇒ You earn 2.04%, but over 2 years! (Not 1 year) ⇒ What’s your EAY?
98 × (1 + y ) × (1 + y ) = 100
|{z}
| {z } | {z }
Value at yr 1 Again invest at y to get 100$ at yr 2s
1
100 100 2
⇒ (1 + y )2 = →y = − 1 = 1.01%
98 98
Generalization: For n year ZCB

n1
fv
EAY = y = −1
p
Interpreting y
y is the effective return earned on your investment

y as the compensation required by the investors. We want to learn in this
course
I What y is in the data? Is y a function of maturity?
I Why y on Indian Government bonds higher than US treasury bills?
I Why y moves over time?
y is called as the yield-to-maturity (ytm)
I ytm is the Internal rate of return (IRR) on the bond
I Assumes that interim coupon can be invested at the same ytm
Notation: We will denote EAY by ytm as is more commonly done
Zero Rates: Some times ymt on ZCB is called zero-rates
Primer on US Treasury Bills
Treasury bills are ZCB’s backed by the guarantee of US Treasury

Maturities from 28 days to 364 days
Prime- ”zero-default”, most liquid bonds around
Globally all major investors (including central banks) purchase it
Information in Treasury Yields: T-rate movement is informative about
I global capital scarcity and overall market liquidity
I Overall risk-aversion in the market
I Expectations of future course of economy
1 Year Treasury Yield USA
91 Day Bills India
Indian Govt Bonds 91 Day Yield

14
12
10
Finding Price Given y
Let’s invert the analysis and find out the price of ZCB. Suppose your required
rate (EAY) is 6%. What’s the maximum price you are ready to pay for a 6
months ZCB? Write down the basic ZCB identity
n
p × (1 + y ) = 100
100 100
⇒p= n = 1 = 97.12 $
(1 + y ) (1.06) 2
Prediction
Price of ZCB and yields move in opposite directions. Moreover price is declining in
maturity
both effects are manifestation of time value of money!
Price of Coupon Bonds and Implied ytm
Coupon bond = Sequence of ZCB’s
Example: Coupon bond with 1 year maturity, 9% coupon paid semi-annually.

zero-rates are 4% for 6 months and 5% for 1-year
4.5 104.5
p = p (ZCB1 )+p (ZCB2 ) = 1 + = 103.93 $
|{z}
Price of Coupon Bond
(1.04) 2
|1.05
{z }
Price of ZCB2
| {z }
Price of ZCB1
Maturity face Value ytm % Price
ZCB1 6 Months 4.5 4 4.412613

ZCB2 12 Months 104.5 5 99.52381
p (ZCB1) + p (ZCB2) = p (Coupon Bond) = 103.93
What’s the ytm on this coupon bond? or what’s the y that solves
4.5 104.5
1 + = 103.93 ⇒ y = 4.97%
(1 + y ) 2 1+y
Bond Issued at Par, Discount, Premium
Par-Value: When bond pays exactly what market requires (YTM), then
p = fv and bond is said to be issued at par
Bond issued at Discount or Premium: When y 6= c, then bond will not
sell at it’s face value
I If y > c ⇒ bond’s coupon less than ytm ⇒ bond will sell at discount (less
than fv)
I If y < c ⇒ bond’s coupon larger than ytm ⇒ bond will sell at premium
(more than fv)
Quiz: If ytm is 4% (BEY) and bond pays 4% coupon annually, will bond be
issued at par?
Properties of Bond Prices
Prediction (Yield and Prices)

Price and yield move in opposite direction
If bond pays 5% coupon and market yield moves to 6% ⇒ only way

investors keep holding this low-coupon bond (relative to current market rate)
is if it’s price (in the secondary market) goes down
Find issue price of 2-year ZCB with market yield of 6% (EAY). Immediately
after issue, yield drops to 4%. Find new bond price
Prediction (Price Convergence)

Price of a bond converges to face value as time to maturity → 0 even if yield is
constant
As maturity nears, the time-value of money decreases for any given yield
An instant before maturity: bond can trade at nothing but face value! Else it
will be an arbitrage opportunity!
Prediction (Convexity)
Bond price is convex in yields. Drop in yield affect bod prices more than rise in
yield
This is called convexity effect

⇒ Bond portfolios have this natural advantage: more gain when rate falls,
less loss when rate rises!
Prediction (Coupon Effect)

When yield changes, lower coupon bonds experience larger swing in the prices
A given change in ytm is proportionally higher relative to low-coupon as

compared to high-coupon
Junk bonds (with high-yield) are at least safer on price-swings !! (this is
ironic)
Prediction (Maturity)
Impact of yield changes on bond prices is higher for longer maturity bonds
longer maturity ⇒ (coupon − ytm) affects you for long time

Bond portfolios with long-maturity investments are inherently risky then to
changes in ytm
of course there are other reasons for it being risky too - which we shall see
later in the course
Excel sheet to explore some of these principles. Please download on ur local drive
and then explore
YTM and Risk-Return on Bond Investments
Three Sources of Returns
Bond investor has three sources of returns (potentially)

I Coupon and principal repayments
I Re-investment of coupon cash-flow
I Capital gain / loss if bond is sold prior to maturity
ytm = Market required rate (as reflected in price).
But is ytm what investor actually gets? Yes only if
I all promised cash flows are paid on time ⇒ no credit risk
I all coupons are re-invested at original ytm ⇒ no interest rate risk
I No capital gain or loss ⇒
F either bond is held till maturity
F or sold when market rate at the time of selling = original ytm
Interest rate risk: ytm or market required rate move through time!
I ⇒ reinvestment rate as well as price when bond is sold prior to maturity is
uncertain
Example
Bond: 2 year 8% annual-coupon bond with face value of 100$ is priced at

p0 = 100 at t = 0 ⇒ trading at par
Exercise 1: Check that par price ⇒ market implied rate or ytm0 on this
bond is exactly 8%
8 × (1 + y ) + 108 8 108
2 = + 2 = 100
(1 + y ) 1+y (1 + y )
I substitute y =0.08 and confirm ! Else you root-solver in excel or matlab!

Note how implicit is the assumption that 8$ received at t = 1 are re-invested
at 8% for remaining time!
Example: Interim Selling
Suppose investor sells the bond at t = 1. What’s his realized return after 1
year?
I Depends upon market rate at t = 1
Unchanged Market rate ⇒ ytm1 = 8%: ⇒ selling price (ex-coupon) is
100$
coupon sell price
z}|{ z}|{
108 8 + 100
p1 = = 100 ⇒ 1 year realized return = − 1 = 8%
1.08 100
|{z}
investment
I Alternatively: you can let this investor invest 108 $ at t = 1 at 8% market rate
and his realized return at t = 2 would be 8% again!
Example: Interim Selling with change in ytm
ytm1 drops to 6%: ⇒ Interest rates have softened in the economy.
Effect 1: Selling price ↑ ⇒ 1-year realized return (r1 ) ↑
108 8 + 101.88
p1 = = 101.88 $ ⇒ r1 = − 1 = 9.88%
1.06 100
Effect 2: Re-investment income ↓ ⇒ a drag on 2-year realised return r2 .
Investor re-invests at new interest rate of 6% in the economy ⇒
Payoff at t=2 = (8 + 101.88) × (1.06) = 116.472 $

| {z } | {z }
cash flow at t=1 Reinvestment rate
What realised return r2 makes your 100$ at t = 0 grow to 116.472 $ at

t = 2?
1
2 116.472 2
100 × (1 + r2 ) = 116.472 ⇒ r2 = − 1 = 7.92%
100
Takeaway: If manager is evaluated based on 2 year performance, it was

prudent to let go the capital gain!
ytm vs Realised of Holding Period Returns
Point 1: When interest rates change, realised return (r ) 6= ytm

I This is true whether you sell early or not
I If you don’t sell at t = 1 and hold till maturity, still reinvestment income takes
a hit ⇒
1
8 × 1.06 + 108 2
r2 (no sell) = − 1 = 7.925% < 8%
100
Point 2: When interest rates change and manager sells before maturity, two
opposite effects take place
I Selling price and re-investment scenario move in opposite directions
Point 3: Net effect can be positive or negative ⇒ r at the end of holding
period can be up or down
Point 4: ytm is ex-ante measure while realised return (r ) is ex-post measure
ytm Is Not Ultimate Criterion of Investment
Suppose your investment horizon is 5 years. Which bond looks better investment?
Bond Coupon Maturity Priced ytm Comment
A 5 3 9 second highest ytm

but you need to find new investment for 2 years
B 6 20 8.6
C 11 15 9.2 Highest ytm Coupon is high too imply added reinvestment risk
but interim selling means re-investment risk.
Coupon is high too imply added reinvestment risk
D 8 5 8 Matches the holding period

but price is too high at priced ytm is only 8%
Duration and Price-Sensitivity of Bond
Price-Sensitivity
Fixing the type of bond, longer maturity ⇒ larger price drop
Fixing the maturity, ZCB ⇒ Larger price drop than Coupon bond
Is there an easy way / formula to find out approximate price change given a
bond?
Quantifying Interest Rate Risk
Recall: yields and bond prices move in opposite directions!
I ∆y > 0 ⇒ ∆p < 0 and vice-versa
But how much bond prices move if yield moves?
Approximation: Suppose yield moves by ∆y ⇒

∆p p− − p+
=
∆y 2 × ∆y
|{z}
∆p if ∆y = 1%
+
I p = new price when yield goes up to y + ∆y
I p − = new price when yield goes down to y − ∆y
Intuition: Approximation computes average change per unit change in y .

This is just the slope of a tangent at y to price-yield curve
also called as price value of basis-point (PVBP)
% Price change: It’s much better to tell % fluctuation in portfolio value

∆p 1
≈ % price change
∆y p
Example
Consider 20-year ZCB with face value of 100 $, and original ytm of 5%
Shock -0.20 % 0% 0.20 %

New Yield % 4.80 5 5.2
Price 39.154 37.689 36.281
% Price change 3.887 0.000 -3.734
39.154−36.281
⇒ pvbp = % price change if ∆y = 1% = 2×0.20 = 19.052%
Extrapolation: Your fund manager wants to know if yield drop by 2%, how
much price would change?
your answer = 3.887% × 10 = 38.86%
Correct answer = 46.907%

⇒ Look for another job!!
Why did you make a mistake?

Errors Due to Convexity
Correcting for Convexity
Intuitively: Convexity is asymmetry in price sensitivity to yield shocks
asymmetry
Convexity =
2 × ∆y 2 × p
Asymmetry for our example:
I ∆y = −.20% ⇒ ∆p = 39.154 − 37.689 = 1.465$
I ∆y = +.20% ⇒ ∆p = 37.689 − 39.154 = −1.407$
I ⇒ asymmetry = 1.465 − 1.407 = 0.057
0.057
convexity = = 0.0190 = 1.905%
2 × (.20)2 × 37.689
Convexity Adjustment to answer your fund manager
adjustment = 0.01905 × 22 = 7.620%
Combining First-Order and Convexity (Second order):
38.86% + 7.62% = 46.48%
(Macaulay) Duration
What’s the effective maturity of the bond?

I 5 year ZCB vs 5 year Coupon bond. Which one has effectively longer maturity?
Duration ⇒ weighted average pay-back of the bond
Computation of Duration for 5 year 10% Annual Coupon Bond
Year Cash Flow Cash Flow Weight Weighted by Maturity
1 10 0.067 0.07
2 10 0.067 0.13
3 10 0.067 0.20
4 10 0.067 0.27
5 110 0.733 3.67
150 1.000 4.33

Total Cash Flow Duration
Quizz: Show that Duration of ZCB = Maturity!
Modified Duration
Modified Duration
D
MD =
1+y
Modified duration is price - sensitivity to first order
∆p 1
MD =
∆y p
Duration as a weighted average
T
X
D= wt × t
t=1
where wt is the weight of present value of time t cash flows to the total
present value of the bond
Duration of a portfolio:
n
X
D(portfolio) = w i Di
i=1
Immunization
Duration ≈ Price Sensitivity of bond

Immunization ⇒ Targeting duration of the bond portfolio to minimize
interest rate change risk
Pension Funds: ⇒ Liabilities to plan holders at future dates
I Accounting rules (& economics) ⇒ plan liabilities are marked-to-market ⇒
if y ↓⇒ Liabilities ↑
I Why? If you have to pay 110$ in 1 year. If market rate is 10% ⇒ today
set-aside 100$ to meet obligation. If market rate ↓ to 0% ⇒ set-aside 110$
today ⇒ real obligation (liabilities) ↑
I Immunization ⇒ duration of assets ≈ duration of liabilities
I When y ↓ ⇒ ↑ Liabilities = ↑ Assets ⇒ Interest rate risk hedged!
Bonds With Embedded Options
Callable Bonds
Bonds with provision that issues / firm can call-back or early-retire the bonds
Call- Features
I First-Call date: date before which a call can’t be made
I Continuously callable (American) or callable only on certain milestone dates
(Bermudan / European)
I Canary structure: A bond can’t be called after a certain period lapse (opposite
of first-call feature)
Repayment on call-back
I Par value
I Make-Whole Provision: typically a handsome premium is paid
I market price of bonds
Economically
buying a call bond = buying a non-callable bond + shorting call option
Why Callable Bonds?
Callable provision ⇒ firms can exploit changing market conditions to

optimize cost of borrowing!
Interest rate: If ytm ↓, firms retire old bonds (perhaps at par) but issue new
ones at low ytm ⇒ reduce cost for firm for remaining period
Credit Rating: If firm’s credit rating ↑ ⇒ risk-premium ↓ ⇒ retire old and
refinance new at lower ytm
Anticipated tightening in future funding conditions: If firm forecasts that at
the time the bonds mature, the market might be facing liquidity squeeze or
funding shortfall or lack of investor appetite
I ⇒ refinancing in future is uncertain
I imply could be optimal to retire old debt and borrow new debt (with probably
longer maturity) even if little bit costly!
Pricing of Callable Bonds
Duration Uncertainty: Investors accept uncertainty of timing of cash-flow

charge premium or lower price for flexibility they offer to the firm!
Reinvestment Risk Premium: Investors are likely to get paid when ytm is
low ⇒ re-investment scenario is tough for investors
Price(callable) < Price(non-callable)
Price-Sensitivity: If ytm ↓ we know that price of bond ↑. But not so much

for callable bond!
I call-back is more likely
I ⇒ benefit of coupon > ytm is not expected to last
I In other words, cash-flows on callable bonds change for worst when ytm ↓
When ytm ↑ , callable bonds behave much as non-callable
I because they are effectively non-callable when ytm is high enough!
Pricing of Callable Bonds
Data on Callable Bonds and Some research findings
Data on Callable Bonds and Some research findings
Just comparing callable vs non-callable bonds is futile! Companies issuing callable
bonds are different (usually low credit rating) ⇒ the spread could be capturing
credit risk premium rather than call-premium

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Fixed Income Securities

Lecture Note 2: Valuation

Indian School of Business

December 11, 2019

Generalization: For n year ZCB

y is the effective return earned on your investment

Treasury bills are ZCB’s backed by the guarantee of US Treasury

Indian Govt Bonds 91 Day Yield

both effects are manifestation of time value of money!

Example: Coupon bond with 1 year maturity, 9% coupon paid semi-annually.

Maturity face Value ytm % Price

ZCB1 6 Months 4.5 4 4.412613

p (ZCB1) + p (ZCB2) = p (Coupon Bond) = 103.93

Prediction (Yield and Prices)

If bond pays 5% coupon and market yield moves to 6% ⇒ only way

Prediction (Price Convergence)

This is called convexity effect

Prediction (Coupon Effect)

A given change in ytm is proportionally higher relative to low-coupon as

longer maturity ⇒ (coupon − ytm) affects you for long time

Bond investor has three sources of returns (potentially)

Bond: 2 year 8% annual-coupon bond with face value of 100$ is priced at

I substitute y =0.08 and confirm ! Else you root-solver in excel or matlab!

Payoff at t=2 = (8 + 101.88) × (1.06) = 116.472 $

What realised return r2 makes your 100$ at t = 0 grow to 116.472 $ at

Takeaway: If manager is evaluated based on 2 year performance, it was

Point 1: When interest rates change, realised return (r ) 6= ytm

A 5 3 9 second highest ytm

D 8 5 8 Matches the holding period

But how much bond prices move if yield moves?

Approximation: Suppose yield moves by ∆y ⇒

Intuition: Approximation computes average change per unit change in y .

also called as price value of basis-point (PVBP)

% Price change: It’s much better to tell % fluctuation in portfolio value

Shock -0.20 % 0% 0.20 %

your answer = 3.887% × 10 = 38.86%

Correct answer = 46.907%

Why did you make a mistake?

adjustment = 0.01905 × 22 = 7.620%

Combining First-Order and Convexity (Second order):

38.86% + 7.62% = 46.48%

What’s the effective maturity of the bond?

Computation of Duration for 5 year 10% Annual Coupon Bond

Year Cash Flow Cash Flow Weight Weighted by Maturity

150 1.000 4.33

Quizz: Show that Duration of ZCB = Maturity!

Duration ≈ Price Sensitivity of bond

buying a call bond = buying a non-callable bond + shorting call option

Callable provision ⇒ firms can exploit changing market conditions to

Duration Uncertainty: Investors accept uncertainty of timing of cash-flow

Price(callable) < Price(non-callable)

Price-Sensitivity: If ytm ↓ we know that price of bond ↑. But not so much

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