Bond Valuation

Dr. Abhay Kumar

 Terminology
• Face Value
• Issue price
• Redemption Value
• Market Price
• Coupon
• Interest rate/reinvestment rate
• Redemption Premium/discount
 Types of Bonds
• Secured (collateral)Vs Unsecured Bond
• Senior Vs subordinate Bond
• Registered Vs unregistered Bond
• Convertible Vs Non Convertible Bond
• Zero coupon Bond
• Bond with detachable warrant
• Triple option convertible Bond
• Floating rate Vs fixed rate bonds
• Callable/ Putable Bonds
Example
• A debenture of Rs.100 face value that
carries an interest rate of 14 percent is
redeemable after 6 years, at a premium
of 2 percent. If you own this debenture,
what are benefits that you will enjoy?
End of year Interest income Principal repayment
Rs. Rs.
1 14
2 14
3 14
4 14
5 14
6 14 102
 Income on Bond
• Interest
• Interest on Interest
• Redemption value/ Sales value
• Capital gain/loss
• Value of a bond =

 Present 
 Annual   
  value   Redemption   Discount 
 interest   annuity  +  value   
 payable      factor 
  factor 
 
 Example
• A debenture of Rs.100 face value that
carries an interest rate of 14 percent is
redeemable after 6 years, at a premium
of 2 percent. How much will you pay for
this debenture if you require a return of
16%.
illustration
• Investor requires a rate of return of 16
percent from this debenture, the present
value of it to you will be:
• Rs.14 (PVIFA16%,6 yrs) + Rs.102
(PVIF16%, 6 yrs)
• = Rs.14 (3.685) + Rs.102 (0.41)
• = Rs.51.59 + Rs.41.82
• = Rs.93.41
PRICE-YIELD RELATIONSHIP ( Convexity)

• For a bond, the relationship between

the price and the required yield is
opposite.
• This is because, the price of the bond is
the present value of cash flows.
• If the required yield increases, the
present value of the cash flow declines
and hence the bond value also declines.
 YTM vs Price
• Let us compute the Yield Price
relationship between (in in
the price and the %) Rs.
required yield for a 4 148.7
bond with coupon rate 6 129.4
of 10% with par value
8 113.4
of Rs.100 maturing
after 10 years for 10 100.00
different required yields 12 88.7
as per the table given 14 79.16
below: 16 71.53
18 64.04
Price and yield relationship (Convexity)
Convexity
• As the yield increases, the rate at which
price of the bond declines becomes
slower. Similarly when yield declines,
the rate at which price of the bond
increases becomes faster.

• Bonds with greater convexity

experiences greater price performance.
 COUPON-PRICE -YIELD
RELATIONSHIP- Theorem
• a. The market price of the bond will be equal to
the par value of the bond, if the YTM equals its
coupon rate.

• Market price of a Rs.1,000 par value bond bearing a

10% coupon rate with an expected YTM of 10% and
a maturity of 10 years is equal to

=100 PVIFA 10%,10 + 1,000 PVIF 10%,10

= 100 x 6.145 + 1,000 x 0.386
= Rs.1,000.50

Thus, when the YTM is equal to the coupon rate, the

market value is equal to the face value of the bond.
COUPON-PRICE YIELD
RELATIONSHIP- Theorem
• b. If the YTM increases above the
coupon rate, then the market value
drops below the face value.
• If the YTM of the above bond increases
to 12%, then the market value of the
bond will drop to Rs.887.
• 100 PVIFA 12%,10 + 1,000 PVIF = 100 x
12%,10

5.65 + 1,000 x 0.322 = Rs.887.

• % Drop in price =-11.3%
COUPON-PRICE YIELD
RELATIONSHIP- Theorem
• c. Inversely to the above principle, if YTM
drops below the coupon rate, the market
value will be more than the face value of
the bond.
• In the case of the above bond, if the YTM falls
to 8%, then the market value of the bond will
rise to,
= 100 PVIFA 8%,10 + 1,000 PVIF 8%, 10
= 100 x 6.71 + 1,000 x 0.463
= Rs.1,134.
• % Increase in price = -13. 4%
Relationship between Bond Price
and Time
• (If Interest Rates are Constant)
• The bond price remains constant when the
bond moves towards its maturity, and if the
interest rates remain constant.
• If the bond is quoted at a premium, the price
of the bond decreases when it approaches
maturity.
• Discount bonds increase their prices when
they approach maturity.
• In both the cases, the bonds will reach par
value at the time-of-maturity.
illustration
Discount bond (5 yr. Premium bond (5 yr. bond with
bond with 10% 10% coupon) (expected
coupon) (expected yield at 8 %)
rate yield at 12%)

5 92.6 107.98
4 93.8 106.62
3 95.1 105.15
2 96.5 103.56
1 98.2 101.85
0 100 100
Calculation of returns
• The return to the bond investor can be
measured in terms of the following:
• a. Current Yield (CY)
• b. Yield to Maturity (YTM)
• c. Realized Yield (RY)
– Yield to Call
– Yield to Put
Current Yield (CY)

• CY is measured by dividing coupon with

the prevailing market price. Thus,
Coupon interest
• CY =
Prevailing market price
 Current Yield (CY)
• An 8% bond (Face value of Rs.100) selling for
Rs.96, would have a current yield of,
• CY = 8.33%

• Current yield of bonds selling at par would be

equal to the coupon interest rate.
• Current yield of bonds selling at a premium
(discount) would be less (more) than the
coupon interest rate.
• An important drawback of current yield is that it
considers only coupon income as a source of
return to the investor, ignoring interest and
capital gains (loss) that would also accrue to
him.
 Yield-To-Maturity (YTM)

• The correct way of computing the return on any asset

involves considering the entire sequence of cash
flows and their timing and calculating the Internal
Rate of Return (IRR).
• For a bond, there is a cash outflow when the bond is
bought.
• Cash inflows when the periodic interest coupons are
received and a redemption value on maturity.
• Calculating the IRR of this stream of cash flows gives
the true return on the bond, which is known as Yield-
To-Maturity (YTM).
Assumption with Yield-To-Maturity (YTM)
• Following assumptions are made while computing
the YTM:
1. All coupon and principal payments are made on
schedule. No default,
2. The bond is held to maturity.
3. The coupon payments are fully and immediately
reinvested at precisely the same interest rate as
the promised YTM.
Yield-To-Maturity (YTM
• Consider a bond with an annual coupon
rate of 12.5% redeemable on 1/7/2017
selling at Rs.80.60 on 1/7/2014. What is
the return earned by the investor, who
buys the bond on 1/7/2014 and holds it
till maturity?
The investor incurs a cash outflow on
1/7/20x2 of Rs.80.60 and receives
interest of Rs.12.50 each on July 1,
20x3, 20x4 and 20x5. On maturity
(1/7/20x5), he also receives Rs.100.

Year 20x2 20x3 20x4 20x5

Cash flow –80.60 12.5 12.5 112.5
Approximation to YTM
C  (F  P)/n
• (F  P)/2
• where ‘C’ is the coupon, ‘F’ is the
redemption value and ‘P’ is the
purchase price.
• Average investment is equal to half the
redemption price and purchase price
i.e., (F + P)/2.
PRINCIPLES OF BOND PRICE
MOVEMENTS-Theorem

i. For a given YTM and the coupon rate

of the bonds, the longer the term to
maturity, the greater will be the change
in price with change in the YTM.
 illustration
A B
Face value Rs.1,000 Rs.1,000

Coupon rate 10% 10%

YTM 10% 10%

Years to maturity 3 6

Market value at YTM of 10% Rs.1,000 Rs.1,000

Market value at YTM of 11% 100 PVIFA 11%,3 + 1,000 100 PVIFA11%,6 +
PVIF11%,3 1,000PVIF11%,6

975.56 957.69
Change in price –2.5% – 4.2%
 Bond Theorem
• ii. The percentage price change described
above increases at a diminishing rate as
the bond’s maturity time increases (Yield
remains constant, the premium or discount
will decrease on increasing rate as maturity
approaches).
• Let us take the case of bond B with face
value of Rs.1,000, coupon rate and YTM of
10% and maturity period of 6 years. Suppose
the YTM changes to 11% at the end of the
fifth year, i.e., when the time to maturity of the
bond is 1 year, then the value of the bond will
fall to Rs.991.1.
Time to Maturity Bond Price (Rs.) Change %

1 991.1 0.89

2 982.87 0.83

3 975.4 0.76

4 969.2 0.64

5 963.04 0.635
 Bond Theorem iii

• A raise in bond price for decline in bond

yield is greater than the fall in the bonds
price for a raise in the yield.
• Let us take the case of bond z with face
value of Rs.1,000, coupon rate and YTM of
10% and maturity period of 5 years. YTM
declines by 2% then the bond price will be
1079.87 (raise 79.87).
• If the YTM increases by 2% then the bond
price will be 927.88 (fall 72.22).
 Theorem iv
• The change in price will be lesser for a
percentage change in bonds yield if
coupon rate is higher.
Bond Bond A Bond B

coupon 10% 8%
yield 8% 8%
Maturity Period 3 3
Price 105.15 100
FV 100 100
Yield Raise 1% 1%
Price after raise 102.53 97.47
%age change in Price 2.4% 2.53%
 REALIZED YIELD
Yield to call
Yield to Put

• Realized yield actually earned by the

investor on his investment and depends
on the reinvestment rate and the holding
period chosen by him.
Yield to call

• 11%, Rs 1000 FV bond is redeemable

after 6 years and callable after 3 years
at a premium of 5%. Calculate yield to
call if CMP is Rs1020.
Yield to Put

• 11%, Rs 1000 FV bond is redeemable

after 6 years and putable after 3 years
at par. Calculate yield to put if CMP is
Rs 920.
 Example
• A debenture of Rs.100 face value that carries
a coupon rate of 14 percent is redeemable
after 6 years, at a premium of 2 percent. CMP
of debenture is 93.41. What is the YTM of the
debenture?
• What is the YTM of the debenture if interest
rate has gone down to 12% immediately after
your purchase.
• What is the realized yield if you hold the
debenture for 4 years only?
Definition: Duration
• Duration is weighted average maturity of a
bond where present values of the cash flows
are used as weights.
• In computing duration we are considering
both the timing and magnitude of cash flow
associated with the security.
• A measure of price volatility.
• Concept of duration used for a single asset
as well as portfolio of assets.
Definition -Duration
 Duration
• Duration is a measure of the
approximate sensitivity of a bond’s value
to rate changes. More specifically, it is
the approximate percentage change in
value for a 100 basis point change in
rates.
• Some times to improve the estimate
provided by duration, a measure called
convexity is used.
Duration -Example

• Calculate the Duration of 12.5%, Rs 100

FV bond maturing in 5 years at a
premium of 5%. Interest rate prevailing
in the economy is 15% (YTM).
 Duration example
Date 1/7/2002 1/7/2003 1/7/2004 1/7/2005 1/7/2006 Total

No of 1 2 3 4 5
Years

Cash flow 12.5 12.5 12.5 12.5 117.5

Present 10.87 9.45 8.22 7.15 58.42 94.11

Value

Year x P 10.87 18.9 24.66 28.59 292.09 375.11

V
Duration
• Divide the sum of the products
(Rs.375.11) by the present value
(Rs.94.11) to get the duration.
• Duration = 375.13/94.11 = 3.99
• Modified Duration= D/(1+Y)
• MD= 3.99/1.15=3.47
Steps in computing duration
Duration 5-year 10% coupon
Par Bond
• Duration 5-year 10% coupon Par Bond
Duration of zero coupon bond
with a yield of 10%
Duration of 5year 8% bond
yielding 10%
5-year 6% coupon Par Bond
Calculation of duration of
bond at discount

D= 4.031 Modified Duration= 3.665

Duration of perpetual bond
• D= (1+Yield)/Yield
 Some examples
1. Duration of a loan of Rs 10000 at 10%-loan
repayable in five equal annual
payments(2638):D=2.81
2. Duration of a loan of Rs 10000 at 10%-loan
repayable at the end of five year; interest paid
at the end of each year (D=4.1697)
3. Duration of a loan of Rs 10000at 10%-loan
payable in equal amounts of Rs 2000; interest
on declining balance at the end of each year
(D=2.66)
4. Repayment of amount and interest at the end
of five years in a lump-sum payment (D=5)
Interpretation of duration
• Duration of bond is the maturity of an
equivalent ZCB
– Duration of 6% , 5 year bond=3.5 => it has the
same price volatility as that of ZCB of 3.5 year
maturity
• Duration is the fulcrum of the present value of
cash flow of a security
• Duration is the time needed to offset the
opposing effects of changes in investment
income and capital value
• Holding horizon H= Duration, immunized
against any parallel shift of yield curve
 Properties of duration
• Duration of ZCB = maturity.
• Duration <maturity.
• Other things remaining the same greater the coupon
lower the duration Other things.
• Other things remaining the same greater the yield
lower the duration.
• Other things remaining the same greater the
frequency of coupon payment lower the duration
• Duration of coupon paying bond decreases slower
than the time .
Modified Duration
Trading strategy using
modified duration
• Expecting Decline in Interest rate;
Increase the average modified duration
of your portfolio.
• Expecting Increase in Interest rate;
Decrease the average modified duration
of your portfolio.
 Bond immunization
• Bond immunization is the strategy of
matching the bond’s duration (and not the
term-to-maturity) with the time horizon of
the investor. So assuming that an investor
wants his investment in a bond to yield 6%
(YTM) in order to cover a known liability
maturing after 10 years, he would be
better off choosing a bond with a duration
of 10 years rather than a bond with a term
to maturity of 10 years.
 Bond immunization
• When the duration of a bond is set equal
to the investment time horizon, any
unexpected change in the market value of
the unmatured bond at the end of the
investment horizon (price effect) will be
exactly equal in magnitude, but opposite
in direction, to any unexpected change in
the reinvestment income (reinvestment
effect).
Bond immunization
• Immunization will provide a compound
rate of return over the period immunized
that equals the bond’s YTM, irrespective
of changes in market rates. Thus, the
year can be locked in over the
investment horizon.
 Risk with the Bonds
• Interest Rate risk
• Default Risk
• Marketability/Liquidity Risk
• Calliability Risk
• Purchasing power risk
• Reinvestment risk
• Currency risk
Thank you