395 33 Powerpoint Slides 6 Valuation Management Bonds CHAPTER 6

CHAPTER 6
VALUATION AND MANAGEMENT OF BONDS
CONTENTS
Introduction Features of the bond
Face Value Coupon Rate Periodicity of coupon payments Maturity Redemption Value Fixed and Floating Rate Bonds Indexed Bonds Callable & Puttable Bonds Zero Coupon and Deep Discount Bonds Convertible Bonds
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Types of Bonds

Cash Flow of the bond

VALUATION & MANAGEMENT OF BONDS
CONTENTS
Pricing of bond/Yield on the bond

Deep Discount/Zero Coupon Bonds & STRIPS Term Structure of Interest Rates
Theories of Term Structure

Duration of the Bond Bond Rating Bond Management Strategies
VALUATION & MANAGEMENT OF BONDS CHAPTER 6
B ONDS
Bonds have emerged as one of the prominent financial instruments of capital markets world over.
Bonds are the instruments of borrowings. They promise a fixed return until their maturity and the payback of principal upon maturity.
F EATURES O F T HE B OND
The terms and conditions for the issue of bonds are pre decided at the time of the issue as a part of bond indenture.
Main features of bond indenture are:

face value,
coupon rate, periodicity of coupon payments,
maturity period, and

redemption value.
CHAPTER 6
T YPES O F B ONDS
Fixed rate and floating rate bonds

Indexed bonds Callable /puttable bonds
Bonds that can be called by the issuer prior to the maturity are known as callable Bonds, while whose redeemable at the option of subscribers are known as puttable bonds
Redemption in lump sum /phased redemption

T YPES O F B ONDS
Zero Coupon/Deep Discount Bonds
Bonds that do not pay any interest but are issued at discount to the face value and redeemed at face value are called Deep Discount Bonds
Convertible Bonds
Convertible bonds are those, which convert a part of the bond into equity shares. It combines the features of bonds and equity in a composite instrument
CHAPTER 6
C ASH F LOW O F T HE B OND
Cash flows of bonds are made up of two components: the periodic coupon payments and principal repayment
0 6 12 18 24 30 36
Time (months from now) Coupon received Principal paid (-) and redeemed (+)
0
-100
5
105
Total cash flow
-100
110
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P RICING O F B OND
The value of bond is arrived by discounting the future cash flows from the bonds at an appropriate discount rate
Discount rate must appropriately be adjusted for the

riskiness of the cash flows, prevalent market conditions, and timing of cash flows to truly reflect the expectations
CHAPTER 6
10
VALUE O F T HE B OND & D ISCOUNT R ATE

Value of the Bond and Discount Rate
140
120
Value (Rs.)
100
80
60 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% Discount Rate (%)
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11
VALUE O F T HE B OND & D ISCOUNT R ATE
Discount rate is a function of risk. Higher the risk, higher the discount rate and consequently lower the price of bond
When discount rate, r > coupon rate, i
Price < Face Value

When discount rate, r < coupon rate, i Price > Face Value
When discount rate, r = coupon rate, i

Price = Face Value
12
VALUE O F T HE B OND A ND R ISK F REE R ATE
Value of the bond does not rise above a certain maximum

Bond Value and Risk Free Rate
Price
Risk Free Rate Discount Rate
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13
VALUE O F T HE B OND W ITH T IME
The difference between the price and the redemption value narrows as maturity nears and price converges to its redemption value at maturity irrespective of the discount rate.
Bond Price and Time Price Premium Bond Par Value= Redemption Value Discount Bond
Maturity
Time
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14
Y IELD O N T HE B OND
There are four types of yields:

current yield; yield to maturity;
realised yield and

yield to call (relevant only for callable bonds)
Current yield is the annual coupon payment divided by the current price.
Interest Amount, Coupon x Face Value x100 Current Price, P0
CHAPTER 6
Current Yield(%) =
15
Y IELD TO M ATURITY (YTM)
Yield to maturity (YTM) is the rate of return the investor earns if he holds the bond till maturity. YTM satisfies the following
Value of the bond
n
= Price, P0 Ct Rt = + t 1 (1 + YTM) (1 + YTM)n
A 5-year bond with 12% coupon payable annually selling at Rs. 90 would have YTM of r such that
Price, P0 = 90.00 = 12 12 12 12 12 12 100 + 2 + 3 + 4 + 5 + 6 + (1 + r) (1 + r) (1 + r) (1 + r) (1 + r) (1 + r) (1 + r)6
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16
YTM A ND VALUE O F B OND
YTM considers the time value of money while calculating returns for the investor.
There is an inverse relationship between the price and the YTM of the bond.
CHAPTER 6
17
R EALISED Y IELD
Realised yield is the rate of return investor earns on bonds if he sells the bonds before its maturity. It has two components: annual coupons received till the date of sale and the capital appreciation realised on sale.
P0 x (1+ ry ) = TVn
18
Y IELD TO C ALL
Yield to call is the return the investors earn on the callable bonds till the time the bonds are called. It comprises of two components: annual coupons till the date of call and the call price. For a 5-year 12% annual coupon bond trading at Rs. 90, callable after four years at Rs. 105 the YTC is computed as below:
Value of the bond = Price, P0 = 90
n Ct Rt = + t 1 (1 + YTC) (1 + YTC)n 4 12 105 = + t 1 (1 + YTC) (1 + YTC)4
19
D EEP D ISCOUNT /Z ERO C OUPON B ONDS A ND S TRIPS
Zero coupon bonds do not pay any interest and instead provide all the returns in the form of capital gains.
They are issued at price substantially lower than the par value and are redeemed at par.
CHAPTER 6
20
Z ERO C OUPON B ONDS
The value of zero coupon bonds is arrived by discounting the par value (redemption price) at an appropriate discount rate
Coupon bearing bonds too can be made to look like zero coupon bonds if we treat all the coupon payments as separate instruments
Face Value (1 + r) T
Value of Zero Coupon Bond =
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21
S TRIPS
The process of segregating the coupon payments and redemption value and issuing them as separate securities is called stripping.
Each of the strips becomes a separate instrument that can be traded independently of the composite instrument. These are known as STRIPS (Separate Trading of Registered Interest and Principal of Securities).
CHAPTER 6
22
A DVANTAGES O F S TRIPS
The advantages of stripping include
increased liquidity due to increased participation by small investors as coupon stripping results in instruments of smaller denominations, larger number of securities available for trading providing depth to the market, and fair pricing due to increased depth and participation.
CHAPTER 6
23
T ERM S TRUCTURE O F I NTEREST R ATES
The timing of cash flows and the discount rates to be used are inter-dependent as the expectations of investors vary with the investment horizon. For example: Term of investment
1 year
Yield
8%
2 years
3 years
9%
10%
CHAPTER 6
24
T ERM S TRUCTURE O F I NTEREST R ATES
The relationship between the yield (interest rate) and the term of investment is called the term structure of interest rates.
TERM STRUCTURE OF INTEREST RATES
11 10
Yield (%)
9 8 10
9 8 7 6 5
2 Term of Investment (Years)
CHAPTER 6
25
YTM A ND T ERM S TRUCTURE
Ideally the value of the bond must be arrived at with the discount rate appropriate with the timing of the cash flow as given by term structure of interest rates, rather that single discount rate for all the cash flows. Value of the bond using single rate:
Price, P0 = 120 120 120 1000 + + + (1+ 0.10) (1+ 0.10)2 (1+ 0.10)3 (1+ 0.10)3 = Rs.1 ,049.73
= 109.09 + 99.17 + 90.16 + 751.31
Value of the bond using discount rate as per the term structure:
Price, P0 = = 111.11+ 101.00 + 90.16 + 751.31
120 120 120 1000 + + + (1+ 0.08) (1+ 0.09)2 (1+ 0.10)3 (1+ 0.10)3 = Rs.1 ,053.58
CHAPTER 6
26
F INDING T ERM S TRUCTURE
Though the YTMs are observable the term structure of interest rates needs to be derived on some rationale basis.
Term structure of interest rates is hidden in the YTMs of bonds with progressive maturities. YTMs of bonds with different maturities do not reflect the term structure unless all of them have only single cash flow attached with them.
CHAPTER 6
27
F INDING T ERM S TRUCTURE
The most suitable method to arrive at term structure on interest rates is to get the yields on bonds with increasing maturities but that have single cash flow, as is the case with zero-coupon bonds.
Bond Zero Coupon Bond Zero Coupon Bond Zero Coupon Bond Maturity 1 Year 2 Year 3 Year Price (Rs.) 925.00 845.00 770.00 Yield 8.11% 8.79% 9.10%
All bonds are redeemable at par with Rs. 1,000 Yields have been worked out using following:
FV P0 = (1 + rn )n
CHAPTER 6
28
I MPLIED F ORWARD R ATES
Term structure of interest rates not only provides expectations of returns with horizon of investment but also imply forward rates of interest.
For example 8% yield for 1 year investment and 9% for two year investment implies yield expectation of 10% for one year investment one year from now. Under conditions of perfect market and well-informed investors the direct investment strategy (investing for two years) and roll over strategy (investing for one year and then rolling over for another year)must result in identical returns.
CHAPTER 6
29
T HEORIES O F T ERM S TRUCTURE

Expectations Hypothesis
The shape of yield curve is dependent upon the expectations of investors about the future interest rates.
Liquidity Preference Hypothesis
Liquidity preference theory suggest that the term structure of the interest rates is governed by preferences of investors for liquidity.
Preferred Habitat/Market Segmentation Theory
Preferred Habitat theory recognises that the investor have preferred investment horizons. Short-term investors invest in securities with short maturities and long-term investors prefer securities with long-term maturities.
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30
D URATION O F T HE B OND
Values of bonds change with the change in interest rates.

With change in interest rates all bonds do not change in value by the same amount. It depends upon the Duration of the bond.
Price sensitivity of the bond is measured by the term called Duration.

31
C OMPUTING D URATION
Duration is the time weighted average of the present values of the cash flows of the bond as proportions of its price.
=
t
1 n
Duration of the Bond =
x PV of CFt P0 P0
1 x CF1 2 x CF2 3 x CF3 4 x CF4 + + + + .......... (1 + r)1 (1 + r)2 (1 + r)3 (1 + r) 4
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32
C OMPUTING D URATION
Time 1 0.081 2 80.00 66.12 60.11 54.64 7.40% 6.73% 6.12% Cash flow 80.00 PV (10%) 72.73 Proportion 8.14% Time x Proportion
0.148
3 0.202 4 0.245 80.00 80.00
5
0.278 6 0.303 7
80.00
80.00
49.67
45.16 41.05
5.56%
5.06% 4.60%
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80.00
0.322
33
S ENSITIVITY O F B OND P RICES
Due to convexity of bond price with interest rate the change in price of bonds is linear only approximately.
Volatility of the bond = =Duration (1+ YTM/m) 6.091 6.091 == - 5.54 (1+ 0.1/1) 1.1
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34
PROPERTIES OF DURATION
Duration of low YTM bonds is higher and hence they are more sensitive as compared to high YTM bonds.
Duration of low coupon bonds is higher
Duration of bonds with longer term to maturity is higher

Duration is always shorter than the term to maturity and increases as maturity extends
Duration of a portfolio of bonds is weighted average of durations of bonds consisting it.

Duration of Bond Portfolio=Dp = wiD1+w2D2+w3D3
35
B OND R ATING
Bond rating is an alphanumeric score given to debt issue of a firm by an independent specialised external agency.
It broadly signifies the level of risk associated with such an issue of debt. Purpose of rating is to facilitate investors to make informed judgment for investing
CHAPTER 6
36
B OND M ANAGEMENT S TRATEGIES

Buy-and-Hold Strategy

The simplest of the strategy of managing the investment in bonds is buy-and-hold. Buy-and-hold strategy has the advantage of least transaction cost.
Bond Laddering
Bond laddering strategy is similar to buyand-hold with the modification that the portfolio of bonds is chosen with staggered and progressive maturities.
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37
M ATURITY V S . D URATION M ATCHING I MMUNISATION
The investors in bond primarily face two kinds of risks

1.
Price Risk: Bonds prices change constantly, albeit not as much as stock prices, with the changing economic conditions that affect the YTM. Reinvestment Risk: Reinvestment risk arises due to inability of the investors to reinvest the interim coupon payments at the desired rate.
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2.
38
By matching maturity with the planned investment horizon the price risk is eliminated but the re-investment risk remains.
By making holding period equal to the duration of the bond the portfolio can be immunized from change in value due to change in interest rates.
39
Matching investment horizon with duration rather than maturity of the bond keeps terminal wealth constant.
1,800
TERMINAL VALUE
Terminal Value
1,400 M aturity M atching
1,000 Duration M atching 600 0 at 10% 1 at 5% 2 at 20% 3 4 5 Time (Years)
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40
R IDING T HE Y IELD C URVE
The strategy is used with rising yield curve to get higher returns by selling the bond rather than holding it till maturity.

a zero coupon bond with two years remaining for maturity. The rising yield curve with yields of 7% for one-year term and 8% for two-year term.
Buy and hold till maturity:

The current price of the bond would be Rs. 857.34 (1,000/1.082). If planned horizon of investment is two years the investor would lock-in the return of 8%.
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41
R IDING T HE Y IELD C URVE

Buy and sell after one year:
if investor sells the bond after one year the bond would trade at a price higher than expected. With 8% yield the price should be Rs. 925.92 (1,000/1.08). But since after one year the time left for maturity is one year only the new price of the bond should be Rs. 934.58 (1,000/1.07) consistent with the yield curve. The investor would realise a return of 9% if the bond is sold one year after investment.
CHAPTER 6

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CHAPTER 6

VALUATION AND MANAGEMENT OF BONDS

Cash Flow of the bond

Pricing of bond/Yield on the bond

Theories of Term Structure

maturity period, and

VALUATION & MANAGEMENT OF BONDS

Fixed rate and floating rate bonds

Redemption in lump sum /phased redemption

Zero Coupon/Deep Discount Bonds

VALUATION & MANAGEMENT OF BONDS

C ASH F LOW O F T HE B OND

Total cash flow

VALUATION & MANAGEMENT OF BONDS

VALUATION & MANAGEMENT OF BONDS

VALUE O F T HE B OND & D ISCOUNT R ATE

60 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% Discount Rate (%)

VALUATION & MANAGEMENT OF BONDS

VALUE O F T HE B OND & D ISCOUNT R ATE

Price < Face Value

When discount rate, r = coupon rate, i

VALUE O F T HE B OND A ND R ISK F REE R ATE

Value of the bond does not rise above a certain maximum

Risk Free Rate Discount Rate

VALUATION & MANAGEMENT OF BONDS

VALUE O F T HE B OND W ITH T IME

VALUATION & MANAGEMENT OF BONDS

There are four types of yields:

current yield; yield to maturity;

realised yield and

VALUATION & MANAGEMENT OF BONDS

Y IELD TO M ATURITY (YTM)

= Price, P0 Ct Rt = + t 1 (1 + YTM) (1 + YTM)n

VALUATION & MANAGEMENT OF BONDS

YTM A ND VALUE O F B OND

VALUATION & MANAGEMENT OF BONDS

D EEP D ISCOUNT /Z ERO C OUPON B ONDS A ND S TRIPS

VALUATION & MANAGEMENT OF BONDS

Z ERO C OUPON B ONDS

Value of Zero Coupon Bond =

VALUATION & MANAGEMENT OF BONDS

VALUATION & MANAGEMENT OF BONDS

The advantages of stripping include

VALUATION & MANAGEMENT OF BONDS

T ERM S TRUCTURE O F I NTEREST R ATES

T ERM S TRUCTURE O F I NTEREST R ATES

2 Term of Investment (Years)

VALUATION & MANAGEMENT OF BONDS

YTM A ND T ERM S TRUCTURE

= 109.09 + 99.17 + 90.16 + 751.31

F INDING T ERM S TRUCTURE

VALUATION & MANAGEMENT OF BONDS

F INDING T ERM S TRUCTURE

VALUATION & MANAGEMENT OF BONDS

I MPLIED F ORWARD R ATES

VALUATION & MANAGEMENT OF BONDS

T HEORIES O F T ERM S TRUCTURE

Liquidity Preference Hypothesis

Preferred Habitat/Market Segmentation Theory

VALUATION & MANAGEMENT OF BONDS

Values of bonds change with the change in interest rates.

Price sensitivity of the bond is measured by the term called Duration.

Duration of the Bond =

1 x CF1 2 x CF2 3 x CF3 4 x CF4 + + + + .......... (1 + r)1 (1 + r)2 (1 + r)3 (1 + r) 4