SS 15 Reading 53 - Introduction To Fixed-Income Valuation

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Reading 53 Introduction to Fixed-Income Valuation

FinQuiz Notes – 2 0 1 7
1. INTRODUCTION

The fixed-income market (also known as debt market or


bond market) represents a significant investing
opportunity for institutions as well as individuals.

2. BOND PRICES AND THE TIME VALUE OF MONEY

2.1 Bond Pricing with a Market Discount Rate

When Coupon rate = yield required by market, → Price


The price of the bond at issuance is the present value of
= Par value
the promised cash flows. When Coupon rate < yield required by market, → Price
• Promised future cash flows include a series of < par value (discount)
coupon interest payments and the principal When Coupon rate > yield required by market, → Price
amount. > par value (premium)
• The discount rate used to estimate present value of
cash flows is the rate of return required by investors
PMT PMT PMT + FV
for assuming risk of investing in the bond. PV = + + ... +
• When a coupon rate offered by a bond is less than (1 + r ) 1
(1 + r ) 2
(1 + r ) N
the market discount rate, it is called a “deficient”
coupon rate. The present value of deficiency is the Where
amount of the discount below par value.
PV = present value, or the price of the bond
Deficiency per period = (Coupon rate – Market
discount rate) × Par value PMT = coupon payment per period
FV = future value paid at maturity, or the par value of
the bond
Amount of discount below par value = Market discount
r = market discount rate, or required rate of return per
rate – Coupon rate
period
• When a coupon rate offered by a bond is greater N = number of evenly spaced period to maturity
than the market discount rate, it is called an
“excessive” coupon rate. The present value of Example: Suppose the coupon rate on a bond is 5% and
excess cash flows is the amount of the premium the payment is annually. The time-to-maturity is five years
above par value. and the market discount rate is 6.5%.

5 5 5 5 (100 + 5)
+ + + + = 4.6948 + 4.4083+ 4.1392 + 3.8866 + 76.6375 = 93.7664
(1.065) (1.065) (1.065) (1.065) (1.065)5
1 2 3 4

Amount of discount below par value = Market discount rate – Coupon rate = 5% - 6.5% = -1.5%

The present value of the deficiency =


− 1 .5 − 1 .5 − 1 .5 − 1 .5 − 1 .5
1
+ 2
+ 3
+ 4
+ = 1.4084 + 1.3225 + 1.2418 + 1.1660 + 1.0948 = −6.2335
(1.065) (1.065) (1.065) (1.065) (1.065) 5
Price of the 5% coupon bond =100 – 6.2335 = 93.7665

Note: If the bond is purchased between coupon payment dates, the purchase price will include accrued interest.
PMT PMT PMT FV + PMT
Price of bond = + + +
(1 + r )1 (1 + r ) 2 (1 + r ) 3 (1 + r ) 4

Practice: Example 1,
Volume 5, Reading 53.

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Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

4. Maturity Effect: For the same coupon rate and same


2.2 Yield-to-Maturity
change in market discount rates, the percentage
price change for a longer-term bond will be greater
The yield-to-maturity is the internal rate of return on the
than the percentage price change for a shorter-
cash flows, i.e. the interest rate that equates the present
term bond.
value of future cash flows to the price of the bond.
 Maturity effect does not hold for bonds offering low
The yield-to-maturity is the rate of return on the bond to
coupon rate (i.e. bonds priced at discount to par
an investor contingent on the following three critical value).
assumptions:  Maturity effect always holds on zero-coupon bonds
1. The bond is held till maturity by the investor. and for bonds priced at par value or at a premium
2. The issuer does not default on any of the payments. above par value.
3. The investor is able to reinvest coupon payments at
that same yield. Important to Note: A bond having a coupon rate equal
to the market discount rate is priced at par value on a
Yields-to-maturity do not depend on the actual amount coupon payment date, irrespective of the number of
of par value in a fixed-income portfolio. years to maturity.

Practice: Example 2,
Practice: Example 3,
Volume 5, Reading 53.
Volume 5, Reading 53.

Bond’s value changes, as the bond gets closer to its


maturity. Holding discount rate constant,
Relationships between the Bond Price and Bond
2.3 1. Value of a bond trading at a premium decreases
Characteristics
over time.
2. Value of a bond trading at a discount increases over
time.
1. Inverse Effect: The bond price is inversely related to 3. Value of a bond trading at par value is unchanged
the market discount rate. When the market discount over time.
rate increases, the bond price decreases.
2. Convexity Effect: For the same coupon rate and
time-to-maturity, the percentage change in price
when the market discount rate decreases is greater
in absolute amount than the percentage change in
price* when the market discount rate increases.
 This implies that the relationship between bond
prices and the market discount rate is curved
rather than linear as shown in the graph below.
  
*Percentage Price change =

Pull to Par Value: The bond’s value moves to its par value
as it gets towards its maturity over time. This property is
known as pull to par value. It should be noted that
bond’s value is always equal to its par value at its
maturity date.
In addition, bond’s value changes, as the bond gets
closer to its maturity due to:
• Changes in the discount rate over time.
• Changes in the cash flow of a bond.

3. Coupon Effect: For the same time-to-maturity and


2.4 Pricing Bonds with Spot Rates
same change in market discount rates, the
percentage price change for a bond with lower
A more fundamental approach to calculate the price of
coupon rate will be greater than the percentage
a bond is to use a sequence of market discount rates
price change for a higher-coupon bond.
Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

that correspond to the cash flow dates. These market


discount rates are called spot rates. Where
Z1 = spot rate, or the zero-coupon yield, or zero rate, for
Spot rates: Spot rates are yields-to-maturity on zero- Period 1
coupon bonds that mature at the date of each cash Z2 = spot rate, or the zero-coupon yield, or zero rate, for
flow. They are also known as “zero rates”. Period 2
 The value of a bond based on spot rates is called the Z3 = spot rate, or the zero-coupon yield, or zero rate, for
arbitrage-free value. Period 3
 If a bond’s price differs from its no-arbitrage value, PV = Present Value
an arbitrage opportunity exists in the absence of
FV = Face Value
transaction costs.
PMT = Coupon payments

According to Arbitrage-free valuation approach, Value


Example: Consider a 3-year 10% coupon bond with face
of a Treasury bond based on Treasury spot rates must be
value of $1000, assuming annual coupon payments:
equal to sum of the PVs of all expected Cash flows.
Spot rates: r1=10%, r2=12%, r3=14%
 When market price of a bond < sum of the PVs of all
100 100 1100
expected Cash flows, buy the bond and sell the Price = + + = 913.1
parts to generate arbitrage profit. (1.10 ) (1.12 ) (1.14 )3
2

 When market price of a bond > sum of the PVs of all


expected Cash flows, buy the parts and sell the
bond to generate arbitrage profit.
Practice: Example 4,
Volume 5, Reading 53.
A general formula for calculating a bond price given the
sequence of spot rates:

PMT PMT PMT + FV


PV = + + ... +
(1 + Z 1 ) 1
(1 + Z 2 ) 2
(1 + Z N ) N

PRICES AND YIELDS: CONVENTIONS FOR QUOTES AND


3.
CALCULATIONS

T = number of days in the coupon period


3.1 Flat Price, Accrued Interest, and the Full Price
t/T = fraction of the coupon period that has
gone by since the last payment
When a bond is purchased between coupon payment
PMT = coupon payment per period
dates, its price has two parts:
i. Flat price (PVFlat): It is quoted by bond dealers. Flat Full Price (PV Full)= Invoice or Dirty Price = PV Flat + AI
price is affected by the changes in market discount Clean or quoted Price = Flat Price = Full Price – Accrued
rate.
Interest
ii. Accrued interest (AI): It is proportional share of the
next coupon payment. The accrued interest does
The full price of a fixed-rate bond between coupon
not depend on the yield-to-maturity. This implies
that it does not take into account the time value of payments given the market discount rate per period (r)
money. It is calculated as follows: can be calculated with the following equation:
AI =   PMT PMT PMT + FV

PV Full = 1− t / T
+ 2 −t / T
+ ... +
(1 + r ) (1 + r ) (1 + r ) N −t / T
Where
t = number of days from the last coupon
payment to the settlement date or number of
days that has gone by since the last payment
 PMT PMT + FV 
 × (1 + r ) = PV × (1 + r )
PMT
PV Full =  + + ... +
t /T t /T

 (1 + r ) 1
(1 + r ) 2
(1 + r ) N

Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

Settlement date: The date at which the bond buyer similar times-to-maturity, coupon rates, and credit quality
makes cash payment and the seller delivers the security are used to estimate the price and market discount rate
is called settlement date. for fixed-rate bonds that are not actively traded. Matrix
pricing is also used in underwriting new bonds to get an
Types of day-count conventions used in bond markets: estimate of the required yield spread over the
• Actual/actual: In this method, the actual number of benchmark rate.
days are used, including weekends, holidays, and
leap days. It is the most commonly used day-count Yield Spread: The additional compensation required by
convention for government bonds. investors for assuming the credit risk, liquidity risk, and tax
• 30/360: This method assumes that each month has 30 risk of the bond relative to the government bond is
days and that a full year has 360 days. It is the most
referred to as the yield spread. Usually, a different yield
commonly used day-count convention for corporate
bonds. spread exists for each maturity and for each credit
rating.
Example: Suppose a semi-annual payment bond pays
Yield spread = Yield-to-maturity on the new bond –
interest on 15 May and 10 November of each year. The
Benchmark rate
settlement date is 25 June. The stated coupon rate is 4%.
Using actual/actual convention:
Term structure of credit spreads: The term structure of
 The actual number of days between 15 May and 25
credit spreads reflects the relationship between the
June = t = 41 days
spreads over the “risk-free” or benchmark rates and
 The actual number of days between 15 May and 10
November = T = 179 days times-to-maturity. The yield spreads reflect the term
AI =
 
  0.45810 per 100 of par value structure of credit spreads.
 

Example: An investor needs to estimate the price of an


Using 30/360 convention:
illiquid four-year, 4% annual coupon payment corporate
 The actual number of days between 15 May and 25 bond. The investor identifies two corporate bonds with
June = t = 40 days
similar credit quality:
 The actual number of days between 15 May and 10
November = T = 175 days i. A three-year, 5% annual coupon payment bond
AI =
 
  0.45714 per 100 of par value priced at 107 per 100 of par value.
  ii. A five-year, 4% annual coupon payment bond
priced at 105 per 100 of par value.
Practice: Example 5,
Volume 5, Reading 53. Using matrix pricing, the estimated price of the
illiquid bond per 100 of par value is estimated as:
5 5 105
107 = + + , r = 0.0255
3.2 Matrix Pricing
(1+ r) (1+ r) (1+ r)3
1 2
The

required on the three-year, 4% bond priced at 105 is


In matrix pricing process, the quoted or flat prices of
more frequently traded comparable bonds having
4 4 4 4 104
105 = + + + + , r = 0.0291
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r)5
1 2 3 4

0.0255 + 0.0291
= 0.0273
The estimated market discount rate for a 4-year bond 2
having the same credit quality is the average of two Given an estimated yield-to-maturity of 2.73%, the
required yields. estimated price of the illiquid 4-year, 4% annual coupon
payment corporate bond is
4 4 4 104
+ + + = 104.79
(1.0273) (1.0273) (1.0273) (1.0273)4
1 2 3
Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

Types of Yields:
Practice: Example 6,
Volume 5, Reading 53.  Street convention yield-to-maturity is the internal
rate of return on the cash flows when the payments
are assumed to be made on the scheduled dates.
 True yield-to-maturity is the internal rate of return on
3.3 Yield Measures for Fixed-Rate Bonds the cash flows using the actual calendar of
weekends and bank holidays. The true yield is never
higher than the street convention yield because
Number of periods in a year is called the periodicity of
weekends and holidays delay the time to payment.
the annual rate. Typically, periodicity is equal to the
Practically, the true yield is not commonly used.
frequency of coupon payments.
 Government equivalent yield is the yield that
• For zero coupon bonds, the periodicity of the annual restates a yield-to-maturity based on 30/360 day-
market discount is arbitrary because there are no
count to actual/actual based convention. The
coupon payments.
• For semi-annual compounding, the annual rate has government equivalent on a corporate bond can
a periodicity of 2. It is known as a semi-annual bond be used to obtain the spread over the government
basis yield, or semi-annual bond equivalent yield. yield.
• For quarterly compounding, the annual rate has a  Current yield is the sum of the coupon payments
periodicity of 4. received over the year divided by the flat price. The
• For monthly compounding, the annual rate has a current yield only considers interest income and
periodicity of 12.
does not take into account the frequency of
• For annual compounding, the annual rate has a
periodicity of one. coupon payments and accrued interest. Hence, it is
• An effective annual rate has a periodicity of one a crude measure of rate of return to an investor. For
because there is just one compounding period in the example, a 5-year, 3% semi-annual coupon
year. payment bond is priced at 90 per 100 of par value.
Its current yield is

Important to understand: The “Semi-annual bond basis = 0.0333

yield” is not the same as “yield per semi-annual period”.  Simple yield is the sum of the coupon payments plus
E.g. if a bond yield is 2% per semi-annual period, then its
the straight-line amortized share of the gain or loss,
annual yield when stated on a semi-annual bond basis is
4%. divided by the flat price. Simple yields are used
mostly to quote Japanese government bonds,
known as “JGBs”.
A general formula to convert an annual percentage
rate for m period per year (APRm) to an annual
percentage rate for n periods per year (APRn) is as
follows: Practice: Example 8,
m n
Volume 5, Reading 53.
 APR m   APR n 
1 +  = 1 + 
 m   n 
General Rule: Compounding more frequently at a lower Valuing a Callable Bond:
annual rate corresponds to compounding less frequently In a callable bond the issuer the right to buy the bond
at a higher annual rate. back from the investor at specified prices on pre-
determined dates. A call protection period is the time
during which the issuer of the bond is not allowed to
Practice: Example 7,Volume 5, exercise the call option.
Reading 53.
Suppose that a seven-year, 7% annual coupon payment
bond is first callable in four years at price of 102.If the

current price for the bond is 107 per 100 of par value, the
yield-to-first-call in four years is estimated as follows:
7 7 7 7 + 102
107 = + + + =, r = 0.054654 = 5.465%
(1 + r ) 1
(1 + r ) 2
(1 + r ) 3
(1 + r ) 4
The yield-to-second-call in five years at call price of 101
is as follows:
Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

7 7 7 7 7 + 101
107 = + + + + =, r = 0.055381 = 5.5381 %
(1 + r ) 1
(1 + r ) 2
(1 + r ) 3
(1 + r ) 4
(1 + r ) 5
The yield-to-third-call at call price of 100 is:
7 7 7 7 7 7 + 100
107 = + + + + + =, r = 0.055945 = 5.5945 %
(1 + r ) 1
(1 + r ) 2
(1 + r ) 3
(1 + r ) 4
(1 + r ) 5
(1 + r ) 6
Finally, the yield-to-maturity is:
7 7 7 7 7 7 7 + 100
107 = + + + + + + =, r = 0.057569 = 5.7569 %
(1 + r ) 1
(1 + r ) 2
(1 + r ) 3
(1 + r ) 4
(1 + r ) 5
(1 + r ) 6
(1 + r ) 7

Yield-to-worst: The lowest of the sequence of yield-to- because the future cash flows (interest payments) are
call and the yield-to-maturity is known as the yield-to- fixed.
worst. In the above example, the yield-to-first-call of
5.465% is the yield-to-worst. The yield-to-worst represents The reference rate on a floating-rate note (usually a
the most conservative assumption for the rate of return. short-term money market rate, i.e. three-month Libor) is
determined at the beginning of the period and the
Option-adjusted price of a Callable Bond = Flat price of interest payment is made at the end of the period. This
the Callable bond + Value of Call option payment structure called “in arrears”. The most common
Value of the call option = Price of the option-free day-count conventions for calculating accrued interest
bond - Price of the callable bond on floaters are actual/360 and actual/365.
 The option-adjusted price is less than the option-
free price of a bond because in a callable bond Quoted margin on FRN: It is the yield spread over the
the investor assumes the call risk. reference rate. It is used to compensate the investor for
the difference in the credit risk of the issuer and that
implied by the reference rate. For example, a company
Option-adjusted Yield: The option-adjusted is the with a stronger credit rating (e.g. AAA) may be able to
required market discount rate whereby the price is issue an FRN that pays 3-month Libor minus 0.30%.
adjusted for the value of the embedded option. The
option-adjusted price is used to calculate the option- Required margin: The required margin refers to the yield
adjusted yield. spread over, or under, the reference rate that equates
the price of FRN to its par value on a rate reset date. The
required margin depends on credit risk, liquidity risk and
3.4 Yield Measures for Floating-Rate Notes
tax status of the bond. If the credit risk of the issuer
remains unchanged, the required margin will remain the
Since the interest payments on a floating-rate note (FRN) same as the quoted margin. If the credit risk of the issuer
are not fixed, it has a stable price even in a volatile increases (e.g. issuer’s credit rating is downgraded), the
interest rate environment. In a FRN, the interest rate required margin increases. The required margin is also
volatility affects future interest payments. In contrast, in a called the discount margin.
fixed-rate bond, interest rate volatility affects the price
The price of a FRN is estimated as follows:
(index + Qm ) × FV ( Index + QM ) × FV ( Index + QM ) × FV
+ FV
PV = m + m + ... + m
Index + DM  Index + DM  Index + DM
1 2 N
   
1 +  1 +  1 + 
 m   m   m 
m = periodicity of the floating-rate note, the number of
Where payment periods per year
PV = present value, or the price of the floating-rate note DM = discount margin, the required margin stated as an
Index = reference rate, stated as an annual percentage annual percentage rate
rate N = number of evenly spaced periods to maturity
QM = quoted margin, stated as an annual percentage (Index + QM) = Annual rate for the period
rate [(Index + QM) × (FV)] / Number of periods in the year (m)
FV = future value paid at maturity, or the par value of = First interest payment
the bond
Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

Note: In the above equation, it is assumed that there is market securities. Money market securities often are
no accrued interest so that the flat price is the full price settled on a “same day” or “cash settlement” basis.
and a 30/360 day-count convention is used so that the
periodicity is an integer. Differences in yield measures between the money
market and the bond market:
• On each reset date, the FRN will be priced at par 1) Bond yields-to-maturity are annualized and
value. compounded; whereas, money market securities’
• When the required margin increases (decreases), yields-to-maturity are annualized but not
FRN will be priced at a discount (premium). compounded. Instead, the rate of return on a
 The amount of the premium is the present money market instrument is stated on a simple
value of the annuity for the “excess” interest
interest basis.
payment each period.
 The amount of the discount is the present 2) Bond yields-to-maturity can be calculated using
value of the annuity for the “deficient” standard time-value-of-money analysis and using a
interest payment each period. financial calculator. In contrast, money market
instruments yields-to-maturity are calculated using
Annuity per period for the remaining life of the bond different pricing equations since they are quoted
= Required margin – Quoted margin using nonstandard interest rates.
3) Bond yields-to-maturity are stated for a common
periodicity for all times-to-maturity as they are
• Between coupon dates, the flat price of FRN will be
at a premium if the reference rate decreases or at a computed using interest rate compounding. In
discount to par value if reference rate increases. contrast, for money market instruments, the
• If the required margin remains the same as the periodicity for the annual rate differs depending on
quoted margin, the flat price is “pulled to par” as the different times-to-maturity as they are computed
next reset date nears. using simple interest without compounding. In the
• If the quoted margin is greater (smaller) than the
money market, the periodicity is the number of days
discount margin, the FRN is priced at a premium
above (discount below) par value. in the year divided by the number of days to
• At the reset date, any change in Libor is included in maturity.
the interest payment for the next period. • In general, commercial paper, Treasury bills (a
U.S. government security issued with a maturity of
one year or less), and bankers’ acceptances
Fixed-rate bond v/s Floating-rate bond: often are quoted on a discount rate basis.
The pricing formula for money market instruments
 In a fixed-rate bond, the premium or discount results
quoted on a discount rate basis:
from a difference in the fixed coupon rate and the
required yield-to-maturity.
 In a floating-rate bond, the premium or discount
results from a difference in the fixed quoted margin  Days 
and the required margin. PV = FV × 1 − × DR 
 Changes in benchmark interest rates tend to affect  Year 
the price of fixed-rate and floating-rate bonds Where
differently. PV = present value, or the price of the money
market instrument
FV = future value paid at maturity, or the face
Practice: Example 9,Volume5,
Reading 53. value of the money market instrument
Days = number of days between settlement and
maturity
Year = number of days in the year
3.5 Yield Measures for Money Market Instruments DR = discount rate, stated as an annual
percentage rate

Money market instruments are short-term debt securities.


DR =  Year  ×  FV − PV 
These include repurchase agreements (repos), bank  Days   FV 
certificates of deposit, commercial paper, government Year/Days = Periodicity of the annual rate
issues of less than one year, bankers’ acceptances, and
time deposits based on such indices as Libor and Euribor.  A money market discount rate tends to understate
Money market mutual funds tend to invest inmoney the rate of return to the investor, and it tends to
Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

understate the cost of borrowed funds to the issuer 360-day year × 365/360
because the PV is less than FV (as long as DR is
greater than zero).
Example: Suppose that an investor is comparing two
 The “amount” of a money market instrument quoted
money market instruments: (A) 90-day commercial
on a discount rate basis typically is the face value
paid at maturity. paper quoted at a discount rate of 5.5% for a 360-day
year and (B) 90-day bank time deposit quoted at an
• Bank certificates of deposit, repos, and such indices add-on rate of 5.70% for a 365-day year.
as Libor and Euribor are quoted on an add-on rate
basis. The price of the commercial paper =
 90 
PV = 100 × 1 − × 0.055  = 98.625
The pricing formula for money market instruments  360 
quoted on an add-on rate basis is as follows:
 365   100 − 98.625 
AOR =  ×  = 0.056541
FV  90   98.625 
PV = The 90-day commercial paper discount rate of 5.5%
 Days 
1 + × AOR  converts to an add-on rate for a 365-day year of
 Year  5.6541%.
Where 365-day year Bond equivalent yield = 5.6541 ×
PV= present value, principal amount, or the price of the 365/360 = 5.7326
money market instrument
365 / 90 2
FV = future value, or the redemption amount paid at  APR2 
 0.10 
maturity including interest 1 +  = 1 +  , APR2 = 0.10127
Days = number of days between settlement and  365 / 90   2 
maturity If the risks are the same, the commercial paper offers
Year = number of days in the year 2.33 bps more in annual return than the bank time
AOR = add-on rate, stated as an annual percentage deposit.
rate
Practice: Example 10,Volume 5,
 Days  Reading 53.
FV = PV +  PV × × AOR 
 Year 
FV
PV = Example: The quoted rate for a 90-day money market
 Days 
1 + × AOR  instrument is 10%, quoted as a bond equivalent yield,
 Year  which means its periodicity is 365/90. The conversion is
from m = 365/90 to n = 2 for APR 365/90 = 0.10.
 Year   FV − PV 
AOR =   ×  
 Days   PV  Therefore, 10% for a periodicity of 365/90 corresponds to
10.127% for a periodicity of two.
 The “amount” of a money market instrument quoted
on an add-on rate basis usually is the principal
Note: The lower the interest rates, the smaller the
(price) at issuance.
difference between the annual rates for any two
 A bond equivalent yield (or investment yield) is a
money market rate stated on a 365-day add-on rate periodicities.
basis. Typically, money market securities are reported
as bond equivalent yields.
365-day year Bond equivalent yield = Add-on rate for a

4. THE MATURITY STRUCTURE OF INTEREST RATES

The yields-to-maturity on any two bonds tend to be a) Currency: If a bond is denominated in a currency
different due to the following reasons. with a higher expected rate of inflation, it will have
higher yield-to-maturity than the bond which is
Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

denominated in a currency with a lower expected Spot Market: In a spot market, there is an immediate
rate of inflation. delivery at current market prices. Spot market is also
b) Credit Risk: Bond with a non-investment-grade rating called cash market.
tends to have higher yield-to-maturity than the bond
having an investment-grade rating of AA. Forward Market: A forward market is a market for future
c) Liquidity: An illiquid bond tends to have a higher delivery at a given point in time in the future (the expiry
yield-to-maturity than a bond that is actively traded. date)at prices agreed-upon today (date of entering into
Older (seasoned) bonds tend to be less liquid than the contract). The credit risk, liquidity, and tax status of
newly issued bonds because they are owned by the bond traded in the forward market are the same as
“buy-and-hold” institutional and retail investors. the one in the cash market.
d) Tax Status: When the interest income on a bond is
Forward Rate: A forward rate is the interest rate on a
taxable, it tends to have a higher yield-to-maturity
bond or money market instrument traded in a forward
than the bond whose interest income is exempt from
market. E.g. a dealer agrees to deliver a seven-year
taxation.
bond three years into the future for a price of 80 per 100
e) Periodicity: When a bond makes a single annual
of par value. Forward rate is calculated as follows.
coupon payment, its yield-to-maturity could be
quoted for a periodicity of one. The other bond may
100
make monthly coupon payments, and its yield-to- 80 = , r = 0.022565 ,×2 = 0.04513
maturity could be annualized for periodicity of 12. (1 + r )10
f) Maturity structure or term structure of interest rates: The 4.513% is the forward rate the “3y7y”. This is
Two bonds may have different yields-to-maturity due pronounced as “the three-year into seven-year rate”, or
to their different times-to-maturity. simply the “3’s, 7’s”.
7-year refers to the tenor of the underlying bond.
Term structure of interest rates: It reflects the relationships
3-year refers to the length of the forward period in
between yields-to-maturity and times-to-maturity. In years from today.
theory, maturity structure should be analyzed for bonds
that have the same properties other than time-to-
In the money market, the forward rate usually refers to
maturity.
months. E.g. the “1m6m” forward rate on Euribor is the
rate on six-month Euribor one month into the future.
Spot, zero, or strip curve: The spot, zero, or strip curve is a
sequence of yields-to-maturity on zero-coupon bonds.
Implied forward rate: It is a break-even reinvestment rate
Zero-coupon bonds tend to have no coupon
that links the return on an investment in a shorter-term
reinvestment risk because there are no coupons to
zero-coupon bond to the return on an investment in a
reinvest. These government spot rates are considered as
longer-term zero-coupon bond. It effectively represents
the “risk-free” yields (default risk free).
an incremental or marginal return for extending the
 The spot curve is upward sloping and flattens for time-to-maturity for an additional time period.
longer times-to-maturity.
 When a spot curve is upward sloping (i.e. longer-term The implied forward rate between period A and period B
yields are higher than shorter-term yields) it is called a
is denoted IFRA,B-A. It is a forward rate on a security that
normal yield curve.
starts in period A and ends in period B.
 When a spot curve is downward sloping (i.e. shorter-
term yields are higher than longer-term yields) it is
called an inverted yield curve. (1 + zA)A × (1 + IFRA,B-A)B-A = (1 + zB)B

zA is the yield on A-period (shorter-term) zero-coupon


Par curve: A par curve is a sequence of the par rate
bond trading in the cash market stated on a semi-
which is the discount rate at which the bond’s price annual bond basis.
equals its par value, assuming that bonds have same zB is the yield on B-period (longer-term) zero-coupon
currency, credit risk, liquidity, tax status, and annual trading in the cash market bond stated on a semi-
yields stated for the same periodicity. Also, between annual bond basis.
coupon payment dates, the flat price (not the full price) B-A is the tenor of the underlying bond.
is assumed to be equal to par value. The par curve is
obtained from a spot curve.
Example: Suppose that the yields-to-maturity on three-
PMT PMT PMT + FV year and five-year zero-coupon bonds are 3.5% and
PV = + + ... + 4.0%, respectively, stated on a semi-annual bond basis.
(1 + z1 ) 1
(1 + z 2 ) 2
(1 + z N ) N
Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

The “3y2y” implied two-year forward yield three years  Z6 = 0.035/2 (per period)
into the future is calculated as follows.  Z10 = 0.040/ 2 (per period)
 A = 3× 2 = 6 (periods)
 B = 5 × 2 = 10 (periods)
 B- A = 10 – 6 = 4 (periods)
6 10
 0.035   0.040 
1 +  × (1 + IFR 6 , 4 ) =  1 +  , IFR 6 , 2 = 0.02376 ,× 2 = 0 .04752
4

 2   2 

The “3y2y” implied forward yield is 4.752% annualized for Uses of Forward Rates:
a periodicity of two.  Forward rates are used to make maturity choice
decisions.
If the investor believes that two-year yield in three  Forward rates are used to identify arbitrage
years will be less than 4.752% (implied forward rate), opportunities between transactions in the cash
the investor might prefer to buy the five-year bond. market for bonds and in forward contract markets.
If the investor believes that two-year yield will be  Forward rates are used to estimate value of
more than the implied forward rate (i.e. 4.752%), the derivatives, especially interest rate swaps and
investor might prefer the three-year bond and the options.
opportunity to reinvest at the expected higher rate.  Like spot rates, forward rates can be used to value a
fixed-income security.

Forward Curve: A forward curve is a series of forward


Practice: Example 11,Volume 5,
rates, each having the same time frame. An implied Reading 53.
forward curve can be calculated from the spot curve.
Similarly, an implied spot curve can be calculated from
the forward curve. Implied spot rates can be estimated
as geometric averages of forward rates.

5. YIELD SPREADS

that is provided to compensate investor for assuming


5.1 Yield Spreads over Benchmark Rates
credit and liquidity risk.

Benchmark yield: It is the base rate (commonly a


 The benchmark yield takes into account the
government bond yield) with a given time-to-maturity for macroeconomic factors i.e. expected rate of
a fixed-income security. The benchmark yield is inflation in the currency in which the bond is
generally known as the risk-free rate. denominated, general economic growth and the
• The benchmark yield can be decomposed into the business cycle, foreign exchange rates, and the
expected real rate and the expected inflation rate in impact of monetary and fiscal policy.
the economy.  The yield spread takes into account the
• In general, on-the-run government bonds are used microeconomic factors specific to the bond issuer
as benchmark. The on-the-run government bond is and the bond itself i.e. credit risk of the issuer,
the most actively traded security and has a coupon changes in the quality rating on the bond, liquidity
rate closest to the current market discount rate for and trading in comparable securities, and the tax
that maturity, implying that it is priced close to its par status of the bond.
value. Typically, on-the-run bonds are traded at
lower yields-to-maturity than off-the-run bonds
(seasoned government bonds). Implied benchmark rate: It is an implied benchmark rate
• Commonly used benchmark for floating-rate bonds is that is derived using interpolation when no benchmark
Libor, which is the composite interbank rate. It is not exists for a specific bond’s tenor or a bond has an
a risk-free rate. unusual maturity.

Yield Spread: The yield spread is the difference between • In addition, for bonds with very long tenors the rate
the yield-to-maturity of a bond and the benchmark on longest available benchmark bond is used as a
yield. It is the risk premium over “risk-free” rate of return benchmark. E.g. for 100-year bonds (century bonds)
Reading 53 Introduction to Fixed-Income Valuation FinQuiz.com

in the U.S., the 30-year U.S. Treasury benchmark rate Zero-volatility Spread or Z-spread: It is a constant yield
is used. spread over a government (or interest rate swap) spot
• For Euro-denominated corporate bonds, EUR interest curve. It is also known as static spread because it is
rate swap is used as a benchmark. E.g. rate on Euro- constant and has zero volatility. The Z-spread over the
denominated corporate bonds may be stated as benchmark spot curve can be calculated as follows:
mid-swap + 100 bps.
 Mid-swap is the average of the bid and offered
PMT PMT PMT + FV
swap rates. PV = + + ... +
(1 + z1 + Z ) 1
(1 + z 2 + Z ) 2
(1 + z N + Z ) N

G-Spread: G-spread is the yield spread of a specific Where


bond over or under the actual or interpolated o zi = Benchmark spot rates for period i, derived from
benchmark (government) bond with a maturity closest the government yield curve (or from fixed rates on
to the corporate bond’s maturity. interest rate swaps).
o Z = Z-spread per period.
Important to Note: As the remaining time-to-maturity
o N is an integer, which implies that the calculation is
changes, the government bond yield or swap rate used
on a coupon date when the accrued interest is zero.
as the benchmark for a specific corporate bond will
change over time. Option-adjusted Spread: It is the spread that is adjusted
for an embedded option. It basically represents the
I-Spread: I-spread is the yield spread of a specific bond
residual risk remaining (i.e. credit risk, liquidity risk) after
over or under the actual or interpolated interest rate
interest rate and volatility risks have been taken out. It is
swap rate in that currency of the same tenor.
estimated as follows
Libor-Spread: Libor-spread can be used to compare OAS = Z-spread – Option value
bonds with differing credit and liquidity risks against an
interbank lending benchmark. It can also be used to Practice: Example 12,Volume 5,
determine the relative cost of fixed-rate bonds versus Reading 53.
floating-rate alternatives, such as an FRN or commercial
paper.

Note: The G-spread and I-spread each use the same End of Reading Practice Problems:
discount rate for each cash flow. Practice all the questions given at
the end of Reading.

5.2 Yield Spreads over the Benchmark Yield Curve

Yield Curve: A yield curve provides a graphical


representation of the relationship between yields-to-
maturity and times-to-maturity for securities with the
same risk profile. Typically, yield curve tends to be
upward-sloping because investors demand a risk
premium for holding longer-term securities. The term
structure of interest rates is dynamic because the short-
term rates are driven by central bank policy while the
longer-term rates are based on long-term growth and
inflation expectations.

Government Bond Yield Curve: The government bond


yield curve graphically shows the relationship between
the yields of on-the-run government bonds and their
times-to-maturity.

Swap Yield Curve: The swap yield curve graphically


shows the relationship between fixed Libor swap rates
and their times-to-maturity.

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