TUTORIAL 3: BONDS/FIXED INCOME SECURITIES

1) Define Yield to Maturity (YTM). Explain the importance of YTM and why it is less
practical to use YTM for the valuation of bond in a callable bond?

 Yield to maturity (YTM) is defined as the indicated (promised) compounded rate of return an
investor will receive from a bond purchased at the current market price and held to maturity.

 The importance of YTM is for the bond valuation where it is used in calculating the bond
price based on the current interest rate and held until maturity. Investors invest on the basis of
promised yields (i.e. YTMs), reflecting current conditions in the market place.

 It is less practical to use YTM in a callable bond because it assumes that all interest income is
reinvested at rate equal to market rate at time of YTM calculation, and no reinvestment risk.
However, for non-callable bond, it has no reinvestment risk, and YTM is appropriate instead
of Yield to Call (YTC).

2) Given two bonds with identical risk, coupons and maturity date, with the only difference
between the two beings that one is callable, which bond will sell for the higher price?
 The noncallable bond will sell at higher price. If interest rates on two bonds are the
same, the callable bond usually has a lower market price than the non-callable bond,
which boosts its effective interest rate.
 Callable bonds usually include a call date as part of the bond agreement.
 Issuers cannot call the bond until the call date. Investors need to be wary of callable
bonds that are close to their call dates; if market interest rates are lower than the
bonds’ interest rate, it will be to the bond issuer’s advantage to call the bonds as soon
as possible.
I. Non- callable:
 higher price
 Because it doesn’t have reinvestment risk so can sell at higher price
II. Callable
 higher risk
 there is chances that it will be called back , so should sell at lower price

 The callable bond will sell for the higher yield (Lower price). Investors should
receive some compensation for the risk that the bond will be called away. Callable
bond usually sell at lower price/higher yield to compensate the investor for the
reinvestment risk.

3) Define two characteristics of a bond that determine its reinvestment rate risk?
 Maturity of the bond. Other factors remaining the same, a bond with a higher maturity will
have higher reinvestment risk. This is because the interim coupon payments need to be
reinvested for a longer period of time to realize the YTM. We can say that it is difficult to
 rely on YTM for long-term bonds to measure earnings potential especially if the investor
wants to hold the bond till maturity.
 Coupon rate. Other factors remaining the same, a bond with a higher coupon will have the
higher reinvestment risk. This is because higher dollar amount needs to be reinvested to
realize the YTM. This again may not always be possible.

4) Explain the conditions that affect the bond to be sold at premium or discount.

• When the terms premium and discount are used in reference to bonds, they are telling
investors that the purchase price of the bond is either above or below its par value.

• Premium bond has a market value that is above par value. It occurs when market
interest rates are below bond’s coupon rate. (C > I)

• Eg : Buy at RM1200 and sell at RM1000 (but receive higher coupon)

• Discount bond has a market value that is below par value. It occurs when market
interest rates are above bond’s coupon rate. (I > C)

• Eg : Buy at RM1000 and sell at RM1200 ( but receive lower / zero coupon)

• For example, a bond with a par value of $1,000 is selling at a premium when it can be
bought for more than $1,000 and is selling at a discount when it can be bought for
less than $1,000

5) What is the value of a zero-coupon bond paying semiannually that matures in 20 years,
has a maturity of $1 million, and is selling to yield 7.6%? (CFA Question)

Use TVM on Calculator;

N = 20 x 2 = 40
I = 7.6%
PMT = 0
FV = 1,000,000
PV = $224,960.29

6) Suppose a 10-year 9% coupon bond is selling for $112 with a par value of $100. What is
the current yield for the bond? What is the limitation of the current yield measure? (CFA
Question)

Current Yield = Annual interest income / Current market price of the bond

= (9%X100) / 112

= 0.0804 @ 8.04%
Limitation:

 Suitable for short-term because ignoring the time value of money

 -Only considers coupon interest
 -ignores any capital gain or loss (a capital loss of $12 for the bond in our example),
 -ignore reinvestment income.

7) Determine whether the yield to maturity of a 6.5% 20-year bond that pays interest
semiannually and is selling for $90.68 is 7.2%, 7.4%, or 7.8%. (CFA Question)

Coupon =6.5%
Compounded Semiannually
Coupon PMT = 3.25% X 100 = 3.25
N = 20X2 = 40
PV = 90.68

When the rate is 7.2%;

PV = 92.64
PMT = (6.5/2) = 3.25
FV = 100
Rate = 7.2
Period = 40
*When the rate is 7.2%, the bond price is $92.64. (THIS IS NOT THE ANSWER)

When the rate is 7.4%;

PV = 90.68
PMT = (6.5/2) = 3.25
FV = 100
Rate = 7.4
Period = 40
*When the rate is 7.4%, the bond price is $90.68. (ANSWER)

When the rate is 7.8%;

PV = 86.94
PMT = (6.5/2) = 3.25
FV = 100
Rate = 7.8
Period = 40
*When the rate is 7.8%, the bond price is $86.94. (THIS IS NOT THE ANSWER)

FV (par value) = 100 (can assume it is 100)

*If ques said the bond selling at 968 then can assume FV = 1000
8) What effect does the use of semiannual discounting have on the value of a bond in
relation to annual discounting?

 If a bond pays coupon interest semiannually instead of annually, it will compound interest twice
rather than once, increasing total bond returns at the end of a year.
 Part of the bond return is also a reflection of the price paid at purchase.
 Depending on market interest rates, bond prices can be lower or higher as a result of payment
frequencies.

9) Explain the term “bond immunization” and how can it reduce the interest rate risk.

 Strategy to derive a specified rate of return regardless of what happens to market interest rates
over holding period.
 Seeks to offset the opposite changes in bond valuation caused by price effect and reinvestment
effect. If interest rate goes UP, Reinvestment risk UP while prices of the bonds DOWN. In
contrary, if interest rate goes DOWN, reinvestment risk DOWN while price of bonds Increases.
 EG: Interest Increases, Bond price will decrease (-ve), Reinvestment opportunity(+ve)
 Bond immunization occurs when the average duration of the bond portfolio just equals the
investment time horizon.
 By retiring the bond at the duration can lower the risk of interest changes as compare with it held
to maturity and it is sufficient to offset the true cost of the bond.

10) A 10-yr bond is paying 8% coupon compounded annually, with a par value of RM1000.
If it is yield at 6%, estimate the followings:
a. duration of the bond

Using TVM Calculator; Using Bond Duration Calculator;

PV= 1147.20 (bond price) Coupon rate = 8%
PMT = 8%X1000 = 80 N=10
FV = 1000 r=6%
FV=1000
Rate = 6
Bond Duration = 7.45 years
Period = 10
Compounded annually

b. the changes of price for a 25 basis point changes in interest rate

Modified Duration
 = (Macaulay) Duration in Years / (1+ Yield to Maturity)
= 7.45 / (1+0.06)
= 7.03

Percentage changes in Bond Price

= -1 X Modified Duration X Changes in Interest rates
= -1 X 7.03 X 0.25%
= -1.76% X 1147.20 = RM 20.19
 When the interest rate increases by 0.25%, the price decreases by RM 20.19.

11) Calculate the price of a 30-year bond with 7% coupon rate which is callable in 5 years at
a price of RM1,030. Assume that the yield to call is 7% and coupon payments are made
semi- annually.

Using TVM Calculator;

PV= RM 1,021.27 (bond price)
PMT = (7%/2)X1000 = RM 35
FV = RM 1030
Rate = 7
Period = 5X2 = 60
Compounded semiannually