Summary Sheet – Helpful for Retention

For
Bonds(Basics + Advanced)

Important Points

1. This Summary Sheet shall only be used for Quick Revision after you have read the
Complete Notes

2. For Building Concepts along with examples/concept checks you should rely only on
Complete Notes

3. It would be useful to go through this Summary sheet just before the exam or before any
Mock Test

4. Questions in the exam are concept based and reading only summary sheets shall not
be sufficient to answer all the questions

1 Summary Points

➢ A Bond is a financial debt instrument used to raise money by the issuer of the bond (e.g.
Companies, sovereign government, states, etc.) from the lenders (e.g. retail investors,
institutional investors, etc.) who invests in it to earn regular interest payments at a
predetermined rate (coupon rate) and schedule until the date of the maturity of the bond
when the initial borrowed amount (face value) is repaid by the issuer.

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 ➢ Basic Comparison between Debt and Equity

Debt Equity
Denotes funds owned by the company Denotes funds raised by the company by
towards another party issuing shares
Are Loan funds of the issuing entity Are Own funds of the issuing entity
Reflects Obligation Reflects Ownership
Holders of the instrument are the Holders of the instrument are the Proprietors
creditors/lenders
Types are term loans, debentures, bonds, etc. Types are Shares and Stocks
Only predetermined Interest is earned by the Dividends and any profits earned
holder
Fixed and regular returns Variable and irregular returns
Collateral is essential to secure loan but funds Collateral not required
can be raised otherwise too depending on the
credit rating of the issuer
Less Risky High Risk factor comparatively
Gets primary claim on assets in case of In case of liquidation of company, equity
bankruptcy holders are paid at last after payment of all
liabilities

➢ Characteristics of Bonds

Example: Company XYZ issues Rs. 1000 bonds which give a coupon rate of 10% per annum. The
bonds are issued on 1st January 2017 and the duration is 10 years with the maturity date as 1 st
Jan, 2027

✓ Face Value/ Par Value/ Principal: Denotes the amount of money a holder gets after
the bond matures. In above example, Rs. 1000 is the face value.
✓ Coupon/ Interest Rate: Denotes the amount that bond holder receives as interest
payments at a certain rate at regular interval. It can be paid monthly, quarterly or
yearly depending on the bond. Depending on interest rates, there can be two types
of bonds i.e., fixed-rate bond (interest rate is fixed) and floating-rate bond (flexible
interest rate that is marked to market rates through an index). In above example, it is
10%.
✓ Maturity: Denotes date in the future on which the investor's principal amount is
repaid. In above example, maturity is in 10 years.
✓ Issuer: Denotes the entity that borrows money or issues bond to raise funds. In above
example, Company XYZ is the issuer.
✓ Bond Price: It is different than the face value of the bond. It denotes the present
discounted value of future cash streams generated by the bond. This computed value

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 represents price of the bond which keeps on fluctuating on daily basis depending on
the supply and demand at any moment. Bond Price is dependent on the prevailing
interest rates in the market depending on which it can either sold at premium or
discounted rate.

✓ Yield: Represents the returns earned on a bond. Formula for Yield is:

Yield = Coupon amount/Price

✓ Yield to Maturity: Denotes total internal rate of return of an investment in a bond if

the investor holds the bond until maturity and if all payments are made as scheduled.
✓ Relationship between Bond Price, Yield and Interest Rate
✓ Price of bond is inversely related to Interest Rates
✓ Price of Bond is inversely related to yields
✓ Yields are directly related to Interest Rates

➢ Government Bonds: Marketable securities issued by any sovereign government such as

treasury bills (maturity in less than a year), treasury bonds (maturity in more than 10 years)
and treasury notes (maturity in 1 to 10 years). Generally considered extremely safe
instruments to invest with few exceptions (in case of developing countries).
➢ Corporate Bonds: Represent bonds issued by the corporate sector in the economy. Tend to
give higher yields as there is a higher risk of a company defaulting than a government. Yields

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 are dependent on the credit rating of the company bonds. Higher the credit rating lesser the
yield provided and vice-versa.
➢ Zero Coupon Bonds: Denotes debt security that doesn’t pay interest( coupon payments ) but
is traded at a deep discount, rendering profit at the maturity when the bond is redeemed at
its full face value

➢ Perpetual Bonds (Consol or prep): Represents bond with no maturity date where issuers
pay coupon payments regularly and do not have to redeem the principal. The formula for
the present value of a perpetual bond is:

Present value = D / r

Where:

D = periodic coupon payment of the bond

r = discount rate applied to the bond

➢ Bond Type Specifics: Complex Bonds get classified depending on its type of issuer, priority,
coupon rate, and redemption features
✓ Bond Issuer: Credit quality of a bond determines the risk factor inherent in the bond.
Bonds can be issued by corporate as well as government in which case government
bonds are less risky
✓ Bond Priority: Priority indicates your place in line should the company default on
payments. This can be unsubordinated (senior) security i.e. first in line to receive
payment if company goes into liquidation and subordinated (junior) debt security i.e.
after senior debt holders get paid
✓ Coupon Rate: Depending on the coupon rate applied bonds get distinguished. These
can be fixed- rate bonds, floating rate bonds, inverse floater bonds (variable coupon
rate that changes in direction opposite to that of short-term interest rates) and zero
coupon bonds
✓ Redemption Features: Based on redemption features bonds could get further
classified. Following can be three types:
• Callable or a redeemable bond: Gives the bond issuer the right but not the
obligation to redeem their issue of bonds before the bond’s maturity date
• Convertible bonds: Gives bondholders the right but not the obligation to
convert their bonds into a predetermined number of shares at predetermined
dates prior to the bond’s maturity
• Puttable bonds: Gives bondholders the right but not the obligation to sell their
bond back to the issuer at a predetermined price and date
➢ Bond Pricing Formula:

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 Where, C = Coupon payment

N = number of payments,

I = interest rate or required yield,

M = value at maturity or par value

➢ Example: Calculate the price of a bond with a par value of $1000 to be paid in 10 years, a
coupon rate of 10%, and a required yield of 6% where coupon payments are made annually,
semiannually and quarterly.
Solution:
Case 1: Annually

C (Coupon Value) = 100

N (Number of periods) = 10

i (Current yield) = 6%

M (Matuity Value) = 1000

Bond Price = 100 * [1- (1 / (1+.06) 10] / .06 + 1000 / (1+.06) 10

= 1294.05

Case 2: Semiannually

C (coupon Value)= 50

N (Number of Periods)= 20

i(Current Yield) = 3%

M (Maturity Value)= 1000

Bond Price = 50 * [1- (1 / (1+.03) 20] / .03 + 1000 / (1+.03) 20

= 1297

Case 3: Quarterly

C (coupon Value)= 25

N (Number of Periods)= 40

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 i(Current Yield) = 1.5%

M (Maturity Value)= 1000

Bond Price = 25 * [1- (1 / (1+.015) 40] / .015 + 1000 / (1+.015) 40

= 1299.1

➢ Bond Pricing Formula of Zero Coupon Bonds:

Where, n = number of payments

i = interest rate or required yield

M = value at maturity or par value

➢ Example: Calculate the price of a zero-coupon bond that is maturing in 5 years, has a par
value of $2000, and a required yield of 8% when coupon payment is made annually and
semiannually.

Solution: Case 1: Annually

n=5

i = 8% or .08

M = 2000

Bond Price = 2000 / (1+.08) 5

= 1361

Case 2: Semiannually

n = 10

i = 4% or .04

M = 2000

Bond Price = 2000 / (1+.04) 10

= 1352

➢ Yield to Maturity Formula for bonds:

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 ➢ Example: Calculate the yield to maturity of a bond with a par value of $1000 to be paid in ten
years, a coupon rate of 10%, and a current bond price of 1297 where coupon payments are
made semi-annually
Solution: Coupon Interest = Coupon rate is 10% but since Coupon payment is semi-annual so
it would be 5% of 1000 = 50
Face Value = 1000

Marker Price = 1297

n = 10 years but since its semiannual payment so periods become 10*2 = 20

Putting the values in Formula we get

YTM = (50 + (1000-1297)/ 20) / (1000+1297) / 2

= .03 or 3%

Since above yield is semiannual so annual yield is 3 *2 = 6 %

➢ Formula for calculating Yield for Zero-Coupon Bonds:

i (Yield) = (M / Bond Price) 1/n – 1

Where n = number of payments

i = interest rate, or required yield

M = value at maturity, or par value

Bond Price is the purchase price of Bond

➢ Example: Determine the yield of a zero-coupon bond that is maturing in five years , has a par
value of $2000, and a price of a bond is 1352 where the coupon payment is Semi-Annually

Solution: i = (2000/1352) 1/10 – 1

i = 4%

But since the payments are made semi-annually, hence the annual yield is i * 2 = 4 * 2 = 8%

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 ➢ Yield to Call: Denotes the yield of a bond if you were to buy and hold the security until
the call date, but this yield is valid only if the security is called prior to maturity. Formula to
Calculate YTC is

➢ Holding Period Return: This calculates the returns earned from bond investment over the
holding period. This holding period needs to be less than maturity period of the bond. The
formula for that is,

➢ Example: Bond X was held for three years, during which it appreciated from $100 to $150
and provided $5 in distributions. Find the HPR.

Solution: Income = 5 (from distributions)

End value = 150

Initial Value =100

t =3 years

Annualized HPR = {[ [5 + (150 – 100)] / 100] + 1}1/3 – 1

= 15.73%

➢ Relationship between Bond Value and Interest Rates

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 Burton Gordon Malkiel has mentioned certain properties of Bonds and its relationship with
interest rates, yield, maturity date and coupon rate. They are:

1. Malkiel’s Property 1: Market Interest Rate and Bond Values are inversely related.
As marker interest rate increases the bond prices fall
2. Malkiel’s Property 2: The relation between Interest Rate and Bonds though
inverse but is not a straight line but kind of convex

➢ Relationship between Bond Value and Yield: According to Malkiel, yield and Market rate of
interest moves in same direction. Hence, both the properties 1 and 2 that hold true for
interest rates also hold for yields

➢ Relationship between Bond Value and Maturity of the bond:

1. Malkiel’s Property 3: Longer the time to Maturity of the Bond, the greater is the
change in its value in response to given change in required rate of return

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 2. Malkiel’s Property 4: Prices of Long term bonds fluctuate more to interest rate
change or the Yield then the prices of short term bond
➢ Relationship between Bond Value and Coupon Rate:

This mentions Malkiel’s Property 5: Prices of High Coupon Bonds are less sensitive to changes in
interest rates than prices of low coupon bonds

➢ Duration of Bond: Represents the number of years it takes for the price of a bond to be repaid
by its internal cash flows. Bonds with higher durations carry more risk and have higher
price volatility than bonds with lower durations.
➢ Duration of a Zero-coupon bond: Here, Duration is equal to the maturity period of the bond
➢ Duration of a Vanilla bond or non-zero coupon bond: In this, duration would always be less
than its time to maturity. A formula called Macaulay Duration is used to compute duration
of a non-zero coupon bond.

Formula for Duration

Duration = (PV1*Time Period1 + PV2 + Time Period2 + PV3 + Time Period3 …………….n) / B0

Where

PV is the Present value of the cash flow in the corresponding year

Time period is the year for which present value has been calculated

B0 is bond price

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 N = Maturity in years

➢ Example: An 8% bond of Rs. 1000 has maturity period of 3 years. The current price of bond is
950. If the YTM of the bond is 10% then find the duration.

Solution: Here N = 3 years, B0 = 950

The cash flows for 3 years would be

Cash flow in first year = 8% of 1000 = 80

Cash flow in second year = 8% of 1000 = 80

Cash flow in third year = 8% of 1000 + 1000 = 80 + 1000 = 1080

Cash Flow Present Value Time Period PV*Time

Year 1 = 80 80/ (1+r) 1 1 72.72

Yield given to be 10% so r = 10%

or .1

= 80 / (1+.1)

72.77

Year 2 = 80 80/ (1+r) 2 2 132.16

=80 / (1+.1)2

= 66.08

Year 3 = 1080 1080/ (1+r) 3 3 2433.24

=1080 / (1+.1)3

= 811.08

Total 2638.12

Duration = 2638.12/B0 = 2638/950 = 2.77 years

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