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WELCOME TO

CHAPTER 6:
BONDS AND THEIR
VALUATION

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CHAPTER 6: BONDS AND THEIR

VALUATION

 What is a bond?
 Key features of bonds
 Bond valuation method
 Measuring yield

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What is a bond?
 A bond is a long-term contract under
which a borrower agrees to make
payments of interest and principal, on
specific dates, to the holders of the bond.
 Bonds may be classified as treasury
bonds, municipal bonds, foreign bonds,
and corporate bonds.

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Key Features of a Bond
1. Par value & number of bonds: Face amount,
e.g., Rs.1000. In 2013 April (2069 Baisakh),
Siddhartha Bank issued:
General public: 100,000 bonds @ Rs.1000 = Rs. 100m
Pvt placement: 400,000 bonds @ Rs.1000 = Rs. 400m.
Total 500,000 bonds @ Rs.1000 = Rs. 500m.
2. Coupon interest rate: Stated interest rate.
Generally fixed. (8% SBL Bond)
3. Maturity: Years until bond be repaid (matures
2076: 7 years).
4. Default risk: Risk that issuer will not
make interest or principal payments.
5. Indenture: Document containing terms &
conditions of bonds.
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6. A call provision: a provision to call in the bond
before maturity. Most bonds have call
provisions.
7.Call premium: Premium to be paid if called
before maturity.
8.Refunding operation: Issuer can refund if rates
decline. That helps the issuer but hurts the
investor.
9. Sinking Fund:
 It is an orderly retirement of bonds.
 Provision to pay off a loan over its life rather
than fall due once at maturity.
 Sinking funds are generally handled in 2 ways.
 - Call a certain % of outstanding bonds every
year at a specified price through lottery method.
 - Open market operation.
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Financial Asset Valuation

 The value of any financial asset – a stock, a

bond, a lease, or even a physical asset such
as an apartment building or a piece of
machinery – is simply the PV of the cash flows
the asset is expected to produce.
 A regular bond will have the following
situation.

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Cash flows for regular bond
The discount rate (ki) is the opportunity cost of
capital, i.e., the rate that could be earned on
alternative investments of equal risk.
Also known as “market rate of interest.”
0 1 2 n
k%
...
Bond Int1 Int2 Intn+ M
Value=?
INT INT INT
Bond value + + .. +
= 1 + k 1 1 + k  2  1 + k n
M

+ ---------
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(1+k) N
All rights reserved.
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What’s the value of a 10-year, 10% coupon

(Rs.1000 par) bond if kd (mkt. rate of intt.) = 10%?

0 1 2 10
kd=10% ...
VB = ? 100 100 100 + 1,000

Rs.100 Rs.100 Rs.1

,.1000
VB  1 + . . . + 10 +
1 + k d  1 + k d  1+ k d 
10

= Rs.90.91 + . . . + Rs.38.55 + Rs.385.54

= Rs.1,000.
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Table Method:
VB= (PVIFAi%,n yrs)C + (PVIFi%,nthyr) M”
VB= (PVIFA10%,10Yrs)Rs.100 +(PVIF10%,10thyr)Rs.1000
VB = (6.1446 x Rs. 100) + (0.3855 x Rs. 1000)
VB = 614.5 + 385.5 = 1000

PV annuity (interest) = Rs. 614.46

PV maturity value = 385.54
Value of bond = Rs. 1,000.00

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Suppose 10% bond was issued for 20 years and
now has 10 years to maturity. What would
happen to its value now (at t=10 years) if the
required rate of return (kd) remained at 7%, 13%,
or at 10%?
If kd = 7%:
VB= (PVIFA7%,10Yrs)Rs.100 +(PVIF7%,10thyr)Rs.1000
VB = (7.0236 x Rs. 100) + (0.5083 x Rs. 1000)
VB = 702.4 + 508.4 = 1211
If kd = 13%:
VB= (PVIFA13%,10Yrs)Rs.100 +(PVIF13%,10thyr)Rs.1000
VB = (5.4262 x Rs. 100) + (0.2946 x Rs. 1000)
VB = 542.6 + 294.6 = 837
If kd = 10%:
VB= (PVIFA10%,10Yrs)Rs.100 +(PVIF10%,10thyr)Rs.1000
VBCopyright
= (6.1446 x Rs. 100) + (0.3855 x Rs. 1000) All rights reserved.
© by R.S.Pradhan
V = 614.5 + 385.5 = 1000
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Bond Value, Rs.
1,318
kd = 7%. Premium bond
1,211
kd = 10%. M
1,000

837
kd = 13%. Discount bond
789

0 10 20
Years remaining to Maturity
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 The value of a discount bond increases to
Rs.1,000 at maturity.
 The value of a premium bond decreases to
Rs.1,000 at maturity.
 At maturity, the value of any bond must equal its
par value.
 A par bond stays at Rs.1,000 if kd remains
constant.
- If kd < coupon rate, bond sells at a premium.
- If kd > coupon rate, bond sells at a discount.
- If kd = coupon rate, bond sells at its par value.

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Yield to maturity (YTM): is the rate of return earned
on a bond held to maturity. Also called “promised
yield.” What’s the YTM on a 10-year, 9% annual
coupon, Rs.1,000 par value bond that sells for
Rs.887? Guess?
0 1 9 10
kd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find kd that “works”!
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Approximate method
FV – MV 1000-887
CI + ------------- 90 + -------------
n 10
YTM = -------------------------- = ----------------------
FV + 2MV 1000+2(887)
------------ --------------
3 3
= 101.3/924.67 = 0.10955 or 10.955 percent.
 Try 10% and 12%
CI : Coupon interest in rupees.
FV : Face value or maturity value of a bond.
MV : Market value of a bond
n : Maturity period of a bond
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OR Finding the YTM (Guess try rate first):
 Try 10%:
VB = (PVIFAi,n)C +(PVIFi,n)M”
Rs.887=(PVIFA10%,10yrs) Rs.90 + (PVIF10%, 10thYr) Rs.1000
Rs.887 = (6.1446) Rs. 90+ (.3855) Rs.1000
Rs.887 = Rs.553.01 + Rs. 385.5
Rs.887 = Rs. 939
 Try 11%:
Rs.887 = (PVIFA11%,10yrs) Rs. 90 + (PVIF11%, 10thYr) Rs.1000
887 = (5.8892) Rs.90 + Rs.1000(0.3522)
887 = 530 + 352
PV of LR - Market value
887 = 882 LR + ---------------------------------------- Diff. in rates
PV of LR - PV of HR
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PV of LR - Market value
LR + ----------------------------------- Diff. in rates
PV of LR - PV of HR
939 - 887
= 10 + -------------------- 2
939 - 882
= 10+ 0.92 =10.92 or say 11.0%

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Current yield

Current yield= Annual coupon pmt

Current price
It shows cash income.
Find current yield and capital gains yield for a
9%, 10-year, Rs.1000 bond when the bond sells
for Rs.887.

Current Rs.90 = 10.15%

yield = Rs.887
YTM = Current yield + capital gains yield
11% = 10.15% + capital gains yield
Hence the capital gains yield is 0.85%.
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Yield to Call (YTC)

It refers to the return the investors receive if it is called
before maturity period which is known as the yield to call
(YTC) or realised rate of return.
Example: An 8-year, 10 percent annual coupon bond,
with a par value of Rs.1,000 is likely to be called in 2
years at a call price of Rs.1,050. The bond sells for
Rs.1080. Assume that the bond has just been issued.
What is the bond’s yield to call? First find approx. YTC.
FV* – MV 1050-1080
CI + ------------- 100 + -------------
n 2
YTC = ------------------------ = ------------------------ = 7.9%
FV + 2MV 1050+2(1080)
------------ --------------
3 3
*FV= Call price Try 7% & 8%
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a)Try 7%
VB = (PVIFAi%,n yrs.)C + (PVIFi%, nth yr) Call Price
Rs.1,080=(PVIFA7%,2yrs)Rs.100+(PVIF7%,2ndyr) Rs.1050
Rs.1,080 = (1.808)100 + (0.8734)1050
Rs.1,080 = 180.8 + 917.1 = 1097.9 or 1098
Try 8%
Rs.1,080=(PVIFA8,2)Rs.100+(PVIF8,2)Rs.1050
Rs.1,080 = (1.7833)100 + (0.8573)1050
Rs.1,080 = 1078 PV of LR - Market value
By interpolation, LR + ---------------------------------------- Diff. in rates
PV of LR - PV of HR

YTC=7+[(1098-1080)x(8-7)/(1098 -1078)] =7.9%.

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Semiannual bond
Find the value of 10-year, 10% coupon, Rs.1000
semiannual bond if kd = 14%.
1. Divide nominal rate by ‘2’ to get periodic rate
(i. e., kd/2).
2. Multiply years by ‘2’ to get periods = 2n.
3. Divide annual rupee interest by ‘2’ to get PMT.
(i. e., coupon interest / 2).
VB=PVIFA(7%,20pds)Rs.100/2 + PVIF(7%,20th pd) Rs.1000
= (10.5940 x Rs.50) + (.2584xRs.1000) =Rs. 788.

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You could buy, for Rs.1,000, either a 10%, 10-
year, annual payment bond or an equally risky
10%, 10-year semiannual bond. Which would you
prefer?
The semiannual bond’s EFF% is:
iNOM 1x m
EFF % = 1+ -------- - 1 = 1 + (0.10/2)1*2-1
m =0.1025 =10.25%
10.25% > 10%. Buy semiannual bond.
Solve Problems: Chapter 6
 Self-Test Problems: SP2 to SP6.
 Quiz
Thanking you
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