Amortizing Bond , Callable Bond

Prof(Dr.) Harsh Vardhan

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 Amortizing Bond
 A plain vanilla Bond also known as a Bullet Bond as it pays the entire
face value back at maturity.
 However, an Amortizing Bond repays the face value in installments
with last installment being paid at maturity.
 Since the outstanding principal declines with each repayment so will
coupon.
 Therefore from the perspective of an investor the default risk is less
than that of a plain vanilla bond because in an amortizing bond some
principal would have been recovered even if there is subsequent
default.
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 Example

 Consider a four year amortizing Bond which repays the face value in four
equal installments.
 The face value is ₹ 1,000 & coupons are paid annually at the rate 6% per
annum.
 If the YTM is 8% per annum ,the price may be computed as given in the next
slide.

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An Amortizing Bond

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 Analysis
 The first principal installment is ₹ 250 which is paid at the end of the
first year.
 Interest for the first year is ₹ 60 which is 6% of the outstanding
principal at the start of the year.
 The principal repayment at the end of the second year is once again
₹ 250 .However ,the interest for the second year is 6% of ₹ 750 which
is the outstanding principal at the start of the second year.
 Consequently the cash flow at the end of year two is ₹ 295.
 Using the similar logic the cash flow at the end of third year is ₹ 280
while terminal cash flow is Rs 265.
 Price of the Bond is ₹ 957.0079

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 The Pull-to-Par Effect
 The price of a premium bond is greater than the face value, whereas
that of a discount bond is less than the face value.
 At maturity all bonds trade at par.
 A par bond will trade at par on every coupon rate no matter how
many coupons are left till maturity.
 In the case of premium bonds, however the price will be higher than
the face value prior to maturity, and hence as one approaches
maturity ,it will gradually decline and will reach par.
 For a discount bond ,the price will be lower than the par value prior
to maturity and hence as one approaches maturity ,it will gradually
increase and will reach par.
 This phenomenon is known as pull-to - par effect
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 The rationale of this phenomenon is as under:
 When one moves from one coupon date to the next coupon date ,we
have one coupon less .Thus the contribution of coupons to the price
goes down, leading to a decline in the price.
 However ,the present value of the face value increases because the
face value is discounted for one period less. This leads to increase in
the bond price.
 For premium bonds, the first effect dominates , and the price steadily
declines as we go from one coupon date to the next.
 In the case of discount bonds, the second effect is more significant
and the bond price steadily increase.
 For par bonds, the two effect neutralize each other and there is no
change in the bond price which continues to remain at par.

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 Example
 Consider two bonds with three years to maturity and a face value Rs
1,000.
 Assume that the coupon for the first Bond is 8% per annum and YTM
is 10% per annum. The Bond will obviously sell at discount.
 For the second bond ,let Coupon is 10% per annum and YTM is 8%
per annum. This Bond will trade at premium

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 Callable Bond
 A Callable Bond (also called redeemable bond) is a type of bond that allows
the issuer of the bond to retain the privilege of redeeming the bond at some
point before the bond reaches the date of maturity.
 In other words, on the call dates, the issuer has the right, but not the
obligation, to buy back the bonds from the bond holders at the call price.
 Technically speaking, the bonds are not really bought and held by the issuer
but cancelled immediately.
 Call price will usually exceed the par or issue price. In certain cases, mainly in
the high-yield debt market, there can be a substantial premium.

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 The issuer has an option, for which he pays in the form of a
higher coupon rate.
 If interest rates in the market have gone down at the time of the call
date, the issuer will be able to refinance his debt at a cheaper level and
so will call the bonds.
 Another way to look at it is that as interest rates have gone down, the
price of the bond has gone up. Therefore, it is advantageous to buy the
bonds back at the par value.
 The investor has the benefit of a higher coupon than he would have had
with a straight, non-callable bond. On the other hand, if interest rates go
down, the bonds get called, and he can only invest at the lower rate.

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 Yield to Call

 Some Bond carry a Call feature that entitles the issuer to call(buy back ) the
bond prior to the stated maturity date in accordance with call schedule YTC is
value r such that
P = C x PVIFAr,n* + M *x PVIFr,n *
Where C = annual interest, M* call price, n* number of years until assumed
call date.
 For calculating the Yield to Call, the call period would be different from the
maturity period and the call (or redemption) value could be different from
the maturity value.

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 Example-6(HW)
 Example: Suppose the 10% 10-years ₹ 1,000 Bond [C=100] is
redeemable (callable) in 5 years(n*) at a call price(M*) of ₹ 1,050.
The bond is currently selling for ₹ 950(P).
 P = C x PVIFAr,n* + M *x PVIFr,n *
5
100 1, 050
950   
1  YTC  1  YTC 
t 5
t 1

 The Bond’s Yield to Call (YTC)is 12.18%.(Verify it)

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 Yield to Call
 Certain Bonds are callable , that is they may be recalled by the issuer
prior to maturity.
 In practice a call premium equal to six month’s of coupon , or even one
year’s worth of coupon, may be paid a call premium.
 The Yield to Call [YTC] is that discount rate that makes the present value
of all cash flows till the call date equal to the dirty price of the bond.
 It can be computed using the RATE function.

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 Example-7
 A Bond with eight years to maturity is callable after five years. The
face value is ₹ 1,000,the coupon rate is 6% per annum. And YTM is
6.8% per annum.
 The Bond will pay six months coupon as a call premium if called
What is the yield to call(YTC)?

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 Ans

 The first step is to find the price using the PV function:

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 Yield to Call
Yield to Call
Face Value 1,000
nper 8
Coupon 6%
Rate 6.8%
Call able 5 years
Price of Bond ₹ 951.26 PV(B5/2,2*B3,-(B4*B2)/2,-B2)
3.8480% RATE(B6*2,-(B4*B2)/2,B7,-1030)
YTC= 7.6961% 2*RATE

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 Dirty Price of a Bond
 A dirty price is a Bond pricing quote which refers to the cost of a
Bond that includes interest based on coupon rate.
 Bond price quotes between coupon payment dates reflects accrued
interest up to the day of quote.
 In short ,a dirty bond price includes accrued interest while a clean
price doses not.
 Dirty Price of the Bond =Accrued Interest +Clean Price.
 The net present value of the cash flows of a bond added to accrued
interest provided the value of Dirty price.
 The accrued interest =(Coupon rate x elapsed days since last paid
coupon )/Coupon Day Period

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Thanks

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