Bond Valuation

Bond Valuation
Bond terminology, Classification, Bond returns (Yields), Bond pricing theories (only brief idea) and empirical evidence. Treatment Lecture mode + problem Solving + on line demonstration Suggested Readings Text Books same as session 1 Ref. Books: Security Analysis and Portfolio Management by Fischer and Jordon, Security Analysis, and Portfolio Management by Punithavathy Pandian and Investment Analysis and Portfolio Management by Reilly and Brown.
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Concepts
A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates.
Coupon rate Face value (or par) Maturity (or term)
Bonds are sometimes called fixed income securities.

Changing complexion of bond market in india

particulars instruments Interest rate Number of players Reference rate Methods of analysis Nature of market Mode of certificate Approach to portfolio management
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Pre-liberalisation Plain vanilla bond Stable and administered few No reference rate Simple- CY, adhoc rules Highly illiquid physical Investors follow fairly passive approach
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Post- liberalisation complex features Volatile and market determined More Reference rate is emerging YTM, Duration Signs of increasing liquidity Demat mode Active approach is gaining ground
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Debt market in India

The debt market in India comprises mainly of two segments viz., the Government securities market consisting of Central and State Governments securities, Zero Coupon Bonds (ZCBs), Floating Rate Bonds (FRBs), T-Bills Corporate securities market consisting of FI bonds, PSU bonds, and Debentures/Corporate bonds. Government securities form the major part of the market in terms of outstanding issues, market capitalization and trading value. It sets benchmark for the rest of the market. The market for debt derivatives have not yet developed appreciably though a market for OTC derivatives in interest rate products exists.
Debt market
Public debt market is divided into three segments
1. Short term issues with maturity of one year or less- money market 2. Intermediate term issues- one to 10 yearsnotes 3. Long term obligation- excess of 10 yearsbonds
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Bond characteristics
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Types of debt securities

The following types of securities are issued by the Government: 1. Securities with fixed coupon rates:
These securities carry a specific coupon rate remaining fixed during the term of the security and payable periodically. These may be issued at a discount, at par or at a premium to the face value, but are redeemed at par. 2. Floating Rate Bonds: These securities carry a coupon rate, which consists of a variable base and a spread. The most common base rate used is the weighted average of yield of 364 day-treasury bills. The spread is decided at the auction.
Types of debt securities

3. Zero Coupon Bonds: These are issued at a discount and redeemed at par. On the basis of the bids tendered, the RBI determines the cutoff price at which tenders would be accepted at the auction. 4. Securities with Embedded Options: These securities, where a call option/put option is specified, are repaid at the option before the specified redemption date.
Bonds with embedded options

Convertible bonds- bond holder holds the right (option) to convert into equity) Callable Bonds- issuer has the right (option) to redeem them prematurely. Puttable Bonds- investor has the right (option) to sell the bond prematurely to the issuer.
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Some other concepts

Pure Discount or Zero-Coupon Bonds
Pay no coupons prior to maturity. Pay the bonds face value at maturity.
Coupon Bonds
Pay a stated coupon at periodic intervals prior to maturity. Pay the bonds face value at maturity.
Perpetual Bonds (Consols)

No maturity date. Pay a stated coupon at periodic intervals.
Self-Amortizing Bonds
Pay a regular fixed amount each payment period over the life of the bond. Principal repaid over time rather than at maturity.
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Some other concepts

Straight bonds plain vanilla bonds Very common form- popular Pays fixed periodic (semi annual coupon) over its life and returns the principal on maturity. Floating rate bonds Interest rate is linked to a bench mark rate. In 1993 SBI issues first ever floating rate bonds having interest rate at 3 % more on the banks maximum term deposit rate. Gaining ground right now.
Perpetual Bonds
Perpetual bonds, also called consols, has an indefinite life and therefore, it has no maturity value. Perpetual bonds or debentures are rarely found in practice.
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Perpetual Bonds
Suppose that a 10 per cent Rs 1,000 bond will pay Rs 100 annual interest into perpetuity. What would be its value of the bond if the market yield or interest rate were 15 per cent? The value of the bond is determined as follows: INT 100
B0
kd
0.15
Rs 667
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Valuation of Bonds
Bond values are discussed in one of two ways:
The Rupee priceThe yield to maturityabsolute value return basis
These two methods are equivalent since a price implies a yield, and vice-versa
Bond Yields
There are several ways that we can describe the rate of return on a bond:
Coupon rateCurrent yieldYield to maturityModified YTMYield to callRealized Yield nominal yield annual coupon income to MP promised yield to maturity (YTM) assumed reinvestment rate return at the point of call this might be called the expected yield
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Current Yield
Current yield is the annual interest divided by the bonds current value. Example: The annual interest is Rs 60 on the current investment of Rs 883.40. Therefore, the current rate of return or the current yield is: 60/883.40 = 6.8 per cent. Current yield does not account for the capital gain or loss.
Yield to- Maturity (YTM)

The yield to maturity is the same as internal rate of return (IRR) for the bond. it is the investors realized yield YTM is the average annual rate of return that a bondholder will earn under following assumptions:
Bond is held to maturity The interest payments are reinvested at the YTM
Most widely used bond yield

B0
t 1
INTt Bn t n (1 kd ) (1 kd )
PRESENT VALUE
PRESENT VALUE OF INTEREST/ COUPON INCOME
+
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OF MATURITY/REDEMPTION VALUE
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An approximation
Trial and error approach-
1 C ( M P) N YTM 0.4M 0.6 P

C= ANNUAL INTEREST PAYMENT M= MATURITY VALUE OF BOND P= PRESENT PRICE OF BOND N= NUMBER OF YEARS TO MATURITY
Perpetual bond
A perpetual bonds yield-to-maturity:
n
INT INT B0 t kd t 1 (1 kd )
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Pure Discount Bonds

Example: A company may issue a pure discount bond of Rs 1,000 face value for Rs 520 today for a period of five years. The rate of interest can be calculated as follows:
520
Refer future value of one rupee table at 5 year
5
1, 000
1 YTM
1, 000 1.9231 1 YTM 520 i 1.92311/ 5 1 0.14 or 14%

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Pure Discount bonds

Pure discount bonds are called deep-discount bonds or zero-interest bonds or zero-coupon bonds. The market interest rate, also called the market yield, is used as the discount rate. Value of a pure discount bond = PV of the amount on maturity:
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B0
1 kd
Mn
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AN EXAMPLE
As an example of the calculation of the bond return measures, consider the following: You are considering the purchase of a 2-year bond (semiannual interest payments) with a coupon rate of 8% and a current price of Rs.964.54. The bond is callable in one year at a premium of 3% over the face value. Assume that interest payments will be reinvested at 9% per year, and that the most recent interest payment occurred immediately before you purchase the bond. Calculate the various return measures. Now, assume that the bond has matured (it was not called). You purchased the bond for Rs.964.54 and reinvested your interest payments at 9%. What was your realized yield?
TIME LINE IF NOT CALLED- HELD TO MATURITY

1,000 -964.54 40 40 40 40
TIME LINE IF CALLED- NOT TO HOLD TO MATURITY

1,030 -964.54 40 40
0
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SOLUTIONS
The yields for the example bond are:
Current yield = 8.294% YTM = 5% per period, or 10% per year Modified YTM = 4.971% per period, or 9.943% per year YTC = 7.42% per period, or 14.84% per year Realized Yield:
if called = 7.363% per period, or 14.725% per year if not called = 4.971% per period, or 9.943% per year
CASE-1
Example: Suppose the 10% 10-year Rs 1,000 bond is redeemable (callable) in 5 years at a call price of Rs 1,050. The bond is currently selling for Rs 950.
950
t 1
100
t
1 YTC 1 YTC
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1,050
5
The bonds yield to call is 12.7%.

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Modified Yield to Maturity (M-YTM)

Lack of practical compliance to assumptions behind calculation of YTM. In particular to the reinvestment assumptionmore practical approach To more accurately calculate the yield, we can change the assumed reinvestment rate to the actual rate at which we expect to reinvest Resulting yield measure is referred to as the modified YTM, and is the same as the MIRR for the bond
Yield to Call (YTC)

Calculated when call provision is exercised. Most corporate bonds, and many older government bonds, have provisions to allow them to be called if interest rates should drop during the life of the bond Normally, if a bond is called, the bondholder is paid a premium over the face value (known as call premium) YTC is calculated as YTM is calculated except:
Call premium is added to the face value, and First call date is used instead of the maturity date
Realized Yield
Realized yield is an ex-post measure of the bonds returns. The realized yield is simply the average annual rate of return that was actually earned on the investment If you know the future selling price, reinvestment rate, and the holding period, you can calculate an ex-ante realized yield which can be used in place of the YTM (this might be called the expected yield)
Moodys Aaa Aa A Baa Ba B Caa Ca C D

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Bond Ratings S&P Quality of Issue

AAA AA A BBB BB B CCC CC C Highest quality. Very small risk of default. High quality. Small risk of default. High-Medium quality. Strong attributes, but potentially vulnerable. Medium quality. Currently adequate, but potentially unreliable. Some speculative element. Long-run prospects questionable. Able to pay currently, but at risk of default in the future. Poor quality. Clear danger of default . High specullative quality. May be in default. Lowest rated. Poor prospects of repayment. In default.
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High Inves tme nt Gr ades AAA (Triple A): Highest Safety
AA (Double A): High Safety
Crisils Debenture Ratings
Debentures rated ÀAA' are judged to offer highes t s afety of timely payment of interes t and principal. Though the circu ms tances providing this degree of s afety are like ly to change, such changes as can be envis aged are mos t unlikely to affect advers ely the fundamentally s trong pos ition of s uch iss ues . Debentures rated 'AA' are judged to offer high s afety of time ly payment of interes t and principal. They differ in s afety fro m ÀAA' is s ues only margina lly. Debentures rated À' are judged to offer adequate s afety of time ly payment of interes t and principal; however, changes in circu ms tances can advers ely affect s uch iss ues more than thos e in the higher rated categories . Debentures rated `BBB' are judged to offer sufficient s afety of timely payment of interes t and principal for the pres ent; however, changing circums tances are more like ly to lead to a weakened capacity to pay interest and repay principal than for debentures in higher rated categories . Debentures rated `BB' are judged to carry inadequate s afety of timely pay ment of interes t and principal; wh ile they are les s s us ceptible to default than other s peculative grade debentures in the immediate future, the uncertainties that the is suer faces could lead to inadequate capacity to ma ke timely interes t and principal payments . Debentures rated `B' are judged to have greater susceptibility to default; while currently interes t and principal payments are met, advers e bus iness or economic conditions would lead to lack of ability or willingnes s to pay interes t or principal. Debentures rated `C' are judged to have factors pres ent that make them vulnerable to default; time ly payment of interes t and principal is pos s ible only if favourable c ircu ms tances continue. Debentures rated `B' are judged to have greater susceptibility to default; while currently interes t and principal payments are met, advers e bus iness or economic conditions would lead to lack of ability or willingnes s to pay interes t or principal.
Inves tment Gr ades A: Adequate Safety
BBB (T rip le B): Moderate Safety
Speculati ve Gr ades BB (Double B): Inadequate Safety
B: High Risk
C: Substantial Risk
D: In De fault
Note:
1.
2. 3.
CRISIL may apply " +" (plus) or " -" (minus) signs for ratings from AA to D to reflect comparative standing within th e category. The contents within parenth esis are a guide to the pronuncia tion of the rating symbo ls. Preference share rating symbols are identical to deben ture rating symbols except that th e letters " pf" are prefixed to the d ebenture rating symbols, e.g. pfAAA (" pf Triple A" ).
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Bond Analysis
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Methods revisited
Annual Pmt CY Face Value
The yield to maturity is the same as the bonds internal rate of return (IRR) Modified YTM is the same as the MIRR for the bond
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1. Bond Values and Changes in Interest Rates

The value of the bond declines as the market interest rate (discount rate) increases. The value of a 10-year, 12 per cent Rs 1,000 bond for the market interest rates ranging from 0 per cent to 30 per cent.
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1200.0 1000.0
Bond Value
800.0 600.0 400.0 200.0 0.0 0% 5% 10% 15% 20% 25% 30% Interest Rate
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2. Bond Maturity and Interest Rate Risk

The intensity of interest rate risk would be higher on bonds with long maturities than bonds with short maturities.
The differential value response to interest rates changes between short and long-term bonds will always be true. Thus, two bonds of same quality (in terms of the risk of default) would have different exposure to interest rate risk.
Present Value (Rs) Discount rate (%) 5-Year bond 10-Year bond Perpetual bond 5 1,216 1,386 2,000 10 1,000 1,000 1,000 15 832 749 667 20 701 581 500 25 597 464 400 30 513 382 333
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3. Bond Duration and Interest Rate Sensitivity

The longer the maturity of a bond, the higher will be its sensitivity to the interest rate changes. Similarly, the price of a bond with low coupon rate will be more sensitive to the interest rate changes. However, the bonds price sensitivity can be more accurately estimated by its duration. A bonds duration is measured as the weighted average of times to each cash flow (interest payment or repayment of principal).
An example
Let us consider the 8.5 per cent rate bond of Rs 1,000 face value that has a current market value of Rs 954.74 and a YTM of 10 per cent, and the 11.5 per cent rate bond of Rs 1,000 face value has a current market value of Rs 1,044.57 and a yield to maturity of 10.8 per cent. Table shows the calculation of duration for the two bonds.
Year 1 2 3 4 5
Cash Flow 85 85 85 85 1,085
Year 1 2 3 4 5
Cash Flow 115 115 115 115 1,115
8.5 Percent Bond Present Value at 10 % 77.27 70.25 63.86 58.06 673.70 943.14 11.5 Percent Bond Present Value at 10.2% 103.98 94.01 85.00 76.86 673.75 1,033.60
Proportion of Bond Price 0.082 0.074 0.068 0.062 0.714 1.000 Proportion of Bond Price 0.101 0.091 0.082 0.074 0.652 1.000
Proportion of Bond Price x Time 0.082 0.149 0.203 0.246 3.572 4.252 Proportion of Bond Price x Time 0.101 0.182 0.247 0.297 3.259 4.086
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Volatility
The volatility or the interest rate sensitivity of a bond is given by its duration and YTM. A bonds volatility, referred to as its modified duration, is given as follows:
Volatility of a bond Duration (1 YTM)
The volatilities of the 8.5 per cent and 11.5 per cent bonds are as follows:
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Volatility
4.252 Volatility of 8.5% bond 3.87 (1.100)
4.086 Volatility of 11.5% bond 3.69 (1.106)
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Bond Valuation

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Bond Valuation

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Bond Valuation

Bonds are sometimes called fixed income securities.

Changing complexion of bond market in india

Debt market in India

Types of debt securities

Types of debt securities

Bonds with embedded options

Some other concepts

Perpetual Bonds (Consols)

Some other concepts

Yield to- Maturity (YTM)

Most widely used bond yield

PRESENT VALUE OF INTEREST/ COUPON INCOME

1 C ( M P) N YTM 0.4M 0.6 P

Pure Discount Bonds

1, 000 1.9231 1 YTM 520 i 1.92311/ 5 1 0.14 or 14%

Pure Discount bonds

TIME LINE IF NOT CALLED- HELD TO MATURITY

TIME LINE IF CALLED- NOT TO HOLD TO MATURITY

The bonds yield to call is 12.7%.

Modified Yield to Maturity (M-YTM)

Yield to Call (YTC)

Moodys Aaa Aa A Baa Ba B Caa Ca C D

Bond Ratings S&P Quality of Issue

High Inves tme nt Gr ades AAA (Triple A): Highest Safety

AA (Double A): High Safety

Crisils Debenture Ratings

Inves tment Gr ades A: Adequate Safety

BBB (T rip le B): Moderate Safety

Speculati ve Gr ades BB (Double B): Inadequate Safety

1. Bond Values and Changes in Interest Rates

2. Bond Maturity and Interest Rate Risk

3. Bond Duration and Interest Rate Sensitivity

Cash Flow 85 85 85 85 1,085

Cash Flow 115 115 115 115 1,115

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