How to Value Bonds?

Application of time value of money

Bonds
The "Name's Rajan, Game's Bond"
• http://blogs.wsj.com/indiarealtime/2013/10/3
1/is-new-rbi-bond-as-good-as-gold/
• Why understand bonds and their pricing?
– To determine risk free interest rates that produce the
yield curve
– Yield curve provides the information for valuing risk
free cash flows and assessing expectations of inflation
and economic growth
http://www.businessweek.com/news/2011-12-22/yield-
curve-signals-economy-may-tame-price-growth-india-
credit.html
– Firms issue bonds to fund their own investments and
the return that investors earn on them are part of cost
of capital
 Bonds
• Assets whose promised cash flows are always
delivered
• Certificate showing that a borrower owes a
specified sum
• Borrower agrees to pay interest and principal
payments on designated dates
• Riskless
• Face value of the bond is known as the principal
• Maturity – both principal and interest
 Effective Annual Interest rate
• Compounding
• Stated interest rate and effective annual
interest rate
• EAR= (1+APR/m)m-1
• APR is the annual percentage rate.
• Amount of simple interest earned in one year
without the effect of compounding
• Suppose a bank advertises savings accounts
with an interest rate of “6% APR with monthly
compounding”
• You will earn 6%/12 = 0.5% monthly
• You will therefore earn 1*(0.005)^12=
1.061678
• EAR = 6.1678%
 Pure Discount Bonds (PDBs)
• Simplest kind of bond
• Single payment at a fixed future date
• Matures or expires on the date of final
payment
• Payment at maturity is bond’s face value
• Zero Coupon Bonds
• Holder receives no cash payment until
maturity
 Value of a PDB
F
PV 
(1  R ) T

A PDB that pays a face value F in T years, where the

interest rate is R in each of the T years
 Example
• Suppose that the interest rate is 10%.
Consider a bond with a face value of Rs.1
million that matures in 20 years.
• PV = 1million/(1.1)^20 = Rs. 148,644
Value of a Coupon Bond (CB)

C C C F
PV    ..... 
1  R (1  R) 2
(1  R) T
(1  R)T

F
PV  C  AF 
(1  R) T
 Example
• Suppose it is November 2006. We see some
13s of November 2010 in the newspaper. The
face value is Rs. 1,000. Interest is paid each
May and November. If the stated annual
interest rate is 10% per year, what is the PV of
the bond?
 Value of a Consol
• Never stop paying a coupon
• Have no maturity date
• Clause: Gives govt the right to buy them back
from the holders (Call Provisions)
• Preferred Stock: Fixed dividend in perpetuity
• Value is same as calculated using Perpetuity
Formula
 Different Types of Bonds

Year 1 Year 2 Year 3 Year 4

6 12 18
ear 1
24 30 36 42 48

ear 1
Year 1
PDB F

CB C C C C C C C C+F

Consols C C C C C C C C C…….
 Bond Concepts
• Interest Rates and Bond Prices
• Example
• The interest rate is 10%. A two year bond with
a coupon pays interest of Rs.100. We assume
that interest is paid annually.
• Bond is priced at face value

100 1000  100

PV   2
 1000
1.10 (1.10)
• If interest rate rises to 12%, the bond sells at

100 1100
PV   2
 966.20 At
1.12 (1.12) Discount

• If interest rate falls to 8%, the bond sells at

100 1100
PV   2
 1035.67
1.08 (1.08)
At
Premium
 General Principle
• A level CB sells in the following ways:
– At the face value of 1000, if the coupon rate is
equal to the marketwide interest rate
– At a discount if the coupon rate is below the
marketwide interest rate
– At a premium if the coupon rate is above the
marketwide interest rate
 Coupon yield
• The coupon yield is simply the coupon
payment as a percentage of the face value.
• Coupon yield = Coupon Payment / Face Value
• Coupon: 8.24
Face Value: Rs.100
Market Value: Rs.103.00
Coupon yield = 8.24/100 = 8.24%
 Current Yield
• The current yield is simply the coupon payment
as a percentage of the bond’s purchase price; in
other words, it is the return a holder of the bond
gets against its purchase price which may be
more or less than the face value or the par value.
• The current yield for a 10 year 8.24% coupon
bond selling for Rs.103.00 per Rs.100 par value is
:
Annual coupon interest = 8.24% x Rs.100 =
Rs.8.24
Current yield = (8.24/Rs.103)X100 = 8.00%
 Yield to Maturity
• If our bond is selling at Rs. 1035.67, what
return is a bond holder receiving?

100 1000  100

1035.67  
1 r (1  r ) 2

• Traders state that the bond is yielding an r %

return
• YTM of r%
 Example
• IFCI Ltd Millionaire Bonds
• Issued at Rs. 5000 as a pure discount bond
• Maturity date of September, 2026
• Redeemed at 5 lac rupees
• In 2001, bond was trading at Rs. 10000
• Calculate YTM
• Comes to 17%
YIELD (settlement,maturity,rate,price,redemption,frequency,basi
s)

Wherein;
• Settlement is the security's settlement date. The security
settlement date is the date on which the security and funds
are exchanged.Maturity is the security's maturity date.
• The maturity date is the date when the security expires.
• Rate is the security's annual coupon rate.
• Price is the security's price per Rs.100 face value.
• Redemption is the security's redemption value per Rs.100
face value.
• Frequency is the number of coupon payments per year. (2 for
Government bonds in India)
• Basis is the type of day count basis to use. (4 for Government
bonds in India which uses 30/360 basis)
India - Bonds

(a) Govt. of India Dated Securities

(b) State Government Securities

(c) 91–Day Treasury Bills

(d) 182–Day Treasury Bills

(e) 364–Day Treasury Bills

 G-sec yields decline marginally
reflecting improved liquidity
conditions

http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14619
The Yield Curve and Discount Rates
• The relationship between investment term
and the interest rate is called term structure
• We can plot this relationship on a graph called
yield curve
 Term Structure Example
Term Jan 2004 Jan 2005 Jan 2006
1 1.15% 2.69% 4.32%
2 1.87% 3.06 4.34
3 2.48% 3.34 4.34
4 2.98% 3.57 4.34
5 3.40% 3.76 4.36
6 3.75% 3.93 4.38
7 4.05% 4.08 4.42
 Using term structure to compute PVs
• A risk free 5 year annuity of Rs. 1000 per year
• Yields on zero coupon risk free treasury
securities of different maturities
• 1 year – 7.48%
• 2 year – 7.52%
• 3 year – 7.58%
• 4 year – 7.62%
• 5 year – 7.75%
• Point to note
• You cannot use annuity formula for different
interest rates over the investment horizon
• To know one interest rate, calculate IRR for the
PV
• Yield curve changes over time
• What accounts for the changes in the yield
curve?
• Strongly influenced by interest rate
expectations
 Practice Questions
1. Following zero coupon bonds are trading at
prices shown below per 100/- face value.
Determine the corresponding YTM for each
bond.

Maturity Price
1 96.62
2 92.45
3 87.63
4 83.06
2. The treasury has just issued a 5year, 1000/-
bond with a 5% coupon rate and semi annual
coupons. What cash flows will you receive if
you hold this bond until maturity and what
will be your YTM for the market price of
957.35/- ?
If the YTM is 6.30% (Annual), then the bond is
trading at what price?
 Duration
• Sensitivity of a bond’s price to changes in the
interest rate
• Bonds with high durations are highly sensitive
interest rate changes
• Compare a 15 year zero coupon bond and a 30
year coupon bond with 10% annual coupons,
if YTM increases from 5% to 6%.
 • Taking a bond having 2 years maturity, and
10% coupon, and current price of Rs.102, the
cash flows will be (prevailing 2 year yield being
9%):
• period
Time
1 2 3 4
Total
(years)

Inflows
5 5 5 105
(Rs.Cr)

PV at an
4.78 4.58 4.38 88.05 101.79
yield of 9%

PV*time 4.78 9.16 13.14 352.20 379.28

Duration in number of periods = 379.28/101.79 = 3.73

Duration in years = 3.73/2 = 1.86 years
Duration refers to:
• the weighted average term (time from now to
payment) of a bond's cash flows or of any series of
linked cash flows.
• The higher the coupon rate of a bond, the shorter the
duration (if the term of the bond is kept constant).
• Duration is always less than or equal to the overall life
(to maturity) of the bond.
• Only a zero coupon bond (a bond with no coupons) will
have duration equal to its maturity.
• the sensitivity of a bond's price to interest rate (i.e.,
yield) movements.