Valuation

Bond Valuation

Bond
Par value (face value)
Coupon rate
Coupon or Coupon payment
Maturity date
Yield or Yield to maturity
Provisions
 Bond Valuation

 1 
1 -
 (1 + r) t  F
Bond Value = C  +
 (1 + r)
n
 r
 

BV = C * PVIFA(r,t) + PVIF(r,n)
Consider a bond issued by XYZ corporation with a maturity
date of 2020 and a stated coupon rate of 7% and a face value
of Rs.1000. In 2000, with 20 years left to maturity, investors
owning the bonds are requiring a 7.5% rate of return. What is
the value of the bond?

Rs. 949.00

Alaskan airlines bonds are maturing in 14 years that pay

Rs.68.75 per year (but disbursed semi-annually) and a face
value of Rs.1000. If the Investors required rate is 7.2%,
what is the Value of this bond?

Rs. 972.00
 Yield to Maturity (YTM)

Rate of return investors earn if they buy

the bond at P0 and hold it until maturity.

YTM is the discount rate that equates the

PV of a bond’s cash flows with its price.
 Computing Yield-to-maturity

Yield-to-maturity is the rate implied by the current

bond price
Face Value – Rs.1000, coupon rate – 9%, time to
maturity – 8 yrs, market price – Rs. 800, find YTM
Suppose you are offered a 14-year , 10% annual
coupon, Rs.1000 par value bond at Rs.1494.93,
find YTM.
YTC
Suppose the bond stated above had a call provision,
to call the bonds 10 years after the issue date at a
price of 1100. suppose further that the interest rates
had fallen and one year after issuance the going
interest rate had declined, causing the price of the
bonds to rise to 1494.93. the return to the investor
is…
Current Yield = I/MP

.
 Relationship / Theorem - 1

Bond prices and market interest rates move in opposite

directions
The Value of a bond is inversely related to changes in
the investor’s present RRR.
The Interest rate increases (decreases), the value of the
bond decreases (increases)

RRR – 12%, Par value – Rs.1000, Annual Interest – Rs. 120.

Time to maturity – 5 years, RRR – 9%, 12% and 15%, find
the Value of the bond.
Graphical Relationship Between Price and
Yield-to-maturity

1500
1400
1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
 Relationship / Theorem - 2

When a bond’s coupon rate is (greater than / equal to /

less than) the market’s required return, the bond’s
market value will be (greater than / equal to / less than)
its par value

When coupon rate = YTM, price = par value.

When coupon rate > YTM, price > par value (premium
bond)
When coupon rate < YTM, price < par value (discount
bond)
 YTM and Bond Value
$1400
Bond Value

When the YTM < coupon, the bond

1300 trades at a premium.

1200

1100 When the YTM = coupon, the

bond trades at par.
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 Discount Rate
When the YTM > coupon, the bond trades at a discount.
 Relationship / Theorem - 3

As the Maturity Date approaches, the Market

value of a bond approaches its Par Value.

At maturity, the value of any bond must equal its

par value

Assuming no changes in the current interest rate, find

the value of both the premium and discount bonds (15%
and 9% respectively) over time of 5,4,3,2,1 year to
maturity.
 Bond Value
1,372 rd = 7%.
1,211

rd = 10%. M
1,000

837
rd = 13%.
775

30 25 20 15 10 5 0

Years remaining to Maturity

 Relationship / Theorem - 4

Long-term Bonds have greater Interest rate Risk

than do Short term Bonds
Given two bonds identical but for maturity, the
price of the longer-term bond will change more
than that of the shorter-term bond, for a given
change in market interest rates.
A bond with longer maturity has higher relative
(%) price change than one with shorter maturity
when interest rate (YTM) changes. All other
features are identical
Find the Bond value if Face Value RS. 1000, Term to
maturity,
Scenario 1 – 5 years
Scenario 2 – 10 years
RRR – Current interest rate 9%, 12% and 15%, Coupon
Rate – 12%

RRR 5 yrs 10yrs

9% 1116.80 1192.16
12% 1000.00 1000.00
15% 899.24 849.28
 Maturity and Bond Price Volatility
Bond Value
Consider two otherwise identical bonds.
The long-maturity bond will have much more
volatility with respect to changes in the
discount rate

Par

Short Maturity Bond

C Discount Rate
Long Maturity
Bond
 Relationship / Theorem - 5

Given two bonds identical but for coupon, the price

of the lower-coupon bond will change more than
that of the higher-coupon bond, for a given change
in market interest rates.
A lower coupon bond has a higher relative price
change than a higher coupon bond when YTM
changes. All other features are identical
Coupon Rate and Bond Price Volatility
Bond Value
Consider two otherwise identical bonds.
The low-coupon bond will have much more
volatility with respect to changes in the
discount rate

High Coupon Bond

Discount Rate
Low Coupon Bond
 Interest Rate Risk

Price Risk
 Change in price due to changes in interest rates
 Long-term bonds have more price risk than short-term bonds

Reinvestment Rate Risk

 Uncertainty concerning rates at which cash flows can be
reinvested
 Short-term bonds have more reinvestment rate risk than long-
term bonds
If we take longer maturities and changes in
interest rates,
Coupon rate – 10%,
Face Value – Rs. 1000,
Interest rate – 5, 10, 15 and
20%,
Maturity – 1 and 30 years
 What is reinvestment rate risk?

The risk that CFs will have to be

reinvested in the future at lower rates,
reducing income.
Illustration: Suppose you just won
500,000 playing the lottery. You’ll
invest the money and live off the
interest. You buy a 1-year bond with a
YTM of 10%.
Year 1 income = 50,000. At year-end
get back 500,000 to reinvest.

If rates fall to 3%, income will drop

from 50,000 to 15,000. Had you
bought 30-year bonds, income
would have remained constant.
Long-term bonds: High interest rate risk, low
reinvestment rate risk.
Short-term bonds: Low interest rate risk, high
reinvestment rate risk.
Nothing is riskless!
True or False: “All 10-year bonds
have the same price and
reinvestment rate risk.”

False! Low coupon bonds have

less reinvestment rate risk but
more price risk than high coupon
bonds.
 Relationship with pattern of Cash Flow

The sensitivity of a bond’s value to changing interest

rates depends not only on the time to maturity, but
also on the pattern of cash flows

A change in interest rates always has a greater

impact on the PV of later cash flows than on earlier
cash flows. Bonds with cash flows coming later, will
be more sensitive to interest rate changes than bonds
with earlier cash flows.

But, How to measure this?

 Duration
A measure of how responsive a bond’s price is to
changing interest rates – estimate of price volatility.
Greater the relative percentage change in a bond
price in response to a given percentage change in
interest rate, the longer the duration

Calculation is based on the weighted average of the

present values for all cash flows
 Macaulay Duration

Duration = sum (t * Ct / (1+Y)^t)/P0

t – year the cash flow is to be received

Ct – Cash flow to be recd in year t
Y – Bond holders RRR
P0 – the bond’s PV

For all bonds, duration is shorter than maturity except zero

coupon bonds, whose duration is equal to maturity
• Newly issued bond which makes semiannual coupon
payments
• Market interest rates for this bond demand 8 percent interest
The bond makes a final repayment of Rs.1,000 after 10 years
Annual coupon Semiannual coupon
Bond value Bond duration
rate payment

0% 0 456 10 years

6 30 864 7.45

8 40 1,000 7.07

10 50 1,135 6.77
Market rate Drops to 7%
Market rate rises to 9%
Market rates
Market rates rise to 9
drop to 7
Annual Bond percent
percent Initial price at 8
coupon duratio
percent market rate
rate n Bond Change
Bond price Change in Price
price in price

0% 10 years 503 10.3% 456 414 -9.2%

6 7.45 929 7.5 864 805 -6.8

8 7.07 1,071 7.1 1,000 935 -6.5

10 6.77 1,213 6.9 1,135 1,065 -6.2

In the above table, bonds with higher durations had a bigger loss
when interest rates rose
Similarly, bonds with higher durations had a bigger gain when
interest rates fell
the rule of thumb for interest rate risk associated with bonds:
When interest rates rise one percent, the percentage loss in a
bond's value equals the bond's duration
The same holds true for appreciation in a bond's price when
interest rates fall
 Modified Duration

Mod.Duration = Macaulay Duration / (1+yield/k))

K = number of compounding periods per year.

 Convexity

Bond prices and yields are inversely related. But,

the relationship is not linear – for small changes in
yield, duration does a good job. When large changes
in yield occur, the convex nature of the price/yield
curve becomes apparent.

A measure of the curvature in the relationship

between bond prices and bond yields
 Immunization

The investment of the assets in such a way that the existing

business is immune to a general change in the rate of interest.

Immunization is accomplished by calculating the duration of

the promised outflows and then investing in a portfolio of
bonds that has identical duration.
 The Bond Indenture

Contract between the company and the

bondholders and includes
 The basic terms of the bonds
 The total amount of bonds issued

 A description of property used as security, if applicable

 Sinking fund provisions

 Call provisions

 Details of protective covenants

 Bond Ratings

Investment Grade vs. Speculative Grade

High Grade
Medium Grade
Low Grade
Very Low Grade
What factors affect default risk and bond ratings?

Financial performance
 Debt ratio
 Coverage ratios, such as interest coverage
ratio or EBITDA coverage ratio
 Current ratios
 Types of Bonds
Bonds Vs Debentures

Security : Secured / Mortgaged bond, and Unsecured Bonds

/ Subordinated Debentures

Transferability : Registered and Unregistered (bearer) Debentures

Conversion: Convertible, partly convertible, Non-Convertible

Debentures

Country and Currency – Foreign Bonds, Eurobonds

Coupon : very low coupon bonds, Zero coupon Bonds

/Zeroes, Deep discount Bonds

Credit rating : Junk / high-yield bonds

 Redemption : Callable and Puttable Bonds

LYONs, ZIFCD, Warrants, SPN, TOCD etc.,

 Zero-Coupon Bonds

Make no periodic interest payments (coupon

rate = 0%)
The entire yield-to-maturity comes from the
difference between the purchase price and the
par value
Cannot sell for more than par value
Sometimes called zeroes, or deep discount
bonds
Valuation of Zeros
 Valuation of Zeros

Assume that the default-free 10 year interest rate on

riskless investments is 4.55% and that you are
pricing a zero with a maturity of 10 yrs and a face
value of Rs.1000. price the zero.
If the 10-yr zero is trading at Rs.593.82, what is 10-
yr default free rate?
 Bond Markets

Primarily over-the-counter transactions with dealers

connected electronically
Extremely large number of bond issues, but
generally low daily volume in single issues
Makes getting up-to-date prices difficult, particularly
on small company or municipal issues
Treasury securities are an exception
 Term Structure of Interest Rates

Term structure is the relationship between time to

maturity and yields, all else equal
It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
Yield curve – graphical representation of the term
structure
 Normal – upward-sloping, long-term yields are higher
than short-term yields
 Inverted – downward-sloping, long-term yields are lower
than short-term yields
Upward-Sloping Yield Curve
Downward-Sloping Yield Curve
 Overview of Term Structure

The relationship between yield to maturity

and maturity.
Information on expected future short term
rates can be implied from yield curve.
The yield curve is a graph that displays the
relationship between yield and maturity.
Three major theories are proposed to explain
the observed yield curve.
 Theories of Term Structure
Expectations Theory
• This theory suggest that the shape of the yield curve
reflects investors expectations about the future
direction of inflation and interest rates.
• Therefore, an upward-sloping yield curve reflects
expectations of higher future inflation and interest
rates.
• In general, the very strong relationship between
inflation and interest rates supports this theory.
 Expectations Theory

Observed long-term rate is a function of today’s

short-term rate and expected future short-term
rates.
Long-term and short-term securities are perfect
substitutes.
Forward rates that are calculated from the yield
on long-term securities are market consensus
expected future short-term rates.
 Theories of Term Structure
Liquidity Preference Theory
• This theory contends that long term interest rates tend to be
higher than short term rates for two reasons:
– long-term securities are perceived to be riskier than
short-term securities
– borrowers are generally willing to pay more for long-
term funds because they can lock in at a rate for a longer
period of time and avoid the need to roll over the debt.
 Liquidity Premium Theory
Long-term bonds are more risky.
Investors will demand a premium for the risk
associated with long-term bonds.
The yield curve has an upward bias built into
the long-term rates because of the risk
premium.
Forward rates contain a liquidity premium
and are not equal to expected future short-
term rates.
 Theories of Term Structure
Market Segmentation Theory

• This theory suggests that the market for debt at any point in
time is segmented on the basis of maturity.

• As a result, the shape of the yield curve will depend on the

supply and demand for a given maturity at a given point in
time.
 Market Segmentation and Preferred
Habitat
Short- and long-term bonds are traded in distinct
markets.
Trading in the distinct segments determines the
various rates.
Observed rates are not directly influenced by
expectations.
Preferred Habitat:
 Modification of market segmentation
 Investors will switch out of preferred maturity segments if
premiums are adequate.
 Factors Affecting Bond Yields

Key Issue:
What factors affect observed bond yields?
Real rate of interest
Expected future inflation
Interest rate risk
Default risk premium
Liquidity premium