Bond valuation

A bond or debenture is a basic fixed income

security which is issued by a borrowing unit under
a borrowing agreement. Under this agreement the
borrower has to pay periodic interest to the
registered holder on specific dates.

The rate of interest is called as coupon rate . is

fixed and applied to the face value of the bond to
find out the periodic interest amount. At maturity
the borrower repays the debt as per terms and
conditions of redemption.
 Features of bond or debentures
• Credit instrument
• Interest rate
• Collateral
• Maturity date
• Voting right
• Face value and redemption value
• Priority in liquidation
• Types of debt instrument:
• Secured and unsecured bond
• Convertible and non convertible bonds
• Zero coupon bonds
• Callable and putable bonds
• Floating rate bonds
• Deep discount bond
• Junk bonds
• Municipal bonds
 Bond Yield
• Bond yield refers to the % rate of return on
amount investment in buying the bond.
• Various factors on which the bond yield
depends are :
• Par value
• Coupon rate
• Maturity
• Market price
 Types of yield
• Current yield or basic yield : relates the coupon interest
rate with the current market price of the bond. In other
words it is the ratio of coupon rate to market price.

interest
• Current yield = ----------------------- *100
market price

If bond is selling at discount the current yield is greater

than coupon rate.
If bond is selling at premium the current yield is less than
coupon rate
If it is issued at par both the coupon rate and current
yield is same.
• Current yield ignores the prospective capital
gains or loss which the bond holder may have
in future.
• It also ignores the reinvestment of interest
income for the remaining life of the bond.
 Weighted yield
• On any particular day the bonds of a particular
type may be traded at different prices. The
weighted yield may be calculated as the
average yield on all these prices by assigning
weights equal to the market value of trade at
different prices. A time series of weighted
yield would help to find out the range of yield
on bonds.
 Yield to maturity
• YTM may be defined as rate of return that will be
earned if the bond is purchased today at the current
market price and is held by the investor till maturity.
YTM is also known as market rate of return.
• YTM is the rate of return that will be earned by the
investor under the following conditions:
• That the bond is purchased today at current market
price
• That the bind is held by investor till maturity
• That there is no default in payment of interest
• The interest received for the period are reinvested at
the rate equal to calculated YTM itself.
• YTM is a periodic interest rate that equates
the present value of expected cash flow from
the bond in terms of interest and redemption
value with the initial investment in the bond.
• IRR technique of capital budgeting to find out
the YTM of the bond.

• B=
Bo  Int * PVAF ( ytm, n )  RV * PVF ( ytm, n)......
 Approximate YTM
• The above trial and error procedure to find
out the YTM requires a lot of calculations. A
more practical alternative to this procedure is
the approximate YTM:

INT  ( RV  B 0) / n
ApproximateYTM 
( RV  B 0) / 2
• If MP = Par Value then YTM = coupon rate

• If MP > par value then YTM < coupon rate

• If MP < Par value then YTM > coupon rate

• YTM and Default Risk : YTM is also Known as
promised YTM as it is based on the expected
cash inflows. However the bonds are always
subject to default risk. So YTM calculated after
considering the default risk may be known as
expected YTM
 Yield to Call
• In the case of callable bonds the issuer
company has an option to call the bond at any
time after a stipulated period. The maturity
period of such bonds depends upon the
exercise of the option or the maximum period
as given in the issue conditions. So calculation
of YTM is of no use and we will calculate YTC
• YTC is calculated in the same way as the YTM
is calculated but only for the periods upto the
date on which the call can first be exercised.
• YTC is calculated in the same way as the YTM
is calculated but only for the periods upto the
date on which the call can first be exercised.

• B0 =
 Holding period returns
• The holding period returns equals the income
earned including capital gain or losses over a
period of time as a percentage of the bond
price.
total int .restincome  Bs  B 0
HPR 
B0
•
 Risk analysis in bond valuation
• Default risk

• Market interest rate risk

• Liquidity risk

• Inflation risk

• Reinvestment risk
 Credit Rating
• Credit rating is an opinion on the future ability and
legal obligation of the issuer to make timely payment
of principal and interest on a specific fixed income
security
• Credit rating is a specialized and technical work. It
requires expertise in the related field. The objective of
the credit rating may be summarized as follows:
• It lends credence to financial and other representation
made by the issuer of debt instrument.
• It provides superior and low cost information to the
investors.
• It imposes a self discipline on the borrower
• It encourages greater information disclosure
• It helps in formulation of public opinion on the issue of
debt instrument. It is a marketing tool for issuer.
 Credit rating agencies in India
• CRISIL: credit rating information services of India Ltd.
• ICRA : investment information and credit rating agency
of India
• CARE: Credit analysis and research ltd.
• Fitch Rating India Pvt. Ltd
• In India the credit rating agencies are registered with
and regulated by SEBI Act 1992. it has issued SEBI
regulation 1999. these regulation provide for
registration, general obligations, restriction on rating,
procedure for inspection and investigation and
procedure for default by credit rating agencies. The
regulation also prescribe a detailed code of conduct for
these agencies registered with SEBI.
 Process of credit rating
• To gather the information to evaluate the
credit risk of the specific issue
• To analyze and come to a conclusion on the
appropriate rating
• To monitor the credit quality of the rated
issuer and or security over time , declining on
the timely changes in rating as company
fundamental changes.
• To keep investor and market place informed
 Precautions of credit rating
• Credit ratings are not recommendations to
buy or sell

• The rating is specific to a instrument and is not

the rating of the issuer

• Specific credit rating opinions are intended to

measure many of the other factors that fixed
income investors must consider in relation to
risk.
 Term structure of interest rates
• The term structure of interest rates is the relationship
between maturity and interest rate.
• Yield curve depicts the relationship between time to
maturity and yields for a particular category of bonds at a
particular point of time.
• Types of Yield curve:
• Normal yield curve: represents an ascending term
structure. In this case interest rates will lengthening of
maturities. It shows the signal that interest rates in
future will rise.
• Inverse yield curve: has a declining tendency which is
signaling a decrease in interest rates
• There is a hump yield curve representing an increase in
the intermediate term interest rates and also indicates
that the interest rates in future may be declining.
• There is a flat term structure depicting that investors
are indifferent between varying maturities of bonds. It
also represents that there is no specific pattern of
future interest rates.
• Yield curve depicts only the expectation of a market
rates of interest in future and it yield curve deals with
YTM and there is an implied assumption regarding the
reinvestment rate. The yield curve assumes that all the
intervening cash flows will be reinvested at a rate equal
to the YTM
 Theories of term structure of
interest rates
• Expectation theory : the theory provides the basic
rationale for the shape of the yield curve. It asserts that
the long term rate is an average of the expected future
short term interest rate over the time horizon. In other
words it states that the return from a n year security is
equal to the average return expected from holding a one
year security over n years period.
• Higher expected interest rate in future will mean that
bond with higher maturities will carry higher YTM than
for shorter maturities. The yield curve will slope upward
it interest rates are expected to rise and will slope
downward if interest rate are expected to fall.
• Expectation theory testify that if the investors
expect interest rate to increase, they would
tend to lend for shorter periods and would
avoid long term commitment however the
borrower will attempt to borrow for a longer
period and to lock in lower interest rate.
 Market segmentation theory
• This theory asserts that long term and short terms
bonds are not substitute of each other and these are
traded essentially in distinct or segmented markets.
• In such a situation the long term equilibrium rates
and short term equilibrium rates are determined
separately by long term and short term participant
respectively.
• Under market segmentation theory the markets for
different maturities are segmented and the yield
curve is determined by the demand and supply
factors in each maturity segment.
 Liquidity preference theory
• This theory is based on the assumption that
the uncertainty of interest rates increases with
time so investors would prefer to lend or
shorter periods and borrowers prefers to
borrow for longer periods. Investors require a
premium for tying up their funds for a longer
period.
• The implication is that longer periods bonds
should offer higher yields
 Duration
• Duration is a summary statistics showing the
average maturity of the expected cash flows
from the bond. Duration may be defines as
the weighted average of the lengths of time
until the remaining cash flows are received.
• In other words it is the weighted average of
the times to each coupon or redemption
payment in relation to a bond. The weight for
each cash flow time is the proportion of the
total value of the bond accounted for by the
payment
• Duration is the measure of length of time at the end
of which the investor would get his investment
returned.
• Duration is different from maturity . Maturity refers
to the time when the redemption value will be paid.
However the duration considers the interest and part
payment through the holding period.
• Duration is a measure of the interest rate risk of a
bond. It shows the sensitivity of a bond price to
interest rate changes and also takes into account the
timings of bond cash flows. It is basically the
weighted average time to maturity of a bond cash
flows
 Types of Duration
• There are two basic measures of duration
• (1)Macaulay duration
• (2) Modified duration
• Macaulay duration: each time period is
weighted by the present value of the cash
flows at that time. The present value are
calculated by discounting the cash flows at
discount rate equal to YTM of the bond.
n
duration   ( PV * time) / currentmarketprice
i 1
 YTM and duration
• The duration of a bond and its YTM are inversely
related. The higher the YTM the lower is the
duration. The reason being that the higher YTM the
bond value will be lower and will be recovered
earlier out of the present value of fixed coupon
interest and repayment and vice versa.
• Duration and coupon rate : duration and coupon rate
are inversely related
• Duration and price sensitivity : the percentage
change in the value of a bond is approximately equal
to the duration multiplied by the change in interest
rates.
 Modified duration
• Another measure of price sensitivity resulting from the
change in interest rates is known as modified duration.
• D* = D / (1+YTM)
• Properties of a duration : for given maturity bonds duration is
higher when its coupon rate is lower.
• For a given coupon rate the maturity and duration have
positive correlation
• For a zero coupon bond the maturity and duration are equal.
• The duration and YTM of a bond have inverse relationship.
• In case of perpetuities the maturity is infinite but the duration
is defined as:
• (1+YTM) /YTM
 Immunization
• Immunization refers to the investment strategy
adopted by an investor to shield his investment from
the interest rate risk exposure.
• A bond investor is subject to 2 types of risk. These
are: Price risk and reinvestment risk
• In case of increase in interest rate the bond value
decline but the reinvestment rate increases and vice
versa. So bond value and reinvestment rates moves
in opposite direction.
• An investor will always like to minimize the overall
interest rate risk.
• Immunization refers to selection of bond portfolio in such
a way that the effect of above mentioned two types of
risk cancel out each other exactly. This can be attained by
selecting the bond whose duration is equal to the
investment horizon.
• When the bond duration is set equal to the investment
horizon, the accumulated value of the investment on the
horizon date will be unaffected by the interest rate
fluctuation.
• Whenever there is a change in interest rate the loss or
gain on capital value will be exactly offset by the gain or
loss on reinvestment risk. By tying investment decisions
to a duration period an investor can take advantage of
the two counter forces to ensure a fixed terminal
amount.
 Bond value Theorems
• Some basic rules which should be remembered with regard to
bonds are:

• When the required rate of return equals the coupon rate, the
bond sells at par value

• When the required rate of return exceeds the coupon rate,

the bond sells at a discount. The discount declines as maturity
approaches.

• When the required rate of return is less than the coupon rate,
the bonds sells at premium. The premium declines as
maturity approaches.

• The longer the maturity of a bond, the greater is its price

change with a given change in the required rate of return.