Fixed Income tutorial

What is fixed income security?
Fixed income terminology
Types of Fixed income
Bonds vs Debentures
Government Securities and Corporate Debentures
Fixed Income Market Structure
How are the prices decided in debt market
Fixed income prices

What is a Realized Profit and Loss?

A realized profit or loss is a capital

gain or a loss that is the
result of a completed transaction. Realized profits are usually
taxable making them different than paper profits.

For example, a paper profit is a profit that hasn’t yet been realized through a transaction. If you buy a stock for $50 and its value jumps to $75, you have a paper profit of $25. If you do nothing, your profit is only on paper and not taxable yet. If you sell the stock and complete the transaction, you have a realized profit of $25 which may be taxable.

If you bought a stock for $50 and its value sinks to $25, you have a paper loss of $25 if you do nothing. You can’t report this as a loss because you have not sold it and realized your loss yet. If you do sell the stock at its reduced value, you have a realized loss which you may be able to use to offset your tax bill.

Realized profits and losses are the result of completed transactions not simply a rise or fall of an item’s value.

Accounting Principles & Standards

Accounting principles are the common set of accounting standards, policies and procedures used to compile financial reports. GAAP (generally accepted accounting principles) are a combination of authoritative standards and the generally accepted methods of recording and reporting accounting information. 
Each country worldwide has its own GAAP, for example US GAAP, French GAAP, and so on.
There are many bodies worldwide that set standards. Some of the leading ones are:
Financial Accounting Standards Board (FASB)
International Accounting Standards Board (IASB)
Accounting Standards Board (ASB)

Bonds: Calculating Yield

When talking about bonds (especially when buying them) you have to take into consideration the yield of the bond. Simply put, a bond’s yield shows the relationship of the investment and the income. For the sake of comparability yield is always shown as an annualized (yearly) percentage.

Current Yield

Although we may know the coupon rate of a bond that only shows the real yield of the bond if the bond was bought at par value and will be held till maturity. Current yield compares the yearly interest income with the current market price. If the bond was bought with a discount the current yield will be higher than the coupon rate, if it was bought with a premium it will be lower. Current yield is calculated with the following formula:

CY=

Holding-period Yield

This yield is used when the investor knows when he will sell his bonds. In this case we use an estimated selling price instead of the face value.

Yield to Maturity

Yield to maturity is the rate at which if we discount the incomes (cash-flows) of the bond, we get the par value exactly. This yield is used most because it takes into consideration all future incomes and also their change over time.

Simplified Yield to Maturity - SYTM

Yield can be calculated many ways. There are bond-tables from which you can calculate yield fairly easily. Some more serious calculators are also capable of doing the calculations. Without these we have two choices. We can either use a method called the trial and error method, or we can use simplified yield calculated method, aptly named SYTM or simplified yield to maturity. Both these choices are approximations, although I consider the trial and error method to be inferior because doing it in reality would be much longer and most probably less exact. The formula for calculating it is:

Yield of Zero Coupon Bonds

Because there is no interest payment here, only one cash-flow, the repayment of the face value, there is no need to use approximations because we know all the information we need. We know already that:

Rearranged:   

Please note that we can also use PVIF tables to solve these problems because:

By substituting this we get:

Yield of Perpetual Bonds

Calculating yield here is very simple, I will only mention it because no further explanation is needed.

Bond pricing

FI (fixed income) securities are traded in market like stocks, so they too have price.
The price of the bond is determined by the :

1. The current rates prevalent in the market
2. Future interest rate expectations
3. Credit quality of the issuer

Like any other asset, the price of the FI security is a present value of the future cash flows.
Bonds and interest rates inverse relation
Bonds price in secondary markets 
Calculating bond price

Calculating the bond price

Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember, to calculate present value--which is based on the assumption that each payment is re-invested at some interest rate once it is received--we have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. (If the concepts of present and future value are new to you or you are unfamiliar with their calculations, refer to our article “Understanding the Time Value of Money” for a quick brush-up.)



Here is the formula for calculating a bond's price, which uses the basic present value (PV) formula:

C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value
The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired (the calculation assumes this time is the present).
You may have guessed that the bond pricing formula shown above may be tedious to calculate since it requires us to add the present value of each future coupon payment. But since these payments are paid at an ordinary annuity, we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon. The following diagram illustrates how present value is calculated for an ordinary annuity:

Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods 1, 2, and 3. Notice how the present value decreases for those coupon payments that are further into the future (if you don't know why, see “Understanding the Time Value of Money”): the present value of the second coupon payment is worth less than the first coupon, and the third coupon is worth the least amount today. The further into the future a payment is to be received, the less it is worth today—this is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present values of all future cash flows, but, unlike the bond-pricing formula we saw earlier, it doesn't require us to add the value of each coupon payment. (For more on calculating the time value of annuities, see our article "Anything but Ordinary: Calculating the Present and Future Value of Annuities.")
By incorporating the annuity model into the bond pricing formula, which requires us to include also the present value of the par value received at maturity, we arrive at the following formula:

Let's now go through a basic example to find the price of a plain vanilla bond.
Example 1 Calculate the price of a bond with a par value of $1000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example we'll assume that coupon payments are made semi-annually to bond holders, and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price:

1. Determine the number of coupon payments: Since two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments.
2. Determine the value of each coupon payment: Since the coupon payments are semi-annual, divide the coupon rate in half. The coupon rate is the percentage off the bond's par value. As a result, each semi-annual coupon payment will be $50 ($1000 X 0.05).
3. Determine the semi-annual yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. (If we left the required yield at 12%, our bond price would be very low and inaccurate.) Therefore, the required semi-annual yield is 6% (0.12/2).
4. Plug the amounts into the formula:

Not too hard was it? From the above calculation, we have determined that the bond is selling at a discount: the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds.
Accounting for Different Payment Frequencies
In the example above coupons were paid semi-annually, so we divided the interest rate and coupon payments in half to represent the two payments per year. You may be now wondering whether there is a formula that does not require steps two and three outlined above (which are required if the coupon payments occur more than once a year). A simple modification of the above formula will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency:

Notice that the only modification to the original formula is the addition of “F,” which represents the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of 1. Should a bond pay quarterly payments, F would equal 4, and, if the bond paid semi-annual coupons, F would equal 2.
Pricing Zero-Coupon Bonds
So what happens when there are no coupon payments? For the aptly-named zero-coupon bond, there is no coupon payment until maturity. Because of this, the present value of annuity formula is unnecessary. You simply calculate the present value of the par value at maturity. Here's a simple example:
Example 2(a) Let's look at how to calculate the price of a zero-coupon bond that is maturing in five years, has a par value of $1000, and a required yield of 6%.

1. Determine the number of periods: Unless otherwise indicated, the required yield of most zero-coupon bonds is based on a “semi-annual coupon payment.” Here's why: the interest on a zero-coupon bond is equal to the difference between purchase price and maturity value, but we need a way to compare a zero-coupon bond to a coupon bond, so the 6% required yield must be adjusted to the equivalent of its semi-annual coupon rate. Therefore, the number of periods for zero-coupon bonds will be doubled, so the zero coupon bond maturing in five years would have ten periods (5 x 2).
2. Determine the yield: The required yield of 6% must also be divided by two since the number of periods used in the calculation has doubled. The yield for this bond is 3% (6% / 2).
3. Plug the amounts into the formula:

You should note that zero-coupon bonds are always priced at a discount: if zero-coupon bonds were sold at par, investors would have no way of making money from them and therefore no incentive to buy them.
Pricing Bonds between Payment Periods
Up to this point we have assumed that we are purchasing bonds whose next coupon payment occurs one payment period away, according to the regular payment-frequency pattern. So far, if we were to price a bond that pays semi-annual coupons and we purchased the bond today, our calculations would assume that we would receive the next coupon payment in exactly six months. Of course, since you won't always be buying a bond on its coupon payment date, it's important you know how to calculate price if, say, a semi-annual bond is paying its next coupon in three months, one month, or 21 days.

Determining Day Count
To price a bond between payment periods, we must use the appropriate day-count convention. Day count is a way of measuring the appropriate interest rate for a specific period of time. There is actual/actual day count, which is used mainly for Treasury securities. This method counts the exact number of days until the next payment. For example, if you purchased a semi-annual Treasury bond on March 1, 2003, and its next coupon payment is in four months (July 1st, 2003), the next coupon payment would be in 122 days:
Time Period = Days Counted
March 1-31 = 31 days
April 1-30 = 30 days
May 1-31 = 31 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 122 days
To determine the day count, we must also know the number of days in the six-month period of the regular payment cycle. In these six months there are exactly 182 days, so the day count of the Treasury bond would be 122/182, which means that out of the 182 days in the six-month period, the bond still has 122 days before the next coupon payment. In other words, 60 days of the payment period (182 - 122) have already passed. If the bondholder sold the bond today, he or she must be compensated for the interest accrued on the bond over these 60 days.
(Note that if it is a leap year, the total number of days in a year is 366 rather than 365.)
For municipal and corporate bonds, you would use the 30/360 day count convention, which is much simpler as there is no need to remember the actual number of days in each year and month. This count convention assumes that a year consists of 360 days and each month consists of 30 days. As an example, assume the above Treasury bond was actually a semi-annual corporate bond. In this case, the next coupon payment would be in 120 days.
Time Period = Days Counted
March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 120 days
As a result, the day count convention would be 120/180, which means that 66.7% of the coupon period remains. Notice that we end up with almost the same answer as the actual/actual day count convention above: both day-count conventions tell us that 60 days have passed into the payment period.
Determining Interest Accrued 
Accrued interest is the fraction of the coupon payment the bond seller earns for holding the bond for a period of time between bond payments. The bond price's inclusion of any interest accrued since the last payment period determines whether the bond's price is “dirty” or “clean.” Dirty bond prices include any accrued interest that has accumulated since the last coupon payment while clean bond prices do not. In newspapers, bond prices quoted are often their clean prices.
Since, however, many bonds traded in the secondary market are often traded in between coupon payment dates, the bond seller must be compensated for the portion of the coupon payment he or she earns for holding the bond since the last payment. The amount of the coupon payment that the buyer should receive is the coupon payment minus accrued interest.
Let's go through a simple example:
On March 1, 2003, Francesca is selling a corporate bond with a face value of $1000 and a 7% coupon paid semi-annually. The next coupon payment after March 1, 2003, is expected on June 30, 2003. What is the interest accrued on the bond?
1. Determine the semi-annual coupon payment: Since the coupon payments are semi-annual, divide the coupon rate in half, which gives a rate of 3.5% (7% / 2). Each semi-annual coupon payment will then be $35 ($1000 X 0.035).
2. Determine the number of days remaining in the coupon period: Since it is a corporate bond, we will use the 30/360 day-count convention.
Time Period = Days Counted
March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
Total Days = 120 days
There are 120 days remaining before the next coupon payment, but, since the coupons are paid semi-annually (two times a year), the regular payment period if the bond is 180 days, which, according to the 30/360 day count, is equal to six months. The seller, therefore, has accumulated 60 days worth of interest (180-120).
3. Calculate the accrued interest: Accrued interest is the fraction of the coupon payment that the original holder (in this case Francesca) has earned. It is calculated by the following formula:

In this example, the interest accrued by Francesca is $11.67. If the buyer only paid her the clean price, she would not receive the $11.67 to which she is entitled for holding the bond for those 60 days of the 180-day coupon period.

Now you know how to calculate the price of a bond, regardless of when its next coupon will be paid. Since bond price quotes are typically their clean prices but buyers of bonds pay the dirty, or full price, both buyers and sellers should understand for what amount a bond should be sold or purchased. In addition, the tools you learned in this section will better enable you to learn the relationship between coupon rate, required yield, and price, and the reasons why bond prices change in the market.

Bonds price in secondary markets

An issued fixed income pays fixed rate of interest in form of coupon until it matures. But if it is sold in the secondary markets before maturity , its value is affected by the current market rates.
So there are 2 cases :

• When the coupon rate is less than current interest rate:
  In this case security will be sold at discount
• When the coupon rate is more that current interest rate
  In this case security will be sold at premium(i.e  at profit)

Bonds can be priced at a premium, discount, or at par. If the bond's price is higher than its par value, it would sell at a premium because its interest rate is higher than current prevailing rates. If the bond's price is lower than its par value, the bond would sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bond's coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. So, usually the required yield on a bond is equal to or greater than the current prevailing interest rates.