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Bond Valuation - Combined PDF
Bond Valuation - Combined PDF
What is a Bond?
• It is a fixed income instrument (can be issued by: government, municipality,
corporate, and agency)
• Made by an investor to a borrower.
• It specifies all related details of the loan and its payments.
• Used to finance long term projects and operations involving huge finance.
• Governments at various level use bonds to raise money needed to fund schools,
dams, roads and so on. These bonds have lowest default risk.
• Corporations use bonds commonly to either buy property or initiate profitable
projects and so on.
• Bonds are tradable; are bought through brokers
• Pays a fixed interest rate (coupon) to debtholders. This is called coupon rate,
which is paid on the face value of the bond.
• When interest rates are high, bonds prices fall down and vice versa.
• Bonds are paid on maturity dates on which principal amounts are paid back in
full.
Government bonds
• Issued by Central Government and supervised by RBI
• Government sells bonds to public to raise funds to finance projects
for welfare of the public
• Regular or fixed interest rates are paid to the investors
• On maturity, the face value of the bond is paid
• These are considered as risk free investments
• The returns are sufficiently goods and are also available for a longer
period of time
• Are liquid as most banks and financial institutions participate
• Is accompanied by tax benefits
What are Corporate Bonds?
• Issued by private and public corporations
• to raise money for a variety of purposes, such as building a new plant,
purchasing equipment, or growing the business
• Are more complex in nature
• Investors face default risk
• Less liquid than government bonds
• Difficult to purchase and sell
• Until maturity, the company pays at a stated rate of interest, usually semi
annually
• When interest rates fall, corporate bonds tend to rise in value and vice
versa
Bond market
• Also known as credit or debts market.
• Provides a platform for trade of debt securities and a proper channel
which helps in long term financing of public and private expenditure.
• The issuer is the owner of the debt and he is obliged to pay the
coupon rate and principal amount on date of maturity.
• Indian bond market is very liquid.
• corporate and government bonds are publicly traded
• some only over-the-counter (OTC) or privately between the borrower
and lender.
Bond Types
• Plain Vanilla Bond: forms of bond with a fixed coupon and a defined maturity and is usually issued and redeemed at
the face value.
• Zero Coupon Bonds: a bond that is issued at a deep discount to its face value but pays no interest.
• Callable Bond: the issuer may redeem before it reaches the stated maturity date
• Puttable bonds: The holder has the right, but not the obligation, to demand early repayment of the principal.
• Convertible bonds: the holder can convert into a specified number of shares of common stock in the issuing
company
• Floating rate bonds: variable interest rate that allows investors to benefit from rising interest rates
• Perpetual bonds: offers perpetual coupon
• Inflation indexed bonds: provides the investor a constant return irrespective of the level of inflation in the economy
• Debenture: an unsecured loan certificate issued by a company
• Yankee bonds: It is issued in the U.S. bond market by a foreign entity, and they are denominated in U.S. dollars.
• Samurai bonds: It is a yen-denominated bond issued in Tokyo by non-Japanese companies, and is subject to
Japanese regulations.
Bond indenture
What is a bond indenture?
- Bond indenture is a legal document that specifies the both the rights of the
bond holders and duties of the issuer.
What is standard provisions?
- Maintain satisfactory accounting records, supply periodic financial
statements, pay taxes and other liabilities when due, maintain all facilities
in good working condition.
What is restrictive provisions?
- That places the operating and financial constraints on the issuer.
( minimum level of liquidity maintenance, limit firms annual cash dividend
payments, constraints on subsequent borrowings, prohibit the sale of
account receivables)
Key inputs for valuation
Valuation inputs:
-Cash flows
-Timing
-Risk
What is Bond Valuation
• Here, the expected cash flows are certain
• Is determining the fair price of bond which is the PV of the stream of
cash flows
• Thus, the bond’s expected cash flows are discounted to get the
present value at a discount rate
• Before understanding the valuation of bonds, let us get familiar with
certain bond related terms.
Par value:
• is the value stated on face value of bond
• Paid at maturity as promised
Coupon rate and interest:
• Par value of the bond*coupon rate=interest payable to bond holder
Maturity period:
• Typically 1-5 years
• The longer the term to maturity, the higher the interest rate
• bond’s coupon and term to maturity are used in determining the bond’s
market price and its yield to maturity.
Interest rate and Inflation
• With lowering of interest rates, people tend to borrow more money
resulting in more money in hand to spend which results in growth in
economy and increase in inflation.
(1 + R) = 1.10
(1 + r) x (1 + i) = 1.0476 x 1.05 = 1.10
Inflation and Returns
At a given level of inflation (i) and nominal return(r), the real return
expectation is constant. But it changes due to variation in ‘I’ and ‘r’
over the period.
- Real return expectation differs from investors to investors
- Real return expectation depends on the selection of the benchmark
risk free return, benchmark inflation rate.
- Many economist even vouch that the real rate of return is the return
adjusted for inflation or other factors.
- Finally, a real rate of return is the annual percentage return realized
on an investment, which is adjusted for changes in prices due to
inflation or other external factors.
Interest rate and Risk premium
Example 2:
Suppose you expect 3% real return from a security after a year on your
today’s Rs. 100 investment. If the inflation expectation is 5% p.a. How
much should be the minimum quoted nominal interest rate on the
said security that motivates you to make investment.
R=(1+3%)*(1+5%)=1.0815. That means the r should be 8.15%
Source: RBI | SKI Research
Usually , a short term bond has lower interest rate as compared to long term bond , hence, a graph of the interest rate of
the short-term bond and longer-term will be an increasing line chart. This in is called an upward sloping curve.
Source: economictimes.indiatimes.com
• For bond valuation, It thus involves
Determining the interest rates
Estimating the expected cash flows
Determining the PV of these cash flows
Certain assumptions
Coupon interest rate is fixed
Coupon payments are annual
The bond is redeemed on par at maturity.
Since the coupon payments are the stream of ordinary annuity, bond value is
equal to:
P=C*𝑷𝑽𝑰𝑭𝑨𝒓,𝒏 + M* 𝑷𝑽𝑰𝑭𝑨𝒓,𝒏
Where, M= maturity value
C= annual coupon payment
r= periodic required return
t= time when payment is received.
A few questions
What determines the real rate of interest?
-Supply and demand of capital
What is term structure of Interest rate?
-Relationship between rate of return and time to maturity
What is YTM?
- Compound annual rate of return earn on a debt security purchased on
a given day and held to maturity.
What is YC?
- relationship between debt’s remaining time to maturity and yield to
maturity ( DYC, NYC, FYC)
The inverse relationship
price
yield
Bond prices vary with interest rates
Inverse relationship
1
1- (1 YTM)t F
Bond Value C
(1 YTM)
t
YTM
PV(lump sum face
PV(Annuity) value of bond )
TCS issued a bond with face value $1000 in the year April 1, 2005 and it
would mature in 14 years from now, the coupon amount is $150 and the
discount rate is 10%. Given this information calculate the present value of
the bond?
YTM: 15%,
Coupon: $150
Period: 14 years
FV: $1000
PV= $150(PVIFA10%,14Yr) +$1000(PVIF10%,14Yr)
= $150(7.3667) +$1000(0.2663)
=$1368.31
Bond Valuation
• TCS issued a bond with face value $1000 in the year April 1, 2005 and it
would mature in 14 years from now, the coupon amount is $150 and the
discount rate is 20%. Given this information calculate the present value of
the bond for each of the year?
YTM: 20%,
Coupon: $150
Period: 14 years
FV: $1000
PV= $150(PVIFA20%,14Yr) +$1000(PVIF20%,14Yr)
= $150(4.6106) +$1000(0.0779)
=$769.49
Bond Valuations
Assume you have the following information.
Suppose XYZ company bond have a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 10%
1. Calculate the present value of the face value
= $1,000 [1/1.1020 ] = $1,000 .14864 = $148.64
2. Calculate the present value of the coupon payments
= $100 [1 - (1/1.1020)]/.10 = $100 8.5136 = $851.36
3. Bond Value = $148.64 + 851.36 = $1,000
Calculate YTM
• Suppose you were offered a 14 year , 15% coupon , $1000 par
value bond at a price of $1368.31. What rate of interest would
you earn on your investment if you bought the bond and held
upto maturity (calculate the yield to maturity)?
• PV= $150/(1+r)^1+ …….$150/(1+r)^14+$1000/(1+r)^14
• PV=$150(PVIFA)+$1000(PVIF)
• $1368.31=$150(PVIFA)+$1000(PVIF)
Trial and Error Method
At 12% for 14 Yrs : $150(6.6282)+$1000(0.2046)=$1198.83< $1368.31
At 10% for 14 Yrs: $150(7.3667)+$1000(0.2633)= $1368.31 = $1368.31
Hence YTM is 10%
Lets understand the discount and premium
bonds
Whenever the YTM=Coupon interest rate: bond is sold at par value
Whenever the YTM>Coupon interest rate: value: Bond is sold at Discount
Whenever the YTM<Coupon interest rate: Bond is sold at Premium
Thus increase in market interest rate will cause the decline in value of an
outstanding bond and vice versa
Market value of bond=Par value on maturity
Why so?? What is the rationale behind it?
Bond value vs. Yrs of maturity
Premium CR>YTM
YTM = CR M
1,000
CR<YTM
Discount
30 25 20 15 10 5 0
Bond Rates and Yields (concluded)
• 3. The yield to maturity (or “YTM”) is the rate that makes the
price of the bond just equal to the present value of its future cash
flows. It is the unknown r in:
$932.90 = $70 [1 - 1/(1 + r)10]/r + $1000 /(1 + r)10
1
1-
C (1 YTM/2)2t F
Bond Value
2 YTM/2 (1 YTM/2)2t
C = Annual coupon payment C/2 = Semi-annual coupon
YTM = Annual YTM (as an APR) YTM/2 = Semi-annual YTM
t = Years to maturity 2t = Number of 6-month
periods to maturity
Present value of semi annual govt. bond
Bond Price Vary with Interest Rates
A few Examples
• Bond J has a 4% coupon and Bond K a 10% coupon having face value of
$ 1000 each. Both have 10 years to maturity, make semiannual
payments, and have 9% YTMs. If market rates rise by 2%, what is the
percentage price change of these bonds? If rates fall by 2%? What does
this say about the risk of lower-coupon bonds?
Solution to Problem
Current Prices:
Bond J:
PV = $20 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20
= $______ (just compute)
Bond K:
PV = $50 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20
= $1065.04
Solution to Problem (continued)
Bond K:
PV = $50 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20
= $______ ( just compute)
Solution to Problem (continued)
• 2. The current yield is the annual coupon divided by the current market price
of the bond:
Current yield = $___ /_____ = 7.5%
• Under what conditions will the coupon rate and current yield be the same?
Index Bond
- Suppose investor A purchases a regular bond of Govt. of India for Rs
1000 during Oct,2018 with coupon rate of 6%, which is maturing in 1
year. At the same point in time suppose investor B purchases an
Indexed bond of GOI for Rs1000 during Oct,2018with Coupon rate of
6%, which is maturing in 1 year.
- If the CPI level at the time of issuance was 141 and CPI level in Oct
2019 has gone up to 146. Whether investor B is loser or gainer
compared to investor A? How much is the loss or gain for investor B?
Solution
Regular Bond:
• Annual interest rate at 6%; interest payment=Rs1000*6%=Rs60
• Principal+Interest=Rs1000+Rs60=Rs1060
Indexed Bond
• CPI for Oct,2019 is 146
• Indexation factor=146/141=1.035
• Inflation rate=3.5%
• Bondholder will receive=1.035*1060=Rs.1097.1
• Annual interest rate on bond=(Rs1097.1-Rs1000)/Rs1000]*100%=9.71%
• Real rate of return=9.71%-3.5%=6.21%
Corporate Bonds And Default Risk
• Corporate bonds-higher risk than Government bonds
• Risk =interest rate risk + credit risk
• Not secured by collaterals
• Credit risk depends on borrowers overall ability repay a loan
• 5 Cs to be considered
Credit history
Capacity
Collateral
Capital
Loan’s condition
Fixed income valuation Case problem Solutions
• Solution1
a. Answer is self explanatory because the coupon rate and
debenture yield has to be same, if debenture is sold at par. Thus the
debenture yield (r) is 4.75% per annum:
Y 1000= Y4705/(1+r)+47.5/(1+r)^2+…….147.5/(1+r)^10
b. P=47.5/(1+0.03)^1+Y47.5/(1+0.03)^2+….Y147.5/(1+0.03)^10
= Y112.28 ( should be sold in Premium)
Fixed income valuation Solutions
• Solution 2 a.
• Patriot’s bonds annual equivalent yield =4%*2= 8%
• Patriot’s bonds annual effective yield =(1+i/m)^n-1= (1.8/2)^2-1 =1.0816 -1= 8.16%
• Thus market value of all three bonds
• PV of Bond A= $1040.55
[ deploy EXl. Price fn=PRICE(DATE(2015,1,1),DATE(2020,1,1),9%,8%,100,2)]
• PV of Bond A= $1000.00
• [deploy EXl. Price fn =PRICE(DATE(2015,1,1),DATE(2025,1,1),8%,8%,100,2)]
• PV of Bond A= $456.39
• [ deploy EXl. formula =$1000/(1+0.0816)^10
Note: for zero coupon bond the effective rate will be applied in the formula
However, excel price function automatically computes the present value of bond taking into account effective yield
Solution 2 b.
Eurobond is sold in 1 % discount @ annual coupon rate of 8% and patriot bond B is sold at par with
effective coupon yield of 8.16% semiannually. Thus patriot bond is better and if Eurobond provides
the same yield like patriot, Alumm would be indifferent to either of the bond.
Fixed income valuation Case problem Solutions
Solution 3:
Rate 9%
Period 20
PMT $ 25,000.00
Mortgage value
today $228,213.64 Ans A1.: Max. mortgage available
$ 4,460.77 Ans A2: Principa paid in the first Yr.
$2064.220183 Ans: A3 (1): Interest paid at the end of 25 th yr
Ans C: No doubt 15 Yr coupon bond will have shorter duration than that of the 15 yr zero coupon bond. But the reinvestment of
proceeds are more riskier for coupon bond and thus coupon bond should command higher required yield.
Fixed income valuation Case Solutions
Bond prices and yields move in opposite directions. India’s benchmark government bond yield has dropped to its lowest
since the subprime crisis of 2008.
Source:economictimes.indiatimes.com
RBI Inflation Indexed Bonds advertisement
Source: https://www.bemoneyaware.com
Source: Economics Times
How to buy Government Bonds in India?
Post office,
Government leading banks
bonds
Requires
Issue of bond
certificate verification