Bond Basics

Contents
Bond Examples Yield to Maturity Price Risk Versus Reinvestment Risk Duration Risk Measures

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Bond Examples
Joe Troccolo, Financial Markets Education

What is a Bond?
Security that represents a loan Way for corporations, banks, governments and others to borrow
money

The borrower (issuer) is obligated to pay interest to the investors The borrower is also obligated to pay back the amount borrowed Important aspects of a bond:

cash flows price currency credit quality

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Bond Examples

Bonds
....

periodic cash flows repayment of principal

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Example
XYV corporation wants to borrow EUR100 million for 5 years XYV issues (sells) a bond that promises to pay:

EUR 8 million in interest on 15 February every year for 5 years EUR 100 million on 15 February 5 years from now

When the bond is first sold the investors pay (collectively) EUR 100
million for the bond

Each investor only buys a part of the bond Later the bond may trade for more or less than when it was issued

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Bond Terminology
Face Value Price Coupon Rate Coupon Period Coupon Date Maturity

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Example

US Treasury 7 1/4s May 16 Coupon is semiannual May 15, November 15 Maturity May 15, 2016 Bond was issued in May 1986 Price: 114 18/32 on October 20

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Invoice Price

Bond buyer pays price plus accrued interest Price + Accrued interest : Dirty price (Invoice price)

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Accrued Interest on US Treasury Bonds

Actual/Actual basis Accrued interest on 7 1/4s May 16 20 October

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Accrued Interest Example I

May 15 Oct 20 Nov 15

Coupon interval: 184 actual days Time from last coupon: 158 actual days Accrued interest 7.25 x 158 = 3.1128 2 184 Invoice Price: 114.5625 3.1128 117.6753
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Eurobond
Province of Quebec 5.25% 7 July 2004 Currency 500 Million SEK Price: 99.7500 on 16 October Coupon is annual Paid 30/360
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Accrued Interest Example 2

Settlement Date: October 16 30/360 days from 7 July = 99 Accrued Interest: 5.25 x 99/360 = 1.4438 Invoice Price: 99.7500 1.4438 101.1938

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Summary
Bonds are issued by corporations and governments to borrow
money

To an investor a bond is a series of promised cash flows The defining characteristics of a bond are:

face amount coupon rate coupon date maturity date

The buyer of a bond pays the market price plus accrued interest

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Yield To Maturity

Bonds and Cash Flows

You own a bond that will pay you:

1000 in one year 1000 in two years 1000 in three years 1000 in four years 11000 in five years

You may have paid

10000 for the bond 9000 for the bond 11000 for the bond

You get the same cash flows, whatever you paid!

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Bonds - Yield to Maturity

A bond is a series of cash flows The price of the bond is the price of the cash flows so The price of the bond is the sum of the present values of the cash
flows

We can observe the market price and we know the cash flows so
there must be an interest rate that equates them.

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Yield To Maturity
The single discount rate that equates the net present value of the
bonds cash flows to its price.

How do we calculate the price given the yield? How do we calculate the yield given the price?

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5 Year Bond with 10% Annual Coupon and Yield = 10%

Price = 10 + 10 + 10 + 10 + 110 2 3 4 5 1.10 (1.10) (1.10) (1.10) (1.10) Price = 9.091 + 8.264 Price = 100.00 + 7.513 + 6.830 + 68.30

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Cash Flows for 5 year Bond 10% coupon

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Present Value of Cash Flows with YTM = 10%

9.09

8.26

7.51

6.83

68.30
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Yield and Coupon

When the price of the bond is 100 then the YTM = Coupon rate If the price of the bond is 100, the bond is called a par bond Terminology:

Price > 100: the bond is a premium bond or is trading at a premium Price < 100: the bond is a discount bond or is trading at a discount

Coupon is determined by the interest rate level when the bond is

issued

YTM is determined by the current interest rate level

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Example
A bond with 5 years to maturity has a coupon of 7% The current level of rates is 10% What is the bonds price? We need to discount the cash flows at 10%

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PV of Cash Flows: 5 Year 7% bond with YTM = 10%

6.36

5.79

5.26

4.78

66.44
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Example
A 3 year bond has a coupon of 6%, paid semi-annually Current interest rates are 5% We need to discount the cash flows using a 5% semi-annual rate.

3 3 3 3 3 103 + + + + + 2 3 4 5 1.025 1.025 1.025 1.025 1.025 1.0256

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3 year semi-annual bond 6% coupon YTM = 5%

3 3 3 3 3 103 + + + + + 1.025 (1.025) 2 (1.025) 3 (1.025) 4 (1.025) 5 (1.025) 6

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Bond Pricing Formula

c c c 100 100 100 + 100 n + n +L+ n Price = r r 2 r nt 1+ (1 + ) (1 + ) n n n

c = coupon rate r = yield to maturity n = coupon frequency t = years to maturity
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Price and Yield

price of 10% semiannual bond 300.00 250.00 200.00 Price 150.00 Par 100.00 Discount 50.00 0.00 10 13 16 19 22 25 Yield 28 1 4 7

Premium

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Example: Yield from Price

If a 4-year 10% annual coupon bond is priced at 105, what is its yield? Yield 9% 8% 8.5% 8.45% 8.47% Yield = 8.4744%
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Price 103.24 106.62 104.91 105.08 105.02

Summary
A bond is a series of cash flows We can observe cash flows and we can observe the price the bond
is trading for in the market

The yield to maturity is the interest rate that equates the price of
the bond with the sum of the present values of the cash flows

The coupon rate is an obligation of the issuer The market price is what the market will pay The yield to maturity is a mathematical concept not a promise!

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Price Risk and Reinvestment Risk

Bonds: Price Risk versus Reinvestment Risk

9 All yields are 8% 8 7 time to maturity Buy 20 year annual 8% bond for par.

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Scenario 1

Yields move to 9% 9 8 Bond Price = 90.87 7 Lose = 9.13% time to maturity

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Scenario 2

Yields move to 7% 9 8 Bond Price = 110.59 7 Gain = 10.59% This is price risk time to maturity

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Scenario 1 (again)

Yields move to 9% 9 8 7 time to maturity We hold the bond to maturity (20 years) and reinvest all the coupons at 9% Return = 8.48%
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Scenario 2 (again)
9 8 Yields move to 7% 7 time to maturity We hold the bond to maturity and reinvest all the coupons at 7% Return = 7.54% This is reinvestment risk
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Holding Period
Holding Period = amount of time the investment is held. During the period, proceeds are reinvested. At the end the investment is sold at the current yield or matures.

Holding Period 1 year 5 years 10 years 20 years

Reinvestment Rate 7 8 9 18.34% 8.00% -0.95% 9.18% 8.08% 7.54% 8.00% 8.00% 8.00% 6.93% 7.96% 8.48%
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Duration
If the bond is held for 10 years, its holding period return will be
about 8%, under all three scenarios

10 years is the bonds duration Duration is the point where price risk = reinvestment risk Bond managers attempt to immunise their portfolios by
adjusting the duration

View: increase in rates

shorten duration

View: decrease in rates:

lengthen duration

Immunise: protect against changes in interest rates

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Risk Measures for Bonds

Joe Troccolo, Financial Markets Education

Risk Measures
Modified Duration Duration and Delta Convexity and Gamma

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Price Change and Yield Change

Price

Change in P = dP

Change in yield = dr Yield

dP is the change in price for a change in yield dr

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Delta

Price Delta = the amount the bonds price changes if the yield changes by 1 basis point = price value of a basis point

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Example: 20 year 8% semi-annual bond

Yield 8.99% 9% 9.01%

Price 90.885 90.800 90.714

Price Delta = = (90.714 - 90.885)/2 = -.0855

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Calculating Delta
1 1 dP D =P dr 1+ r
D mod 1 = D 1+ r

D = Macauleys Duration

Modified Duration dP is change in price dr is change in yield

dP = P D mod dr

Price Delta -P Dmod

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Delta and Duration

dP = P D mod dr
In the example Dmod = 9.41 P = 90.80 dr = .0001 dP = -90.80 x 9.41 x .0001 = -0.085

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Price Delta is not constant!

At higher yields a bond is less sensitive to a change in yield Yield 9% 11% Price 90.80 75.93 Dmod 9.41 8.48 pvbp -0.085 -0.064

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Delta at Different Yield Levels

Price

dP dP dr dr Yield

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Gamma
Since = - P Dmod

An increase in yields lowers both Price and Duration. The change in (due to yield changes) is called gamma. = change in delta (due to yield changes)

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Duration and Convexity

As yield changes duration changes. The change in duration (due to yield changes) is called
convexity.

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Gamma and Convexity

Example: Yield 8% 7.90 8% Price 100 101 20 year semiannual bond Duration 9.90 9.95 Delta -.0990 -.1005

For a 10 basis point change in yield: = .0015 Convexity = .05

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Summary
Fixed Income investments are exposed to risks A primary risk is the change in value due to changes in the level of
interest rates

The price value of a basis point measures how much the value will
change for a one basis point change in yield

pvbp is called a bonds delta The change in delta is called gamma and measures how the price
risk of the bond changes as yields change parallel fashion

All of these risk measures have assumed that yields move in a More sophisticated methods use models of the yield curve
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