CHAPTER 6

VALUATION AND
MANAGEMENT OF BONDS
CONTENTS

 Introduction
 Features of the bond
– Face Value
– Coupon Rate
– Periodicity of coupon payments
– Maturity
– Redemption Value
 Types of Bonds
– Fixed and Floating Rate Bonds
– Indexed Bonds
– Callable & Puttable Bonds
– Zero Coupon and Deep Discount Bonds
– Convertible Bonds
 Cash Flow of the bond
Chapter 6
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Valuation & Management of Bonds
CONTENTS

 Pricing of bond/Yield on the bond

– Current Yield
– Yield to Maturity
– Realised Yield
– Yield To Call
 Deep Discount/Zero Coupon Bonds & STRIPS
 TERM STRUCTURE OF INTEREST RATES
– Finding Term Structure
– Term Structure & YTMs
– Expectations of interest rates and implied forward
rates

Chapter 6
3
Valuation & Management of Bonds
CONTENTS

 Theories of Term Structure

– Expectation Hypothesis
– Liquidity Preference Hypothesis
– Market Segmentation/Preferred Habitat
 DURATION OF THE BOND
– Sensitivity of bond prices
– Properties of duration
 Bond Rating
 Bond Management Strategies
– Buy & hold strategy
– Bond laddering
– Maturity matching vs. Duration matching
 Active bond management strategies
– Riding the yield curve
Chapter 6
4
Valuation & Management of Bonds
BONDS

 Bonds have emerged as one of the

prominent financial instruments of
capital markets world over
 Bonds are the instruments of
borrowings.
 They promise a fixed return until their
maturity and the payback of principal
upon maturity.

Chapter 6
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Valuation & Management of Bonds
FEATURES OF THE BOND

 The terms and conditions for the issue

of bonds are pre decided at the time of
the issue as a part of bond indenture
 Main features of bond indenture are:
– face value,
– coupon rate,
– periodicity of coupon payments,
– maturity period and
– redemption value
Chapter 6
6
Valuation & Management of Bonds
TYPES OF BONDS

 Fixed rate and floating rate bonds

 Indexed bonds
 Callable /puttable bonds
– Bonds that can be called by the issuer
prior to the maturity are known as callable
Bonds, while whose redeemable at the
option of subscribers are known as
puttable bonds
 Redemption in lump sum /phased
redemption

Chapter 6
7
Valuation & Management of Bonds
TYPES OF BONDS

 Zero Coupon/Deep Discount Bonds

– Bonds that do not pay any interest but are
issued at discount to the face value and
redeemed at face value are called Deep
Discount Bonds
 Convertible Bonds
– Convertible bonds are those, which convert
a part of the bond into equity shares. It
combines the features of bonds and equity
in a composite instrument
Chapter 6
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Valuation & Management of Bonds
CASH FLOW OF THE BOND

 Cash flows of bonds are made up of

two components: the periodic coupon
payments and principal repayment
Time (months from
0 6 12 18 24 30 36
now)

Coupon received 0 5 5 5 5 5 5

Principal paid (-) and -

105
redeemed (+) 100

Total cash flow -

5 5 5 5 5 110
100

Chapter 6
9
Valuation & Management of Bonds
PRICING OF BOND

 The value of bond is arrived by

discounting the future cash flows from
the bonds at an appropriate discount
rate
 Discount rate must appropriately be
adjusted for the
– riskiness of the cash flows,
– prevalent market conditions and
– timing of cash flows to truly reflect the
expectations
Chapter 6
10
Valuation & Management of Bonds
VALUE OF THE BOND &
DISCOUNT RATE
Value of the Bond and Discount Rate
140

120
Value (Rs.)

100

80

60
5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Discount Rate (%)

Chapter 6
11
Valuation & Management of Bonds
VALUE OF THE BOND &
DISCOUNT RATE

 Discount rate is a function of risk.

Higher the risk, higher the discount
rate and consequently lower the price
of bond
When discount rate, r > coupon rate, i
Price < Face Value
When discount rate, r < coupon rate, i
Price > Face Value
When discount rate, r = coupon rate, i
Price = Face Value
Chapter 6
12
Valuation & Management of Bonds
VALUE OF THE BOND AND RISK
FREE RATE
 Value of the bond does not rise above a
certain maximum
Bond Value and Risk Free Rate

Price

Risk Free Rate

Discount Rate

Chapter 6
13
Valuation & Management of Bonds
VALUE OF THE BOND WITH
TIME

 The difference between the price and the

redemption value narrows as maturity nears
and price converges to its redemption value
at maturity irrespective of the discount rate.
Bond Price and Time

Price
Premium Bond

Par Value= Redemption Value

Discount Bond
Maturity
Time

Chapter 6
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Valuation & Management of Bonds
 YIELD ON THE BOND

 There are four types of yields:

– current yield;
– yield to maturity;
– realised yield and
– yield to call (relevant only for callable
bonds)
 Current yield is the annual coupon
payment divided by the current price.
Interest Amount, Coupon x Face Value
Current Yield (%) = x100
Current Price, P0

Chapter 6
15
Valuation & Management of Bonds
YIELD TO MATURITY (YTM)

 Yield to maturity (YTM) is the rate of return the

investor would earn if he holds the bond till the date of
maturity.
 YTM satisfies the following
Value of the bond = Price, P0
n Ct Rt
=∑ t +
1 (1 + YTM) (1 + YTM)n
 A 5 year bond with coupon of 12% payable annually
and selling at Rs. 90 would have YTM of r such that
Price, P0 = 90.00
12 12 12 12 12 12 100
= + + + + + +
(1 + r) (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5 (1 + r)6 (1 + r)6

Chapter 6
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Valuation & Management of Bonds
YTM AND VALUE OF BOND

 YTM considers the time value of money

while calculating returns for the
investor.
 There is an inverse relationship
between the price and the YTM of the
bond.

Chapter 6
17
Valuation & Management of Bonds
REALISED YIELD

 Realised yield is the rate of return

investor earns on bonds if he sells the
bonds before its maturity. It has two
components: annual coupons received
till the date of sale and the capital
appreciation realised on sale.

n
P0 x (1+ ry ) = TVn
Chapter 6
18
Valuation & Management of Bonds
YIELD TO CALL

 Yield to call is the return the investors earn on the

callable bonds till the time the bonds are called. It
comprises of two components: annual coupons till the
date of call and the call price.
 For a 5-year 12% annual coupon bond trading at Rs.
90, callable after four years at Rs. 105 the YTC is
computed as below:
Value of the bond = Price, P0 = 90
n Ct Rt
=∑ +
1 (1 + YTC)t (1 + YTC)n
4 12 105
=∑ t +
1 (1 + YTC) (1 + YTC)4

Chapter 6
19
Valuation & Management of Bonds
DEEP DISCOUNT/ZERO
COUPON BONDS AND STRIPS
 Zero coupon bonds do not pay any interest
and instead provide all the returns in the
form of capital gains.
 They are issued at price substantially lower
than the par value and are redeemed at par.

Chapter 6
20
Valuation & Management of Bonds
ZERO COUPON BONDS

 The value of zero coupon bonds is arrived by

discounting the par value (redemption price)
at an appropriate discount rate
 Coupon bearing bonds too can be made to
look like zero coupon bonds if we treat all the
coupon payments as separate instruments
Face Value
Value of Zero Coupon Bond =
(1 + r)T

Chapter 6
21
Valuation & Management of Bonds
STRIPS

 The process of segregating the coupon

payments and redemption value and
issuing them as separate securities is called
stripping.
 Each of the strips becomes a separate
instrument that can be traded
independently of the composite instrument.
 These are known as STRIPS (Separate
Trading of Registered Interest and Principal
of Securities).

Chapter 6
22
Valuation & Management of Bonds
ADVANTAGES OF STRIPS

 The advantages of stripping include

– increased liquidity due to increased
participation by small investors as coupon
stripping results in instruments of smaller
denominations,
– larger number of securities available for
trading providing depth to the market and
– fair pricing due to increased depth and
participation

Chapter 6
23
Valuation & Management of Bonds
TERM STRUCTURE OF
INTEREST RATES

 The timing of cash flows and the

discount rates to be used are inter-
dependent as the expectations of
investors vary with the investment
horizon. For example:
Term of investment Yield
1 year 8%
2 years 9%
3 years 10%
Chapter 6
24
Valuation & Management of Bonds
TERM STRUCTURE OF
INTEREST RATES

 The relationship between the yield (interest

rate) and the term of investment is called the
term structure of interest rates.
TERM STRUCTURE OF INTEREST RATES

11 10

10 9

9
Yield (%)

7
6
5
1 2 3
Term of Investment (Years)

Chapter 6
25
Valuation & Management of Bonds
YTM AND TERM STRUCTURE

 Ideally the value of the bond must be arrived at with

the discount rate appropriate with the timing of the
cash flow as given by term structure of interest
rates, rather that single discount rate for all the cash
flows irrespective of when they accrue.
 Value of the bond using single rate:
120 120 120 1000
Price, P0 = + + +
(1+ 0.10) (1+ 0.10)2 (1+ 0.10)3 (1+ 0.10)3
= 109.09 + 99.17 + 90.16 + 751.31 = Rs.1,049.73
 Value of the bond using discount rate as per the term
structure:
120 120 120 1000
Price, P0 = + + +
(1+ 0.08) (1+ 0.09)2 (1+ 0.10)3 (1+ 0.10)3
= 111.11+ 101.00 + 90.16 + 751.31 = Rs.1,053.58

Chapter 6
26
Valuation & Management of Bonds
FINDING TERM STRUCTURE

 Though the YTMs are observable the

term structure of interest rates needs
to be derived on some rationale basis.
 Term structure of interest rates is
hidden in the YTMs of bonds with
progressive maturities.
 YTMs of bonds with different maturities
do not reflect the term structure unless
all of them have only single cash flow
attached with them.
Chapter 6
27
Valuation & Management of Bonds
FINDING TERM STRUCTURE

 The most suitable method to arrive at term structure

on interest rates is to get the yields on bonds with
increasing maturities but that have single cash flow, as
is the case with zero-coupon bonds.
Bond Maturity Price Yield
(Rs.)
Zero Coupon Bond 1 Year 925.00 8.11%

Zero Coupon Bond 2 Year 845.00 8.79%

Zero Coupon Bond 3 Year 770.00 9.10%

All bonds are redeemable at par with Rs. 1,000

FV
Yields have been worked out using following: P0 =
(1 + rn )n
Chapter 6
28
Valuation & Management of Bonds
IMPLIED FORWARD RATES

 Term structure of interest rates not only

provides expectations of returns with
horizon of investment but also imply
forward rates of interest.
– For example 8% yield for 1 year investment and
9% for two year investment implies yield
expectation of 10% for one year investment one
year from now.
– Under conditions of perfect market and well-
informed investors the direct investment strategy
(investing for two years) and roll over strategy
(investing for one year and then rolling over for
another year)must result in identical returns.

Chapter 6
29
Valuation & Management of Bonds
THEORIES OF TERM
STRUCTURE
Expectations Hypothesis
– The shape of yield curve is dependent upon the
expectations of investors about the future
interest rates.
Liquidity Preference Hypothesis
– Liquidity preference theory suggest that the
term structure of the interest rates is governed
by preferences of investors for liquidity
Preferred Habitat/Market Segmentation Theory
– Preferred Habitat theory recognises that the
investor have preferred investment horizons.
Short-term investors invest in securities with
short maturities and long-term investors prefer
securities with long-term maturities
Chapter 6
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Valuation & Management of Bonds
DURATION OF THE BOND

 Values of bonds change with the

change in interest rates.
 With change in interest rates all
bonds do not change in value by the
same amount. It depends upon the
Duration of the bond.
 Price sensitivity of the bond is
measured by the term called
Duration
Chapter 6
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Valuation & Management of Bonds
COMPUTING DURATION

 Duration is the time weighted average

of the present values of the cash flows
of the bond as proportions of its price.
n
∑t x PV of CFt
1
Duration of the Bond =
P0
1 x CF1 2 x CF2 3 x CF3 4 x CF4
= + + + + .......... P0
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)4

Chapter 6
32
Valuation & Management of Bonds
COMPUTING DURATION

Time Cash flow PV (10%) Proportion Time x Proportion

1 80.00 72.73 8.14% 0.081

2 80.00 66.12 7.40% 0.148
3 80.00 60.11 6.73% 0.202
4 80.00 54.64 6.12% 0.245
5 80.00 49.67 5.56% 0.278
6 80.00 45.16 5.06% 0.303
7 80.00 41.05 4.60% 0.322
8 1080.00 503.83 56.40% 4.512
Price 893.30 100.00%
Duration of the Bond (Yrs) 6.091

Chapter 6
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Valuation & Management of Bonds
SENSITIVITY OF BOND PRICES

 Due to convexity of bond price with

interest rate the change in price of
bonds is linear only approximately.

Duration
Volatility of the bond = -
(1+ YTM/m)
6.091 6.091
=- =- = - 5.54
(1+ 0.1/1) 1.1

Chapter 6
34
Valuation & Management of Bonds
PROPERTIES OF DURATION

 Duration of low YTM bonds is higher and

hence they are more sensitive as compared
to high YTM bonds.
 Duration of low coupon bonds is higher
 Duration of bonds with longer term to
maturity is higher
 Duration is always shorter than the term to
maturity and increases as maturity extends
 Duration of a portfolio of bonds is weighted
average of durations of bonds consisting it.
– Duration of Bond Portfolio=Dp = wiD1+w2D2+w3D3…

Chapter 6
35
Valuation & Management of Bonds
BOND RATING

 Bond rating is an alphanumeric score

given to debt issue of a firm by an
independent specialised external
agency.
 It broadly signifies the level of risk
associated with such an issue of debt.
 Purpose of rating is to facilitate
investors to make informed judgment
for investing
Chapter 6
36
Valuation & Management of Bonds
BOND MANAGEMENT
STRATEGIES

Buy-and-Hold Strategy
– The simplest of the strategy of
managing the investment in bonds is
buy-and-hold.
– Buy-and-hold strategy has the
advantage of least transaction cost.
Bond Laddering
– Bond laddering strategy is similar to
buy-and-hold with the modification that
the portfolio of bonds is chosen with
staggered and progressive maturities.
Chapter 6
37
Valuation & Management of Bonds
MATURITY VS. DURATION
MATCHING – IMMUNISATION
 The investors in bond primarily face
two kinds of risks
1. Price Risk: Bonds prices change
constantly, albeit not as much as stock
prices, with the changing economic
conditions that affect the YTM.
2. Reinvestment Risk: Reinvestment
risk arises due to inability of the
investors to reinvest the interim
coupon payments at the desired rate.

Chapter 6
38
Valuation & Management of Bonds
MATURITY VS. DURATION
MATCHING – IMMUNISATION

 By matching maturity with the

planned investment horizon the price
risk is eliminated but the re-
investment risk remains.
 By making holding period equal to
the duration of the bond the portfolio
can be immunized from change in
value due to change in interest rates.

Chapter 6
39
Valuation & Management of Bonds
MATURITY VS. DURATION
MATCHING – IMMUNISATION
 Matching investment horizon with duration rather than
maturity of the bond keeps terminal wealth constant.
TERMINAL VALUE
1,800

1,400
Terminal Value

M aturity
M atching

1,000
Duration
M atching

600
0 1 2 3 4 5

at 10% at 5% at 20% Time (Years)

Chapter 6
40
Valuation & Management of Bonds
RIDING THE YIELD CURVE

 The strategy is used with rising yield curve

to get higher returns by selling the bond
rather than holding it till maturity.
Assume
• a zero coupon bond with two years remaining
for maturity.
• The rising yield curve with yields of 7% for
one-year term and 8% for two-year term.
Buy and hold till maturity:
– The current price of the bond would be Rs. 857.34
(1,000/1.082).
– If planned horizon of investment is two years the
investor would lock-in the return of 8%.
Chapter 6
41
Valuation & Management of Bonds
RIDING THE YIELD CURVE

Buy and sell after one year:

– if investor sells the bond after one year the bond
would trade at a price higher than expected.
– With 8% yield the price should be Rs. 925.92
(1,000/1.08).
– But since after one year the time left for maturity
is one year only the new price of the bond should
be Rs. 934.58 (1,000/1.07) consistent with the
yield curve.
– The investor would realise a return of 9% if the
bond is sold one year after investment.

Chapter 6
42
Valuation & Management of Bonds