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Bond Markets: Advanced Perspectives
Part-03A
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We have assumed earlier that we are on a
coupon payment date.
It implies that the next coupon is exactly one
period away.
How do we value a bond between two
coupon dates?
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Calculate the actual no. of days between the
date of valuation and the next coupon date.
Include the next coupon date.
But do not include the starting date.
Or vice versa
Let us call this interval N
1
.

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Calculate the actual no. of days between the
preceding coupon date and the next coupon
date.
Include the ending date but exclude the starting
date or vice versa
Let us call this time interval as N
2
.

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The next coupon is then k periods away
where
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There is a Treasury bond with a face value of
$1,000.
The coupon rate is 8% per annum, paid on a
semi-annual basis.
The coupon dates are 15 July and 15 January.
The maturity date is 15 January 2033.
Today is 15 September 2013.
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Month No. of Days
September 15
October 31
November 30
December 31
J anuary 15
TOTAL 122
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Month No. of Days
J uly 16
August 31
September 30
October 31
November 30
December 31
J anuary 15
TOTAL 184
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K = 122/184 = .6630
This is called the Actual/Actual method and
is often pronounced as the Ack/Ack method.
It is the method used for Treasury bonds in the
U.S.
It is the method used for Corporate bonds in
India.

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Wall Street professionals will then price the
bond using the following equation.

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In our example

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The approach used by the Treasury to value
T-bonds is different.
The Treasury uses a simple interest approach for
the fractional first period.
This is known as the Moosmuller yield
calculation method.
It is also used in some German markets
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The Treasury will use the following
equation.

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The Treasury approach will always give a
lower price
For a fractional period simple interest will always
give a larger discount factor
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The Actual/Actual method is applicable
for Treasury bonds in the U.S.
For corporate bonds in the U.S. we use
what is called the 30/360 NASD method.
The number of days between successive coupon
dates is always taken to be 180.
Each month is considered to be of 30 days.
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The # of days from the valuation date till the
next coupon date is calculated as:
The start date is defined as
D
1
= (month
1
, day
1
,year
1
)
The ending date is defined as
D
2
= (month
2
,day
2
,year
2
)

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The number of days is calculated as
360(year
2
year
1
) + 30(month
2
month
1
) +
(day
2
day
1
)

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If day
1
= 31 then set day
1
= 30
If day
1
is the last day of February, then set
day
1
= 30

If day
1
= 30 or has been set equal to 30, then
if day
2
= 31, set day
2
= 30
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Assume that the bond considered earlier was
a corporate bond and not a Treasury bond.

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In this convention, if day
2
= 31, then it is
always set equal to 30.
So the additional rules are:
If day
1
= 31 then set day
1
= 30
If day
2
= 31 then set day
2
= 30
This is the convention used in India for
Government securities
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The denominator in this convention will
consist of 365 even in leap years.
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This is used for Japanese Government Bonds
(JGBs)
It is similar to the Actual/365 method.
The difference is that in this case, the extra day
in February is ignored in leap years
While calculating both the numerator and the
denominator.
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It is identical to Actual/365 for a coupon period
that does not include days within a leap year.
However for a period that includes days falling
within a leap year, the day count is given by:
#of days falling within the leap year
______________________________ +
366
#of days not falling within the leap year
_________________________________
365
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This is a simple variant of Actual/365.
This is the convention used for money market
instruments in most countries.
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A bond with one coupon remaining (at
maturity) is akin to a ZCB
Thus these bonds are usually discounted on a
simple interest basis for the fractional period
that remains
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A T-bond has a face value of $1,000
A coupon of 8% payable semi-annually
The maturity date is 15 January 2014
Today is 15 September 2013
The quoted price is 99-12
The day-count convention is Actual/Actual
The fractional period remaining = 122/184 =
0.6630
The AI = 40x62/184 = 13.4783
The dirty price is 1007.2283
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If we compute the YTM as
1007.2283 = 1040/(1+i)
0.6630
i = 4.9478
Thus the annual YTM is 9.8956%
However the market in the US would
compute as follows.
1007.2283 = 1040/(1+i x 0.663/2)
Thus i = 9.8149%

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Price of a bond is the PV of all the cash
flows that the buyer will receive
The seller is compensated for all the cash flows
that he is parting with.
This includes the amount due to the seller for
parting with the entire next coupon
Although he has held it for a part of the current
coupon period.
This compensation is termed as
Accrued Interest
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The fraction of the next coupon that is
payable is calculated as per the day-count
convention
That is for U.S. Treasury bonds the Actual/Actual
method is used
Whereas for U.S. corporate bonds the 30/360
NASD method is used.
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Why calculate the accrued interest if it is
already included in the price calculation?
The quoted bond price does not include accrued
interest.
That is, quoted prices are net of accrued
interest.
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The rationale is as follows.
On July 15 the price of the Treasury bond
using a YTM of 10% is $829.83.
On September 15 the price using a yield of
10% is $843.5906.
The yield on both the days is the same
Hence the increase in price is entirely due to the
accrued interest.
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On July 15 the accrued interest is zero.
On a coupon payment date, the accrued interest
has to be zero.
On September 15 the accrued interest is
8/28/2014 36
The price net of accrued interest is
$843.5906 - $13.4783 = $830.1123$
which is very close to the price of $829.83 that
was observed on July 15.
As the yield changes, so will the price.
If the accrued interest is not subtracted
from the quoted price we would be
unsure
Whether the price change is due to a change in
the yield or if it is partly due to accrued interest.
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However if prices are reported net of
accrued interest, then in the short run
observed price changes will be entirely due to
changes in the yield.
Consequently bond prices are always reported
after subtracting the accrued interest.
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Quoted bond prices are called clean or add-
interest prices.
When a bond is purchased quoted price plus
the accrued interest has to be paid.
The total price that is paid is called the dirty
price or the full price or all-in price.
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Can the accrued interest be negative?
Can there be cases where the seller of the bond
has to pay accrued interest to the buyer.
The answer is yes.
In markets where bonds trade ex-dividend
The dirty price will fall by the present value of
the next coupon on the ex-dividend date
And the dirty price will be less than the clean
price.
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It is actually a misnomer for bonds do not
pay dividends
Till this date the buyer will get the
forthcoming coupon
Starting from this date, the next coupon will
go to the seller.
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Take a T-bond that matures on 15 July 2032.
It pays a 9% coupon semi-annually on 15
January and 15 July every year.
The face value is 1000 and the YTM is 8%.
Assume that we are on 5 January 2013 which
is the ex-dividend date.
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Using the Actual/Actual convention
we can calculate k to be 0.0543.



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The moment the bond goes ex-dividend the
dirty price will fall
By the present value of the forthcoming coupon
Because the buyer will be no longer entitled to it.
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Thus the ex-dividend dirty price is




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This is the amount payable an instant after it
goes ex-dividend.
The accrued interest an instant before the
bond goes ex-dividend is:
0.09x1000 174
________ x ____ = $ 42.5543
2 184
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The clean price at the time of the bond
going ex-dividend is
1140.4910 42.5543 = $1097.9367
The clean price is greater than the ex-
dividend dirty price.
This represents the fact that the seller has to
compensate the buyer
While the buyer is entitled to his share of the next
coupon the entire amount will be received by the seller.
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The fraction of the next coupon that is
payable to the buyer is
0.09x1000 10
_________ x ____ = $2.4457
2 184
Hence the buyer has to pay
1097.9367 2.4457 = $1095.4910
Which is the ex-dividend dirty price.
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The yield or the rate of return from a bond
can be computed in various ways.
Various yield measures have their merits and
demerits.
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This is very commonly reported.
Although it is technically very unsatisfactory.
It relates the annual coupon payment to the
current market price.
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Also known as
Flat Yield
Interest Yield
Running Yield
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A 15 year 15% coupon bond is currently
selling for $800.
The face value is $1,000
The current yield is given by
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If this bond is bought for $800 and held for
one year it will earn an interest of $150.
So the interest yield is 18.75% for a trader with a
one-year horizon
However, if it is sold after one year the
trader will make a Capital Gain or Loss.
The current yield does not take such gains and
losses into account.

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The current yield is used to estimate the cost
of or profit from holding the bond.
It is a Rough & Ready interest rate
calculation
If short-term rates are higher than the
current yield
The bond is said to involve a running cost.
This is known as negative carry or negative
funding.
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This tries rectify shortcomings of the current
yield by considering capital gains and losses.
The assumption made is that capital gains and
losses accrue evenly over the life of the bond.
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The formula is:
Simple YTM = C M-P
__ + ______
P PXN/2
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For the 15 year bond that we considered
earlier
Simple YTM = 150 1000-800
_____+ _________ = 20.42%
800 15 x 800
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The simple YTM does not take into account
the compound interest that can be earned
By reinvesting the coupons.
This will obviously increase the overall return
from the bond.
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The YTM is the rate that equates the present
value of the cash flows from the bond to its
price
Assuming that the bond is held to maturity
It is analogous to the concept of the IRR
used in project valuation.
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Consider a bond that pays an annual coupon
of C on a semi-annual basis.
The face value is M, the price is P, and the
number of coupons remaining is N.

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The YTM is the value of y that satisfies the
following equation.

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The YTM is a solution to a non-linear
equation.
We generally require a financial calculator or
a computer to calculate it.
However it is fairly simple in two cases
If we have a coupon paying bond with exactly two
periods to maturity.
In such a case it is simply a solution to a quadratic
equation.
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The YTM is easy to compute in the case of
zero coupon bonds.
Consider a ZCB with a face value of $1,000,
maturing after 5 years.
The current price is $500.
The YTM is the solution to

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The YTM calculation takes into account all
the coupon payments
As well as any capital gains/losses that
accrue if the bond is held to maturity.
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A bondholder can expect to receive income
from the following sources.
There are coupon payments which are typically
paid every six months.
There will be a capital gain/loss when a bond is
redeemed
It may mature or may be called or may be sold before
maturity.
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The YTM calculation assumes that the bond is
held to maturity.
Finally when a coupon is received it will
have to be reinvested till redemption
Once again the YTM calculation assumes that the bond is
held till maturity.
The reinvestment income is interest on interest.
A satisfactory yield measure should take into
account all the three sources

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The YTM calculation takes into account all
the three sources of income.
However it makes two key assumptions.
Firstly it assumes that the bond is held till
maturity.
Secondly it assumes that all intermediate
coupons are reinvested at the YTM itself.
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The latter assumption is built in to the
mathematics of the calculation.
The YTM is called a Promised Yield.
It is Promised because in order to realize it the
holder has to satisfy both the above conditions.
If either of the two conditions is violated she may not
get what was promised.
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Consider a bond that pays a semi-annual
coupon of $C/2.
Let r be the annual rate of interest at which
these coupons can be re-invested.
r would be dependent on the market conditions
prevailing when the coupon is received
It need not be equal to y, the YTM, or c, the
coupon rate.
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For ease of exposition we will assume that r is a
constant for the life of the bond.
In practice, each coupon may have to be
reinvested at a different rate of interest.
Thus each coupon can be re-invested at a rate of
r/2 per six monthly period.
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The coupon stream is an annuity.
The final payoff from re-investment is the
future value of this annuity.
The future value is

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The future value is the sum of all the
coupons which are reinvested
Which in this case is the principal
Plus the interest from re-investment.
The total value of coupons that are
reinvested is

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The interest on interest is therefore

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The YTM Calculation assumes that r/2 = y/2.
Consider an L&T bond with 10 years to
maturity.
The face value is Rs 1,000.
It pays a semi-annual coupon at the rate of 10%
per annum.
The YTM is 12% per annum.
Price can be calculated to be Rs 885.295.
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Assume that the coupons can be reinvested
at a six monthly rate of 6%
Which corresponds to a nominal annual rate of
12%.
The total coupon income = 50 x 20 = 1000
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Interest on interest gotten by reinvesting the
coupons

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In the end the holder will get back the face
value of Rs 1,000.
So the total cash flow at the end
= 1000 + 839.3 + 1000 = 2839.3
To get this income, the bondholder has to
make an initial investment of 885.295.

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So what is the effective rate of return?
It is the value of i that satisfies the following
equation

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So the rate of return is 6% on a semi-annual
basis or 12% on a nominal annual basis
Which is exactly the same as the YTM.
So how was this return achieved?
Only by reinvesting all the coupons at an annual
rate of 12%, compounded on a semi-annual basis.
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The reinvestment rate affects only the
interest on interest income.
The other two sources are unaffected.
If r > y, then the investors interest on
interest income would be higher
And the return on investment, i, would be
greater than the YTM, y.
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If r < y, then the interest on interest
income would be lower
And the rate of return, i, would be less than the
YTM, y.
So if one buys a bond by paying a price
corresponds to a YTM
The holder will realize that YTM only if
The bond is held till maturity
He is able to reinvest all the intermediate coupons at
the YTM.
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Future reinvestment rates may be less than
the rate prevailing at the outset
This risk is called Reinvestment Risk.
The degree of this risk depends on the time to
maturity as well as the quantum of the coupon.
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For a bond with a given YTM, and a coupon
rate, the greater the time to maturity
The more dependent is the total return from the
bond on the reinvestment income.
Thus everything else remaining constant, the
longer the term to maturity
The greater is the reinvestment risk.
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For a bond with a given maturity and YTM,
the higher the coupon rate
The more dependent is the total return on the
reinvestment income.
Thus everything else remaining the same, the
larger the coupon rate
The greater is the reinvestment risk.
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Thus premium bonds will be more vulnerable
to such risks than bonds selling at par.
Correspondingly, discount bonds will be less
vulnerable than bonds selling at par.
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If a zero coupon bond is held to maturity,
there will be no reinvestment risk
Because there are no coupons to reinvest.
Thus if a ZCB is held to maturity, the actual rate
of return will be equal to the promised YTM.
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This explains the popularity of ZCBs for many
investors, in particular, long-term investors
They can lock in a compounded rate of return if
they hold the bond till maturity
Without worrying about the need to reinvest cash
flows periodically
This explains the popularity of securities such as
STRIPS
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We will continue with the assumption that
the bond is held till maturity.
But we will explicitly assume the rate at
which the coupons can be reinvested.
That is we will no longer take it for
granted
That intermediate cash flows can be reinvested
at the YTM.
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Let us reconsider the L&T bond.
Assume that intermediate coupons can be
reinvested at 7% for six months
That is a nominal annual rate of 14%.
The total coupon income and the final face
value payment will remain the same
But the reinvestment income will change.
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The interest on interest

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So the final amount received
= 1000 + 1049.75 + 1000 = 3049.75
The initial investment is once again 885.295
Therefore, the rate of return is given by

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This is the return for six months.
The nominal annual return is 6.38 x 2 = 12.76%
Which is greater than the YTM of 12%.
The RCY is greater than the YTM, because we
assumed
That the reinvestment rate was greater than the
YTM.
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Had we assumed the reinvestment rate to be
less than the YTM
The RCY would have turned out to be less than
the YTM.
The RCY can be an ex-ante or an ex-post
measure.
Ex-ante means that we assume a reinvestment
rate and calculate the RCY.
Ex-post means that we take into account the
actual reinvestment

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We will now relax both the assumptions
which were used to calculate the YTM.
Firstly the investor need not hold the bond until
maturity.
Secondly he may not be able to reinvest the
coupons at the YTM.
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Now the return will depend on three sources
the coupons received
the reinvestment income
and the price at which the bond is sold prior to
maturity.
The sale price would depend inversely on the
prevailing yield at that point in time
And need not equal the face value.
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Assume that an investor with a 7 year
investment horizon buys the L&T bond
He will get coupons for 14 periods (not 20).
The total coupon income will be
50x14 = 700
Assume that the reinvestment rate is
expected to be 7% per six monthly period.
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We will also assume that the investor expects
the YTM after 7 years to be 12% per annum.
The first step is to calculate the expected
price at the time of sale.
At that point in time the bond will have 3 years
to maturity.
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The price using a YTM of 12% can be shown
to be Rs 950.865.
The interest on interest


8/28/2014 98
The total terminal cash flow
= 700 + 427.50 + 950.865 = 2,078.365
The initial investment as before is
885.295

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The nominal annual rate of return is
6.29x2 = 12.58%
This is the Horizon Yield.
It is also known as the Holding Period Yield
Once again, it can be calculated ex-post or
ex-ante.
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This measure of the rate of return is used for
callable bonds.
It is the yield that will make the PV of the
cash flows from the bond equal to the price
Assuming the bond is held till the call date.
In principle a bond can have many possible call
dates.
Each date will give rise to a corresponding YTC.
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In practice the cash flows are usually taken
only till the first call date
Although they can be taken to any subsequent
call date.
The YTC is given by the equation

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N
*
is the number of coupons till the call
date.
M
*
is the price at which the bond is
expected to be recalled.
M
*
need not equal the face value.
In practice many companies pay a Call
Premium at the time of recall.
As much as one years coupon
If so, M
*
= M + C

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Assume that the L&T bond is a callable bond
and that the first call date is 7 years away.
Assume that a call premium of Rs 100 will be
paid if the bond is recalled.
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The YTC is the solution to the following
equation

8/28/2014 105
The solution comes out to be 6.74%.
So the YTC on an annual basis is 13.48%.
The YTC is very important for Premium
Bonds.
The fact that a bond is at a premium, indicates
that the coupon is greater than the yield
And that therefore there is a greater chance of
recall.
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In practice the investors compute the YTC
for every possible call date.
They then compute the YTM as well.
The lowest of all possible values is called the
Yield to Worst.
8/28/2014 107
Consider a portfolio or a collection of bonds.
We cannot calculate the portfolio YTM as a
weighted average of the individual YTMs
Although in most cases it gives a very close
approximation
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You have to compute the cash flows from the
portfolio, and then find that interest rate
Which makes the PV of the cash flows equal to
the sum of the prices of the component bonds.
In other words we need to calculate the Portfolio
IRR
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Consider a person who buys a TELCO bond
and a Ranbaxy bond.
The TELCO bond has a maturity of 5 years,
face value of 1000, and pays a 10% coupon
The YTM is 12% per annum.
8/28/2014 110
The Ranbaxy bond has a face value of 1000,
4 years to maturity and pays a coupon of 10%
The YTM is 16% per annum.
Consider a portfolio consisting of one bond of
each company.
8/28/2014 111
The price of the TELCO bond can be shown to
be 926.405.
The price of the Ranbaxy bond can be shown
to be 827.63.
The total initial investment is therefore
1,754.035
8/28/2014 112
Period Investment Inflow from
TELCO
Inflow from
Ranbaxy
Total
0 (1754.035) (1754.035)
1 50 50 100
2 50 50 100
3 50 50 100
4 50 50 100
5 50 50 100
6 50 50 100
7 50 50 100
8 50 1050 1100
9 50 50
10 1050 1050
8/28/2014 113
Using a calculator or EXCEL, the portfolio
yield can be calculated to be 13.76%.
8/28/2014 114
Certain bonds are tax exempt
In the US both federal and state governments
can levy income tax
To compare a normal bond with a tax-free
bond we need to compute the TEY of the
tax-free bond
8/28/2014 115
In countries like the US, both federal and
state governments are empowered to levy
income tax
Governments in the US follow the guideline
of mutual reciprocity
Federal securities are exempt from state income
taxes
State and local government securities are
exempt from federal income taxes
Certain securities are exempt from both taxes
and are consequently tax free
8/28/2014 116
The method of calculation depends on the
applicable taxes
Let us consider a Municipal bond which is
yielding 6%
It is obviously exempt from Federal IT
Assume the Federal tax rate is 25%
TEY = 6.00/(1-0.25) = 8%
8/28/2014 117
The implication is the following
An investor should be indifferent between a
taxable bond yielding 8% and the Muni
If a taxable bond yields more than 8% go for it
If it yields less than 8% choose the Muni
8/28/2014 118
Sometimes a Muni may be exempt from both
Federal and state taxes.
The net impact of federal and state taxes fro
an investor may be computed as follows.
Assume the federal tax rate is 25%
And the state tax rate is 8%
State taxes may be claimed as an expense
while computing federal taxes

8/28/2014 119
On $100, the income net of state taxes will
be $92. $23 will be deducted as state tax.
The post tax income is $69
Thus the effective tax rate is 31%
So the TEY of a Muni that yields 6% is
6 (1 0.31) = 8.70%
8/28/2014 120

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