VALUATION OF BONDS

Valuation

Value of bonds/debentures
= PV of expected future cash flows

To value bonds we need to:

Estimate future cash flows:
Size (how much) and
Timing (when)

Discount future cash flows at an appropriate rate:

The rate should be appropriate to the risk presented by the
security.
Indian Debt Market
Consists of mainly two categories:
the government securities comprising central
government and state government securities,
the corporate bond market consists of financial
institutions (FI) bonds, public sector units (PSU) bonds,
and corporate bonds/debentures.

The government securities are the more dominant

category of debt markets
Bonds
Bonds, generally, provide a fixed return to the
holder

Types:
Coupon and Zero Coupon
Key Features of a Coupon Bond
Par value or Face value: Rs 1,000 or Rs 100 (usually)
Issue Price is generally equal to the par value, but may be
lower or higher
Market Price: Price of the bond in the market.

Changes according to changes in interest rates

Coupon interest rate: Stated interest rate.
Coupon interest amount = Coupon interest rate x par value
Maturity: Years until bond must be repaid or Life of the bond
Maturity Value: generally same as the par value
but may be different, i.e. either higher or lower than par value
VALUE OF A BOND
n
P= Ct
(1+r)t
+
M
(1+r)n
t=1

Ct = Coupon Interest Amount

M = Maturity value (usually the Face value)
r = return required by the bondholder
n = number of years to maturity
ILLUSTRATION

Compute the price of a 15-year, 12 percent coupon

bond with a par value of 1,000. Let us assume that
the required yield on this bond is 12 percent.
Lay down the cash flows:
15 annual coupon payments of Rs. 120
Rs. 1000 principal repayment 15 years from now

The value of the bond is:

= Rs 1000
ILLUSTRATION

Continuing with the previous example, now assume

five years have passed. Now time left to maturity is
10 years. Let us assume that the required yield on this
bond has gone up to 13 percent. Compute the price.
The cash flows for this bond are as follows:
10 annual coupon payments of Rs. 120
Rs. 1000 principal repayment 10 years from now

The value of the bond is:

= 651.1492 + 294.5883 = Rs. 945.74
Practice
3 year corporate bond with 8% coupon rate and
1000 face value
Annual interest payments

Market rate on similar bonds is 10%

Answer: 950.26
VALUE OF A BOND WITH SEMI-ANNUAL INTEREST

2n

P = t= 1 Ct / 2
+
M
(1+r/2)t (1+r/2)2n

where:
P = market price of the bond
Ct = annual coupon payment
n = number of years to maturity
M = Maturity value of the bond
r = annual return required by the bondholder
 ILLUSTRATION
As an illustration, consider an 8 year, 12 percent coupon bond with a
par value of Rs. 100 on which interest is payable semi-annually. The
required return on this bond is 14 percent.
Value of the bond is:
16

P= 6
(1.07)t
+
100
(1.07)16
t=1

= Rs. 90.55

In EXCEL use the function called PRICE

Semiannual Compounding Example

What is the price of a three-year, 5 percent coupon bond when

the market interest rate is 8 percent, if the coupon payments
are made semi-annually? Face value is Rs 1000

Answer: 921.37
PRICE-YIELD RELATIONSHIP
Coupon is 14%
Coupon Rate, Required Yield, & Price

Coupon rate > Required yieldPrice > Par (Premium bond)

Coupon rate =Required yield Price = Par (At Par bond)

Coupon rate<Required yield Price<Par (Discount bond)

Zero coupon bonds

Zero coupon bonds do not pay any periodic interest;

Issued at a price substantially lower than the par value (or

face value) and redeemed at par value (or face value).

The difference between issue price and redeemable price

(face value) itself acts as interest to holders.
 The value of zero coupon bonds is arrived by discounting the
par value (redemption price) at an appropriate discount rate

Value of Zero Coupon Bond with annual compounding

if semi annual
What is the price of a zero coupon bond with a 1,000 face
value, 10-year maturity, and semiannual compounding when
the market interest rate is 12 percent?

1000/ (1.06) 20
=311.8

If it was an annual bond then,

P = 1000 / (1.12) 10
=321.97
Practice
X is interested in buying a five-year zero coupon
bond whose face value is 1,000. He understands
that the market interest rate for similar investments is
9 percent. Assume annual compounding for
payments. What is the current price of this bond?

649.93
Computing Bond Yields

Yield to Maturity
 Yield to Maturity

Discount rate that makes present value of coupon and

principal payments equal to price of bond.

It is the yield that investor earns if bond is held to maturity,

and all coupon and principal payments are made as
promised.

It assumes all the bonds cash flow is reinvested at the

computed yield to maturity
Example

Find the yield-to-maturity of a 5 year 6% coupon bond that is

currently priced at 850 using annual compounding (face
value being 1000)

Trial and Error method

In EXCEL use the function called YIELD.

If annual compounding is assumed, the answer is 9.95%

Approximation method
Reinvesting of coupons at YTM

Year CF FV

1 60 87.69316

2 60 79.75577

3 60 72.53682

4 60 65.97127

5 1060 1060

Total FV 1365.957

PV 850
Yield
[(1365.957/850)^(1/5)]-1 9.95%
Approximation method

M-P
C
Annual Yield to Maturity n
MP
2

M = Maturity Value
P = Bond Price
C = the annual coupon interest (in Rupees)
n = number of years

Answer using approximation formula : 9.73%

Find the yield-to-maturity of a 5 year 6% coupon bond that is
currently priced at 850 using semi annual compounding (face
value being 1000)

I. In EXCEL use the function called YIELD.

I. Answer using Excel is 9.87

II. Approximation method

Approximation method

M-P
[C/2]
Semi - annual Yield to Maturity 2n
MP
2

For annualisation:

Simple YTM = 2*semi-annual YTM

Effective YTM = (1 + semi-annual YTM)2 1

For semi annual bond the yield is:

9.73% (simple YTM); 9.97% (effective YTM)
Bond Theorems
1. Bond prices are negatively related to interest
rate movements

2. For a given change in interest rates, the prices of

long term bonds will change more than the prices of
short term bonds

3. For a given change in interest rates, the prices of

lower coupon bonds change more than the prices of
higher coupon bonds
Bond Theorems
1. Bond prices are inversely related to interest rate
movements.

As interest rates decline, prices of bonds rise; as

interest rates rise, prices of bonds decline.
Bond Theorems
2. For a given change in interest rates, prices of long-
term bonds will change more than prices of short-term
bonds.

This means that:

Long-term bonds have greater price volatility than
short-term bonds.

Long term bonds receive much of their cash flows into the
future, and because of time value of money, these cash
flows are heavily discounted.
Assume two, 8% coupon bonds, one with a maturity of 2 year, other
with 10 years. Calculate price with YTM of 7%. FV is Rs 100.

The price for 2 year bond is Rs 101.81

The price of 10 year bond is Rs 107.02

What would happen to the price if YTM changes to 10%

Maturity Maturity
2 years 10 years
YTM Price % change YTM Price % change

If 7% 101.81 7% 107.02

10% 96.53 -5.19% 10% 87.71 -18.05%

Bond Theorems
3. For a given change in interest rates, prices of
lower-coupon bonds change more than prices
of higher-coupon bonds.

The lower the bonds coupon rate, the greater the proportion
of the bonds cash flow investors will receive at maturity.
Consider two 20 year bonds, one with a
coupon rate of 3% and the other with 8%

Coupon 3% Coupon 8%
YTM Price % change YTM Price % change
If 7% 57.62 7% 110.59
If 10% 40.40 -29.9% 10% 82.97 -24.98%
Bond Theorem Applications

Trading Strategies

If interest rates are expected to decline, bonds with

higher interest rate sensitivity should be selected
long maturity bonds with low coupons

If interest rates are expected to increase, bonds with

lower interest rate sensitivity should be chosen to
minimize capital losses short maturity bonds with
high coupons
Risk in Bonds

Interest Rate Risk

A rise in interest rates will depress the market prices and vice
versa
Default Risk
The borrower may not pay interest and/or principal on time
Call Risk
A Call provision gives the issuer the option to redeem the bond
before its maturity
When bonds are called, investors suffer financial loss because
they are forced to surrender their high-yielding bonds and
reinvest their funds at lower prevailing market rate of interest.
 Liquidity Risk
Liquidity is the ability to sell a security quickly at low
transaction cost, and at its fair market value.
Risk is: selling at a discount and buying at a premium

Inflation risk
Higher than expected inflation reduces the cash proceeds in
real terms for lender
Reinvestment risk
Interest payments may have to be reinvested at a lower
interest rate
Foreign exchange risk
If bonds are denominated in a foreign currency
 Term Structure of Interest Rates

This is the relationship between yield and term to maturity.

Yield curves depict graphically how market yields vary as

term to maturity changes.
 Yield Curves
Yields

Upward Sloping

Flat

Downward Sloping

Maturity
 The Structure of Interest Rates

Three basic shapes (slopes) of yield curves in the

marketplace:
1. Ascending or normal yield curves are upward sloping yield
curves that occur when economy is growing.

2. Descending or inverted yield curves are downward sloping

yield curves that occur when economy is declining or heading
into recession.
3. Flat yield curves imply interest rates unlikely to change in
near future.
 The Structure of Interest Rates

Three economic factors determine shape of yield

curve:

1) Real rate of interest

2) Expected rate of inflation
3) Interest rate risk
Real Rate of Return (using Fisher equation) =

(1 Nominal RR)
1
(1 Rate of Inflation)
 The Structure of Interest Rates
The Real Rate of Interest
The real rate of interest varies with business cycle.
Highest rates seen at end of a period of business
expansion.
Lowest rates at bottom of a recession.
 The Structure of Interest Rates

The Expected Rate of Inflation

If investors believe inflation will be increasing in future, yield
curve will be upward sloping, since long-term interest rates
will contain a larger inflation premium than short-term
interest rates.

If investors believe inflation will be subsiding in future,

prevailing yield will be downward sloping.

http://blogs.wsj.com/indiarealtime/2015/08/24/raghuram-rajans-common-
man-theory-on-inflation/
 The Structure of Interest Rates

Interest Rate Risk

The longer the maturity of a security, the greater
its interest rate risk, and the higher the interest
rate.
The interest risk premium always adds upward bias to
slope of yield curve.
 Yields in November 2016

91 day T Bill rate : 6.36 %

364 day T bill rate: 6.46%
10 Year GOI Bond rate: 6.83%
Yields
6.90%

6.80%

6.70%

6.60%

6.50%

6.40%

6.30%

6.20%

6.10%
91 day 364 day 10 year

Source:
https://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx
http://www.tradingeconomics.com/india/government-bond-yield