Valuation of Bonds

BONDS

• Bonds are units of corporate debt issued by companies and

securitized as tradable assets.

• A bond is referred to as a fixed income instrument since bonds

traditionally paid a fixed interest rate (coupon) to debt holders.
Variable or floating interest rates are also now quite common.

• Bond prices are inversely correlated with interest rates: when rates
go up, bond prices fall and vice-versa.

• Bonds have maturity dates at which point the principal amount must
be paid back in full or risk default.
TYPES OF BONDS
• Government Bonds
• Government securities
• State Bonds
• Corporate Bonds
• Zero Coupon Bonds
• Floating Rate Bonds
• Convertible and Non Convertible Bonds
• Secured and Non Secured Bonds
• Junk Bonds- High yield bonds with high risk of default
• Call Option Bonds- Issues can call back the bonds if interest rates go
down
• Put Option Bonds- Investors can redeem their bonds from company
before maturity
RISKS INVOLVED IN BONDS

• Interest Rate Risk  Interest rates tend to vary over time, causing
fluctuations in bond prices.

• Inflation Risk  Interest rates are in nominal terms, so a sharp shift

in inflation can hurt the returns. Longer the tenure, higher the risk.

• Default Risk  the risk accruing from the fact that a borrower may
not pay interest / principal. Bonds with lower rating have higher
yields, due to high default risk.
 RISKS INVOLVED IN BONDS
(Continued)

• Call Risk  A bond may have a call option that gives the issuer the
option to call the bond before its scheduled maturity.

• Liquidity Risk  Barring some of the popular government of India

securities which are traded most of the other instruments do not have
a liquid market.

• Reinvestment Risk  When a bond pays periodic interest there is a

risk of that the interest payment may have to be invested at a lower
rate.

• Foreign exchange Risk  If a bond has payments that are

denominated in a foreign currency, its rupee flows are uncertain.
BOND PRICING

• Bond valuation is a way to determine the theoretical fair value (or par
value) of a particular bond.
• It involves calculating the present value of a bond's expected future
coupon payments, or cash flow, and the bond's value upon maturity,
or face value.
• As a bond's par value and interest payments are set, bond valuation
helps investors figure out what rate of return would make a bond
investment worth the cost.
Valuation of Bonds

A bond/ debenture is a long-term debt instrument used by government/

government agency (ies) and business enterprises to raise a large sum of money.
Par value is value on the face of the bond.
Coupon rate is the specified interest rate available on a security.
Maturity period is the number of years after which the par/specified value is
payable to the bondholders
 • The value of a bond is the present value of the contractual payments its issuer
(corporate) is obliged to make from the beginning till maturity.
• Symbolically,

Where:
B = value of the bond at t = 0
I = annual interest paid
n = number of years to maturity (term of the bond)
M = par/ maturity value
= required return on the bond.
Valuation of Bonds

A Rs.1000 par value bond, bearing a coupon rate of 12

percent will mature after 6 years. What is the value of
the bond, if the discount rate is 16 percent?
Valuation of Bonds

A Rs.1000 par value bond, bearing a coupon rate of 12

percent will mature after 6 years. What is the value of
the bond, if the discount rate is 16 percent?

= Rs.120 x PVIFA(16%, 6 years) + Rs.1000 x PVIF (16%,

6 years)
= Rs.120 x 3.685 + Rs.1000 x 0.410
= Rs. 852.20
BOND PRICING
Valuation of Bonds: Semi annual
interest rate
A Rs.1000 par value bond bears a coupon rate of 10
percent and matures after 5 years. Interest is payable
semi-annually. Compute the value of the bond if the
required rate of return is 18 percent.
Valuation of Bonds: Semi annual
interest rate
A Rs.1000 par value bond bears a coupon rate of 10
percent and matures after 5 years. Interest is payable
semi-annually. Compute the value of the bond if the
required rate of return is 18 percent.
 

= 50 x PVIFA (9%, 10 years) + 1000 x PVIF (9%, 10

years)
= 50 x 6.418 + Rs.1000 x 0.422
= Rs. 742.9
 BOND PRICING : ZERO COUPON
BOND

• Price Amount at Maturity

= -----------------------
(1+r)n

Amt at Maturity = 1,00,000; Interest rate =

12%; Period = 25 years

Price = 1,00,000
----------- = 5,882.331
(1.12)25
BOND YIELD MEASUREMENT

Current Yield- It is the bond's annual return based on its annual

coupon payments and current price. It is an accurate measure of

calculating the yield on a bond as it reflects the market sentiment

and investor expectations from the bond in terms of return(

required rate of return ) Bond prices fluctuate and prices

increase/decrease as per the required rate of return of the

investors.
CURRENT YIELD

• Current Yield Coupon Interest

= ----------------------------
Prevailing Market Price

The current yield of 10 year, 12% bond with a par value of Rs 1,000
and selling for Rs 950/- ?

Soln: Current Yield = 120/ 950 = 12.63%

Valuation of Bonds:
Yield to Maturity

•Yield to maturity (YTM) is the rate of return an investor earns on a bond held till
maturity.
• It assumes that the issuer of the bond makes al due interest payments and repayments of
principal as contracted/ promised.

Where:
C – Interest/coupon payment
FV – Face value of the security
PV – Present value/price of the security
t – How many years it takes the
security to reach maturity
Valuation of Bonds:
Yield to Maturity
The price of a Rs.1,000 par bond carrying a coupon rate
of 8 percent and maturing after 5 years is Rs.1020. What
is the approximate YTM?
Valuation of Bonds:
Yield to Maturity
Consider a 13% bond (FV Rs 200) redeemable after 5
years at a premium of 5%. Calculate YTM if the
purchase price of the bond is Rs 191.5
Valuation of Bonds:
Yield to Maturity
Consider a 13% bond (FV Rs 200) redeemable after 5
years at a premium of 5%. Calculate YTM if the
purchase price of the bond is Rs 191.5

YTM=14.79%
YTM – PRICE RELATIONSHIP

• The market price of the bond will be equal to the par value of the
bond, if the YTM is equal to the coupon rate.

• If the YTM increases above the coupon rate, then the market value
drops below the face value

• Inversely, if the YTM drops below the coupon rate, the market value
will be more than the face value of the bond.
Term Structure of Interest Rates
• The term structure of interest rates, also called the yield curve, is a
graph that plots the yields of similar-quality bonds against their 
maturities, from shortest to longest. 

• It enables investors to quickly compare the yields offered on short-

term, medium-term and long-term bonds.
Term Structure of Interest Rates

• The term structure of interest rates takes three primary shapes. It is

important that only bonds of similar risk are plotted on the same yield
curve. The shape of the curve changes over time. Investors who are
able to predict how term structure of interest rates will change can
invest accordingly and take advantage of the corresponding changes
in bond prices.
Term Structure of Interest Rates

• If short-term yields are lower than long-term yields, the curve slopes
upwards and the curve is called a positive (or "normal") yield curve.
when the term structure of interest rates curve is positive, this
indicates that investors desire a higher rate of return for taking the
increased risk of lending their money for a longer time period.
Term Structure of Interest Rates

• If short-term yields are higher than long-term yields, the curve slopes
downwards and the curve is called a negative (or "inverted") yield
curve.
Term Structure of Interest Rates

• A flat term structure of interest rates exists when there is little or no

variation between short and long-term yield rates. 
REALIZED YIELD

Realized yield is the yield actually earned by the investor on his

investment and depends on the reinvestment rate and the holding
period.

It is the future value of the purchase price to the total cash flow
realized on the bond.
REALIZED YIELD

RY = C + Pf - Pm
hp .
Pf + Pm
2
Here, Yr is the Approximate Realized Yield
C is the Coupon Payment of the Bond
Pf is the Future Selling Price/FV of the Bond
Pm is the Current Market price of the Bond
hp is the Holding Period of the Bond (In Yrs)
REALIZED YIELD

• Calculate the Realized Yield of a 3 yr bond if the Current Market price

of the Bond(Face Value) is Rs 100, Coupon rate is 10%, Future Selling
Price of the Bond at the end of holding period is Rs 111.
REALIZED YIELD

• Calculate the Realized Yield of a 3 yr bond if the Current Market price

of the Bond(Face Value) is Rs 100, Coupon rate is 10%, Future Selling
Price of the Bond at the end of holding period is Rs 111.
RY = 10 + 111 - 100
3 .
111 + 100
2
= 12.95%
REALIZED YIELD – PROPERTIES
• Realized yield will be between YTM and Reinvestment Rate.

• If Reinvestment rate is lower than YTM, the Realized Yield will be lower than
the YTM

• If the Reinvestment rate is higher than YTM, the Realized Yield will be higher
than the YTM.
In short:
Reinvestment Rate = Realized Yield = YTM
Reinvestment Rate > Realized Yield > YTM
Reinvestment Rate < Realized Yield < YTM

• For bonds with longer term maturity realized yield will be close to
reinvestment rate.

• For bonds with shorter term maturity realized yield will be close to YTM.
YIELD TO CALL

• Yield options for Call Options is different than that of Regular Bonds

Ytc = C + Cp - Mp
n .
Cp + Mp
2
Here, Ytc is the Yield to Call
C is the Coupon Payment of the Bond
Cp is the Call Price
Mp is the Market price
n is the No of Yrs to call
YIELD TO CALL

Consider a callable bond that has a face value of $1,000 and pays a
annual coupon of 10%. The bond is currently priced at $1,175 and has
the option to be called at $1,100 five years from now. 
YIELD TO CALL

• A 10-year corporate bond has a $1,000 par value, a fixed

annual coupon rate of 9.5%, and a call protection period of 5
years. The issuer has a right to redeem the bond at any time
during the fifth year at $1,050. Let’s assume that a bond is
currently traded at $985, coupon payments are made
semiannually, and two years remain before the end of the call
protection period.
YIELD TO CALL

• A 10-year corporate bond has a $1,000 par value, a fixed annual

coupon rate of 9.5%, and a call protection period of 5 years. The
issuer has a right to redeem the bond at any time during the fifth
year at $1,050. Let’s assume that a bond is currently traded at
$985, coupon payments are made semiannually, and two years
remain before the end of the call protection period.

• YTC = 47.5 + 1050 - 985

4
1050 + 985
2
= 6.27%
DURATION

• Duration is a measure of a bond's sensitivity to interest rate changes.

The higher the bond's duration, the greater its sensitivity to changes in
interest rates.

• The Macaulay duration calculates the weighted average time before a

bondholder would receive the bond's cash flows. 

• It is the time during which the interest rate risk disappears.

• It measure interest rate sensitivity of a bond and is a useful tool for

hedging.
DURATION
Bond investors are faced with reinvestment--the threat that if
interest rates fall, the interest payments and principal that
investors receive will have to be reinvested at lower rates. This
is important because the yield-to-maturity calculation assumes
that all payments received are reinvested at the exact same
rate as the original bond's coupon rate. However, this is rarely
the case. As a result, brokers and portfolio managers try to
account for reinvestment risk by calculating a bond's duration--
the number of years required to recover the true cost of a
bond, considering the present value of all coupon and principal
payments received in the future. 
DURATION

• Duration = ∑ (Present value of cash flows * times to cash flows)

∑ (Present value of cash flows)
• A bond with 5 years to maturity, face value of Rs 100 and 12.5%
interest rate and required rate of 15%. What would be the duration if
it is redeemable at 5% premium?
DURATION

Calculate the duration of a three-year, $1,000 Company XYZ bond with a

semiannual 10% coupon and is currently priced to yield 10%. 
 DURATION

Calculate the duration of a three-year, $1,000 Company XYZ bond with a

semiannual 10% coupon and is currently priced to yield 10% 

Period Cash Flow PV @5% PV of Cash Flows PV of CashFlow*period

1 $50 0.9524 $47.62 $47.62
2 $50 0.9070 $45.35 $90.70
3 $50 0.8638 $43.19 $129.58
4 $50 0.8227 $41.14 $164.54
5 $50 0.7835 $39.18 $195.88
6 $1,050 0.7462 $783.53 $4,701.16
Total $1,000 $5,329.48

MD= 5329.48/1000= 5.33 periods

CONVEXITY
• When the relationship between price and yield is graphed, it produces a
line that is curved, or convex

• Convexity measures the curvature in this relationship i.e. how the duration
changes with a change in yield of the bond. Convexity is a good measure
for bond price changes with greater fluctuations in the interest rates. 
CONVEXITY
• Higher the coupon rate of a particular bond, the shorter its duration
will be. In other words, the more money coming in now (because of
a higher rate), the faster the cost of the bond will be recovered.

• Price of long term bonds are more sensitive to interest rate changes
than price of short term bonds.

• Longer bond maturities mean longer durations, since the fixed

interest payments will be spread over longer periods and will be
more greatly affected by inflation. 
 CONVEXITY
• Convexity is a risk management tool used to define
how risky a bond is as more the convexity of the
bond, more is its price sensitivity to interest rate
movements. A bond with a higher convexity has a
larger price change when the interest rate drops
than a bond with lower convexity. Hence when two
similar bonds are evaluated for investment with
similar yield and duration the one with higher
convexity is preferred in stable or falling interest
Bond A is more convex than Bond B even
rate scenarios as price change is larger.  though they both have the same duration.
MODIFIED DURATION

• The modified duration figure indicates the percentage

change in the bond’s value given an X% interest rate change.
Unlike the Macaulay duration, modified duration is
measured in percentages.
MODIFIED DURATION
Duration
Modified duration 
 Yield 
1   
 Coupon Payments per Year 
For our solved numerical, Duration = 3.99, If Yield = 10% for an annual
coupon payment,

Modified Duration = 3.99

1.1
= 3.6273%
So if the interest rate changes by 1%, the impact on price will be 3.63%
CONVERTIBLE BONDS

• Convertible bonds are corporate bonds that can be exchanged for

common stock in the issuing company.
• Companies issue convertible bonds to lower the coupon rate on debt and
to delay dilution.
• A bond's conversion ratio determines how many shares an investor will
get for it.
• Companies can force conversion of the bonds if the stock price is higher
than if the bond were to be redeemed.
Why Do Companies Issue Convertible
Bonds?

• Companies issue convertible bonds or debentures for two main reasons.

The first is to lower the coupon rate on debt. Investors will generally
accept a lower coupon rate on a convertible bond, compared with the
coupon rate on an otherwise identical regular bond, because of its
conversion feature. This enables the issuer to save on interest expenses,
which can be substantial in the case of a large bond issue. 

• The second reason is to delay dilution. Raising capital through issuing

convertible bonds rather than equity allows the issuer to delay dilution to
its equity holders. 
Conversion Ratio of Convertible Bonds

• The conversion ratio—also called the conversion premium—

determines how many shares can be converted from each bond.
• For example, a conversion ratio of 45:1 means one bond—with a
$1,000 par value—can be exchanged for 45 shares of stock.
Convertible Bonds
• ABC issued a convertible bond with a $1,000 face value that pays 4%
interest. The bond has a maturity of 10 years and a convertible ratio of
100 shares for every convertible bond.

• If the bond is held until maturity, the investor will be paid $1,000 in
principal plus $40 in interest for that year. However, the company's
shares suddenly spike and are trading at $11 per share. As a result, the
100 shares of stock are worth $1,100 (100 shares x $11 share price),
which exceeds the value of the bond. The investor can convert the bond
into stock and receive 100 shares, which could be sold in the market for
$1,100 in total.
Convertible Bond Example
For example, consider a Company XYZ bond with a $1,000 par value that is

convertible into Company XYZ common stock. It has a coupon of 6%, payable

annually. The bond's prospectus specifies a conversion ratio, which is the number

of shares that the investor will receive if he chooses to convert.

In this example, Company XYZ's convertible bond has a conversion ratio of 20.

The investor is effectively purchasing 20 shares of Stock XYZ for $50 per share

($1000 / 20 = $50).

The bondholder keeps the bond for two years and collects a $60 interest payment

each year. At the end of year two, he elects to convert his bond into 20 shares of

stock. By this time, the stock price has risen to $75 per share. The bondholder

converts his bond to 20 shares at $75 per share, and now his investment is worth

$1,500.

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