Security Analysis & Portfolio Management

Professor J P Singh
Department of Management Studies
Indian Institute of Technology, Roorkee
Lecture 11
Yield To Maturity I

Welcome back, so before we continue, a quick recap of where we were last time, with respect to
bond analysis.

(Refer Slide Time: 00:36)

We defined a bond as a legally binding agreement between the borrower, who is the bond issuer
and a lender who is the bond holder. This agreement specifies the principal amount of the loan
and the size and timing of the cash flows that are to arise on account of interest and the
repayment of principle.

This cash flow interest payments may be defined at a fixed rate or with reference to another
variable like LIBOR or MIBOR etc. (in which case the bond is called a floating rate bond). If the
interest rate is fixed then the bond is called a fixed rate bond.
(Refer Slide Time: 01:29)

Now, some terminology, maturity is the point in time at which the bond matures for the
repayment of principal. The time remaining from today up to the maturity date of the bond is
called its term to maturity".

The face value is a very important concept. It is the notional value or nominal value of the bond.
It is the value of the bond with respect to which coupon payments are made. In other words, to
arrive at the cash flow on account of the coupon payments, we multiply the coupon rate, which is
given in terms of the percentages, with the face value.

Similarly, the redemption value is also usually expressed in terms of the face value. Either
redemption may be at face value or it may be with reference to the face value at a premium or a
discount. Coupon rate is the contracted rate of interest. Please note this very important
difference. Coupon rate is not the market rate of interest. It is the rate of interest which is given
in the issue document. It is the contracted rate and in the case of a fixed rate security, the coupon
rate will remain fixed over the life of the bond.

The frequency of coupon payments is also specified in the issue document and is singular to the
instrument as is the coupon rate itself. In fact the coupon rate and the frequency of coupon need
to be specified together to arrive at the cash flow pattern arising from the bond.
At a particular point in time, bonds may be selling at a premium (that is above face value) or at a
discount (that is below face value) or they may be selling at par (that is at face value), depending
on the relationship between the coupon rate and the then prevailing market rates of interest.

Bonds may be redeemed at face value, which is usually the case, but not necessarily so. Bonds
can be redeemed at a premium or discount to face value. There are no legal restrictions
mandating the redemption of bonds at face value. Redemption below or above the face valueis
legally admissible. But it is important here to emphasize that whatever the case may be, whether
the bonds are to be redeemed at a premium or a discount, the amount or percentage thereof in
relation to face value needs to be specified in the issue document at the time of issue of the
instruments. In other words, the redemption proceeds need to be unambiguously specified in the
issue document. You cannot have a situation where the redemption value is fixed at a later day
during the life of the bond. It has to be pre-specified in the contract of issue.

Then, we came to a very important concept, that is the concept of intrinsic value. I emphasized
that intrinsic value of security is not only security specific, but it is also investor specific in the
sense that the intrinsic value of an instrument is arrived at by an investor on the basis of a model
chosen by him, (which he deems appropriate for the evaluation of the security being analyzed),
and also on the basis of the inputs that go in to the model as estimated by the analyst or the
investor, as the case may be.

(Refer Slide Time: 04:44)

So the important thing is that intrinsic value is not a market based attribute of a security, it is not
a market based value. It is a value which is computed by reference to a model which the investor
deems to be appropriate and the inputs to this model are also estimated by the investor. So to that
extent intrinsic value is singular to the investor and gives the worth of the security as perceived
by the investor. Of course, then the investor can compare his perception of the value of a
security as encoded in its intrinsic value, with the current market price and take investment
decisions accordingly.

(Refer Slide Time: 05:27)

Then we talked about how the market trades emanate. As I mentioned just now, we have a
comparison between the intrinsic value that the investor obtains and the current market price and
on that basis, the investor identifies mispriced securities and investment decisions follow
thereafter.

(Refer Slide Time: 05:51)

So the key takeaways are, let me read them out. In financial analysis, intrinsic value is the
calculation of an asset's worth based on a financial model, with inputs that are worked out by the
analyst or the investor. By comparing the intrinsic value with the current marker price, mispriced
securities that may constitute potential investment opportunities are identified.

(Refer Slide Time: 06:19)

Then, I talked about the intrinsic value as computed by the discounted cash flow model. As per
the discounted cash flow model, the intrinsic value of a security is the present value of all future
cash flows that maybe attributed to that particular security, discounted at a rate, which is
appropriate to riskiness rather of realizability of the cash flows. So, on the basis of the
assessment or the riskiness of the cash flows, we arrive at the intrinsic value of the securities by
discounting those cash flows at the risk adjusted discount rate. The formula thereof is given right
at the bottom of the slide in the right hand corner.

(Refer Slide Time: 07:17)

Then I discussed in detail the rationale of the DCF model by constructing two portfolios and
invoking the law of one price & arbitrage procedures. Portfolio A comprised of two deposits for
valuation of a two year bond, the first with a maturity of one year and the second with a maturity
of two years. The cash flows from this portfolio were compared with a portfolio that involved a
bond which has a lifespan of two years and which gave cash flow C1 and C2 at the end of year 1
and year 2 respectively. I will not go through it again. You can refer to the previous lecture in
which this was discussed in a lot of detail.
(Refer Slide Time: 07:45)

(Refer Slide Time: 07:53)

Then the above was generalized to the entire life of a T-period security, or a security which
generates cash flows over T periods, and the formula there of is given right in the bottom line of
your slide.
(Refer Slide Time: 08:10)

Then I came back to one particular point and that was the reference to the use of subscripts to
describe interest rates. Why I had used subscripts to describe interest rates? This is because of
the phenomenon which prevails in the interest rate market,and which is termed as the term
structure of interest rates. What this means is that there is functional relationship between the
interest rates and the maturity of the underlying deposits. In other words, if you make a deposit
for six months you will get a particular rate, which may be different from the rates you get on a
deposit for one year or three years.

In other words, the maturity of the deposit has a relationship with the interest rates that we get on
the deposit. Therefore, it is necessary to specify the interest rates that are relevant to a particular
cash flow discounting because the cash flows arise at different points in time. So they need to be
discounted at the appropriate deposit rates for the particular time interval or the time points at
which the cash flows are taking place.
(Refer Slide Time: 09:28)

Let us recap the steps in the evaluation of bonds. (i) Estimate future cash flows. I emphasized
that so far as the estimation or cash flows of a bond security is concerned, it is a relatively easy
exercise because all the information required therefor is encoded in the issue document and we
do not have to look far to arrive at the cash flows that are relevant to a particular fixed income
security. The cash flows are pretty much contractual and are contained in the issue document.
The size of the cash flows as well as the timing of the cash flows are detailed in the document.
The real challenge in the evaluation of bonds lies in the estimation of the risk adjusted discount
rate, because this rate needs to encapsulate the risk profile of the cash flows that are going to
arise out of the contractual obligation arising from the issue of the bond. In other words, it is here
that the possibility of default in the realizability of the cash flows needs to be considered and an
appropriate premium added to the risk free discount rate to arrive at the appropriate rate at which
these cash flows are to be discounted to arrive at the intrinsic value.

I also emphasized at this point that if we use, instead of the inputs determined by the analyst, the
market risk adjusted interest rates for discounting the cash flows arising from the security, we
will get the market price of the security on the left hand side. So if we put in risk adjusted market
rates, we get the market price, and if we put in the risk adjusted investor ascertained rates i.e.
rates based on the investor’s risk return perception, we get the investor perceived value or the
intrinsic value.
(Refer Slide Time: 11:41)

Then I discussed the issue of semi-annual coupons. It is quite straightforward. We double the
number of discounting periods, the nominal interest rate or the coupon rate, as you may call it
and we discounted for double the number of periods. We also half the discount rate because that
is the convention that prevails in the financial bond markets.
(Refer Slide Time: 11:57)

The above is an illustration of how the semi-annual coupons need to be treated. As you can see
here, we are having two coupons payments per year because semi-annual payments are made.
The discount rate is halved and the number of discounting periods is doubled. In essence, we
consider six month period as the unit of time.

(Refer Slide Time: 12:23)

Then, I took up the above example. It is a straightforward example. So I will not repeat the
working. The solution is given on the slide.
(Refer Slide Time: 12:29)

(Refer Slide Time: 12:53)

Now, I reiterate what I mentioned just a few minutes back. Similar to intrinsic value if we use the
appropriate market rates, what will arrive at the market price of the bond. However, at the macro
level, at the level of empirical observation, it is difficult to observe the interest rates which relate
to different maturities in the market. It is more convenient to observe the market prices of
securities. Hence, the principle that I have just elucidated operates backwards. In other words, on
the basis of the market prices which are very easily and very precisely observable quantities, we
work backwards and arrive at the relevant interest rates for various periods of discounting. For
example, by observing the price of the six-month bond i.e. a bond which has a remaining tenure
of six months to maturity, as of today, we can get an estimate of the six month spot interest rate,
prevailing the market. Similarly, by observing the current market price of a bond which has a
maturity of one year remaining, we can arrive at the one year spot interest rate that is prevailing
in the market. So in practice, the principle that is given on the slide operates in the reverse
direction, we first ascertain the price as the market input or as the quantity/ parameter determined
by the market and on that basis we workout the implied market interest rates.

(Refer Slide Time: 14:14)

Let us recap one more thing that I have mentioned just a few minutes earlier. I reiterate this
because this is important. In the case of fixed income bonds, the magnitude of the cash flows is
fixed by the contract of issue. So there is little chance of difference between the market estimate
and the analyst’s estimate or the investor's estimate. Because the magnitude and timing of cash
flows is given in the contract of issue, so whether you do the analysis or I do the analysis or
somebody else does the analysis, he is pretty much going to use the information that is contained
in the contract of issue. Hence, the entire game of mispricings or perceived mispricings by an
investor, rests in the estimation of the discount rate i.e. calculation of the risk adjusted discount
rate. Again the risk free rate is pretty much a universally accepted number. Thus, this analysis
boils down to the fact that it is the perception of risk or the assessment of risk and the subsequent
embedding of that risk in the risk adjusted discount rate i.e. the risk premium that injects
subjectivity into the analysis. We need to add on to the risk free rate, an amount based on our
risk perception to arrive at the risk adjusted rate for discounting the cash flows from the
instrument. Thus, it is the variation of risk premium amongst investors that manifests itself as
perceived mispricings in the market. In other words, if my perception of risk of a particular
security is different or if I ascribed a different risk premium to the riskiness of the realizability of
cash flows of a fixed income security compared to what the collective wisdom of the market
does, then obviously I will end up with a situation where I perceive this security as mispriced and
I may take investment decisions accordingly.

(Refer Slide Time: 16:22)

We, now, work out the value of a discount bond. In the case of a discount bond i.e. a bond that is
issued at a discount and redeemed at a par with no intermediate cash flows, because there is only
one cash flow and that is the face value at the date of redemption of the bond (t=T), the current
market price is the discounted value of that final cash flow at the appropriate risk adjusted
market interest rate. It will be the market rate, if we want to work out the market price or the
investor estimated rate if we want the intrinsic value. Conversely if we know the market price,
we can work out the prevailing market spot interest rate corresponding to the riskiness and the
tenure of the bond. Otherwise, we can also plug in our estimate of the discount rate and arrive at
F
the intrinsic value of the bond V0 = .
(1 + S )
T
0,T
(Refer Slide Time: 17:05)

Now, let us examine a level coupon bond. A level coupon bond is a bond which has a fixed
coupon rate over the life of the bond and redemption usually at face value. In fact most of the
analysis that we are going to do in this particular segment of the course is on the level coupon
bond, unless explicitly specified. So, in the absence of any specification or explicit information,
we will assume that the analysis we are doing is of a level coupon bond. The coupon rate is
fixed, and the redemption is at face value. We also call this bond a plain vanilla bond. Here

T T
Ct 1 F
V0 =  = cF +
(1 + S0t ) (1 + S0t ) (1 + S0T )
t t T
t=1 t=1

The coupon rate is c, the cash flow at time t is Ct, t is an arbitrary point in time and the
summation index, t=T is the bond’s maturity. Because the bond is a level coupon bond with
coupon rate c, each coupon over its life will be Ct = cF . Because the coupon rate is fixed over

the life of the bond, we take it outside the summation. At maturity the bond will be redeemed at
face value F which accounts for the second term. So c applied on the face value F will give the
coupon payment in money terms, which are the cash flow at the coupon payment points, over
the life of the bond. Then, of course, we also have to account for the final payment i.e. the
repayment of principal or redemption value that is assumed at the face value of the bond, which
is given by the second term.
(Refer Slide Time: 18:48)

Now, I will talk about spot rates. It is a very important concept. Spot rates naturally lead us to the
concept of yield to maturity (YTM). What are spot interest rates? Spot interest rates are the
YTMs (yield to maturity) on bonds that pay only one cash flow to the investor. Such bonds are
called zero coupon bonds. So we can say the spot interest rates are the YTMs on zero coupon
bonds i.e. bonds which do not have any coupon payments. Bonds that are either issued at
discount and redeemed at face value or issued at face value and redeemed at a premium. Spot
interest rates are usually calculated and quoted for six monthly intervals, and then annualized by
doubling the six month rate, as we saw in the example that we did a few minutes back.

(Refer Slide Time: 19:51)

We used the expression YTM while defining spot rates. So what is YTM? YTM is the most
important concept that we have in the case of fixed income securities evaluation. Yield to
maturity or YTM is the discount rate that equates the present value of future cash flows from
the instrument to its current market price, including accrued interest.

For the moment let us keep the issue of accrued interest separate to keep exposition tractable,
simple. We shall return to it at a later point in this segment of the course. So, let us assume that
the bond is being valued at one of the coupon payment dates, just after one of the coupon
payments has been made. Hence, in this situation, the yield to maturity is that discount rate
which equates the present value of all future cash flows attributable to that instrument to its
T
Ct
current market pric. P0 =  . P0 is the current market price of the bond, Ct is the cash
(1 + y )
t
t=1

flow arising from holding the bond at time t and y is the YTM of the bond. Clearly in the case of
zero coupon bond or a pure discount bond, because there is only one cash flow and which is at
F
maturity, we will P0 = , where t=T is the maturity of the bond and y is the yield to
(1 + y )
T

maturity of the zero coupon bond or the discount bond.

The rationale of the definition of spot rates in terms of the YTM of zero coupon bonds follows
easily from definition of YTM e.g
 F F
P0 = ( DCF MODEL ) ; P0 = ( DEF of YTM )  S 0T = y .
(1 + S0T ) (1 + y )
T T

(Refer Slide Time: 22:04)

Let us assume that S0T is the current market interest rate relating to a maturity of t=T years, then
F
we arrive on the left hand side is the current market price P0. P0 = ( DCF MODEL )
(1 + S 0T )
T

Also, from the definition of YTM, YTM is that discount rate y, at which the future cash flows
(there is only one cash flow in this case which is the maturity cash flow and face value), when
F
discounted to present value yield the current market price P0, P0 = ( DEF of YTM ) .
(1 + y )
T

The second equation arises from the definition of YTM, the first equation arises from the
definition of the DCF model. If we compare the two, we immediately get is S0T= y> this is what
the definition of spot rates says. Let me read it ones again, spot interest rates are the YTMs on
zero coupon bonds. So that is precisely what we have proved above, the spot interest rate S0T =y
the YTM of this zero coupon bond.

(Refer Slide Time: 23:44)

We, now, address the case of YTM of level coupon bonds.

T
Ct T
cF F T
1 F  ( 1 + y )T - 1  F
V0 =  = + = cF  + = cF  T 
+
(1 + S 0t ) (1 + y ) (1 + y ) (1 + y ) (1 + y )  r (1 + y )  (1 + y )
t t T t T T
t=1 t=1 t=1

cF F  c  c  1 
= + T 
1 -  = F + F  − 1 1 − T
y (1 + y )  y   y   (1 + y ) 

T T
Ct cF F
The equation V0 =  follows from the DCF formula while V0 =  +
(1 + S0t ) (1 + y ) (1 + y )
t t T
t=1 t=1

is obtained from the definition of YTM. The rest is algebraic manipulation using summation of
geometric progressions.
So if we equate the two expressions (DCF & YTM) for P0, we can get a relationship between
the spot interest rates and the YTM in the case of a level coupon bond.

Let us now investigate the relationship between coupon rates and YTM. This is very interesting
and can be done on the basis of the formula that we arrived at just now viz

 c  1  V0 - F  c  1 
V0 = F + F  − 1 1 −  whence =  − 1  1 − T
 y   (1 + y )   y   (1 + y ) 
T
F

 1 
But. 1 − T
> 0 ALWAYS for y > 0 .
 (1 + y ) 

V0 - F  c  1 
So now if we look at equation =  − 1  1 − T
very carefully, we find that the
F  y   (1 + y ) 

 1 
second factor 1 − T
> 0 ALWAYS for y, T > 0 , which is normally the case.
 (1 + y ) 

(Refer Slide Time: 24:53)

  1 
Because 1 − T
> 0 ALWAYS for y, T > 0 , the sign of the left hand side, will be
 (1 + y ) 

c 
determined by whether the first factor that is  − 1  is positive or negative.
y 

c  c 
If  − 1  is positive then left hand side will be positive and if  − 1  is negative, the left
y  y 
hand side will be negative. What does this mean? It means that if c>y, that is, the coupon rate
is greater than the yield to maturity, V0>F and bond will trade at a premium, and if c<y then
V0<F and the bond will quote at a discount. And, of course if c=y then the right hand side
becomes 0 and therefore V0=F or the bond will be quoting at par. So this is a very important
information, that depending on the relationship of the coupon rate with the YTM, we can arrive
at whether the bond should technically quote at a premium, par or a discount.

(Refer Slide Time: 27:11)

Now we will talk about the sources of return that are generated on a fixed income security.

(i) First and the most obvious is the coupon income i.e. the income that arises out of
contractual cash flows that are paid on account of interest when a person takes up a long
position in the bond, that is, he buys a bond. When an investor invests in a bond, he is
 entitled to coupon payment, during the life of the bond as per the terms of the issue
contract.

(ii) If the coupon payments are reinvested by the investor, he gets interest on interest which
constitutes reinvestment income. Suppose you invest in an annual coupon bond at t=0,
say with an investment horizon of five years. You will receive the first coupon payment
at the end of year t=1. You can reinvest this coupon for the next four years and receive
interest on the reinvestment. Similarly, the coupon received at t=2 years may be
reinvested for 3 years etc. The interest that aries on account of the reinvested coupons is
called reinvested income. You would not like to keep the coupon interest idle. A rational
investor would either leave the money in his deposit account or he would invest the
money somewhere else. So the return that he would get by reinvesting the coupon
payment is called the reinvestment income. This is the interest on interest component,
you receive the interest, you reinvest the interest and you receive interest on the
reinvested interest. So this is the second component of return that you get.

(iii) Then there is the issue of capital gains. In the event that you do not hold the bond to its
date of maturity, you would sell it off in the market to recover the current value of the
bond, as on the date that you decide to exit the investment. In that case, of course, it is the
market price which will be a factor in determining the overall return, that you are going
to get. The market price could be higher or lower than the carrying value of the bond at
that time point in time, and correspondingly you would get a capital gain or a capital loss.
If you sell the bond a price in the market higher than the carrying value of the bond in
your books, you will get a capital gain and vice versa.

What is carrying value? It is defined in this slide.

(Refer Slide Time: 29:53)

The carrying value is defined as the amortized value. I will come back to this again in a later
slide and explain how this carrying value is calculated with an example, but for the moment let
us stick to the definition. The carrying value is the amortized value on the date of sale, calculated
at the YTM at which the bond was purchased. In other words, it is the amortized value which is
in your books, provided that amortized value is calculated on the basis of the YTM, at which you
had purchased the bond.

So, if your selling price is higher than the carrying value, you make a capital gain and if your
selling price is lower than the carrying value, you make a capital loss.

So there are three sources of income, (i) the coupon income, (ii) the interest on interest or the
interest on reinvested coupons and (iii) the capital gains that is the difference between the selling
price and carrying value.

If you hold the bond for a period less than its maturity, then the difference between the market
price i.e. the price at which you exit the investment, and the amortized value or the carrying
value of the bond will constitute the capital gain or capital loss.

Now, I will talk about the measures of yield. I have just talked about the sources of income on
the security. I will now talk about the measures of yield.
(Refer Slide Time: 31:28)

(i) First is the nominal yield, that is the coupon rate, so nothing much to say about that.

(ii) The current yield measure is defined as the ratio of the aggregate of coupons over the
year (the total coupons that are paid during the year) divided by the current market price
of the bond.

(iii) We shall talk about yield to maturity again in a few minutes,

(iv) Holding period yield, I introduced in the context of money market instruments in a
previous lecture. I shall be talking more about this.

(v) Annualized holding period yield. Then we have annualized holding period yield which is
the same as the effective annual yield EAY

(vi) Then we can also have the yield to call, yield to put if the bond has the properties of
having a callability option or a puttability option.

We shall continue after the break, thank you.