UNIT II (BOND VALUATION)

SECURITY:

Equity shares, bonds, debentures or any other marketable instruments are popularly termed
as securities. These are various sources by which corporates raises funds from public.

Generally Investment avenues can be categorized on the basis of income generation ability
as follows:
Investment

Financial Investment Real Investment

Fixed Income Variable Income

Investment Investment
Avenues Avenues
SECURITY ANALYSIS:
ment
Various investment avenues are to be evaluated on the basis of attributes like return risk,
marketability, tax shelter, safety and convenience. Therefore, determination of future
dividend or earning flows, forecast of the stock price in future and estimating the intrinsic
value of a security is termed as security analysis.

MEANING OF BOND:

A bond is more or less the same as a debenture. In India, the two terms are generally
interchangeable. There is no significant distinction between the two and the difference if
any, is for all practical purpose negligible. In India it is common to refer to the long term debt
securities issued by the state governments/Central government or by undertakings owned
by them or by development financial institutions, as Bond.

DEFINITION OF BOND:

A bond is a marketable, legal contract that promises to pay whoever owns it a predetermined
rate of interest for a defined period and then repay the principal at the specific date of
maturity.

A bond is a contract that requires the borrower to pay the interest income to the lender; it
resembles the promissory note and issued by the government and corporate.

The par value of the bond indicates the face value of the bond i.e., the value stated on the
bond paper, generally, the face values of bonds are Rs. 1000, 2000, 5000, 10000 and alike.

Most of the bonds make fixed interest payment till the maturity period. This specific rate of
interest is known as coupon rate. Coupons are paid quarterly, semiannually and annually. At
the end of the maturity period, the value is repaid.

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The following are the silent features of the bond defining the contractual rights of the bond
holder of the issuer.

Face value: The face value of nominal value of the bond can b e thought of as the principal
amount on which interest is paid by the issues. In many cases, t his is also the amount which
is repaid at the end of the life of the bond. This is also often the price at which the bond is
originally issued by the issuer. But there are exceptions to both of these as explained
subsequently.

Coupon: Bonds typically pay interest periodically at a pre specified rate of interest. The
annual rate at which this interest is paid is known as the coupon rate or simply the coupon.

Maturity date and Maturity: The maturity date of the bond is the date on which the bond
is repaid and extinguished. The time period (for e.g. number of years) remaining till the
maturity date is known as the number maturity of the bond. The maturity at issue refers to
the time to maturity from the date of issue of the bond and the residual maturity refers to
the time to maturity at any subsequent point of time.

Redemption Premium: bonds are not always redeemed at par on the maturity date. In
other words, the repayment on the maturity date is not necessarily equal to the face value.
Some bonds pay a redemption premium in addition to the face value.

TYPES OF FIXED INCOME SECURITIES:

The different type of fixed income securities that are available in India are as follows:

1. BANK DEPOSITS: Deposits with banks are the safest mode of investment and earns
a fixed rate of interest. Fixed deposits up to Rs. One lakh, in individual accounts
covered by deposits insurance scheme. They are highly liquid as fixed deposit
receipts can been cashed premature at a discount 1% on interest. They are neither
tradable or nor transferable. Nomination facility is available.
2. Company Deposits: These deposits are with manufacturing and non banking
financial companies and earn a fixed rate of interest usually higher than bank fixed
deposits rate. These deposits are neither secured nor guaranteed by RBI and noted
for untimely payment of principal amount. They are not exactly liquid. These are
neither tradable nor transferable. They are without nomination facility.
3. Small Savings Schemes: These are the safest mean of investment and initial
investment gets doubled in 5-6 years time. In the section88, they are not tradable
and most instruments are accepted by banks as collateral.
4. Debentures and Bonds: These are long term debt instruments usually yields high
rate of interest. The safety factor with these investments can be analyzed by
considering credit ratings. They are freely tradable and transferable and hence
provides for liquidity. Fixed income securities provide investors with two kinds of
income i.e.,
i. Current Income (Periodical receipt of interest or dividend)
ii. Capital Gains

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Advantages of Fixed Income Securities:

1. High yields, if the interest/ dividend rates are good

2. Minimum risk exposure
3. Opportunity for capital gains, if they are traded
4. Tax advantages

Disadvantages of Fixed Income securities:

A major disadvantage of investing in fixed income securities is that the interest rate or
dividend rate is fixed for the life of the issue and therefore cannot move up overtime in
response to inflation.

TYPES OF BONDS/CLASSIFICATION OF BONDS:

A bond is a long term debt instrument that promises to pay a fixed annual sum as interest
for a specified period of time. The basic types of bonds are given below:

1. Secured Bonds and Unsecured Bonds: The secured bond is secured by the real
assets of the issuer. In case of the unsecured bond, the name and fame of an issuer
may be the only security.
2. Perpetual Bonds and Redeemable Bonds: Bonds that do not mature or never
mature are called perpetual bonds. The interest alone would be paid. In redeemable
bonds, the bond is redeemed after a specific period of time. The redemption value is
specified by the issuer.
3. Fixed Interest Rate Bonds and Floating Interest Rate Bonds: In fixed interest
rate bonds the interest rate is fixed at the time of the issue, where as in the floating
interest rate bonds, the interest rates change according to already fixed norms. For
example, in December 1993 the state bank of India issued floating interest rate
bonds worth ₹500 crore, pegging the interest rate with its three and five years fixed
deposit rates to provide built-in yield flexibility to the investors.
4. Zero coupon Bonds: A zero-coupon bond is a bond that makes no periodic interest
payments and is sold at a deep discount from face value. The buyer of
the bond receives a return by the gradual appreciation of the security, which is
redeemed at face value on a specified maturity date.
The discount value is calculated using the formula

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑

Present Value = (1+𝑅)2

R = interest rate and n = number of years

Deep Discount Bonds: A deep discount bond is another form of zero coupon bonds.
The Bonds are sold at a large discount on their nominal value and interest is not paid
on them.
5. Deep Discount Bonds: A deep discount is another form of zero coupon bonds, the
bonds are sold at a large discount on their nominal value and interest is not paid on
them. Also, they mature at par value. The difference between the maturity value and

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 the issue price serves as an interest return. The deep discount bonds maturity period
may range from three years to 25 years or more.
6. Capital Indexed Bonds: In the capital indexed bond, the principal amount of the
bond is adjusted for inflation for every year. The bond is advantageous because it
gives the investor more return by taking inflation into account. The value of the
principal repayment is adjusted by the Index Rate (IR), which is announced by the
RBI two weeks prior to the repayment of the principal. The IR is estimated as follows:

IR = Reference WPI as in Aug 2002/Base WPI (Whole sale price Index)

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 TIME VALUE CONCEPT
Time Value of Money (TMV)
The concept of time value of money deals with the fact that an amount of money received in
the future is not as valuable as the same amount money received in the present. This is
because:
The future is uncertain
Individuals prefer current to future consumption
Inflation trends or common feature reducing the value of money in the future

Definition of Time value of money

The time value of money is the value of money figuring in a given amount of interest earned
or inflation accrued over a given amount of time.
It is an idea that money available at the present time is worth more than the same amount
in the future due to its potential earning capacity. This core principle of finance holds that,
provided money can earn interest, any amount of money is worth more the sooner it is
received.

Formulas Based on TMV Concept

Ct
Present value =
( 1+𝑟)𝑛

Present value of cash inflows, r = interest rate, n = no of years.

Future value = PV (1+r) n

Problem:
Calculate future value of Rs 5,000, 10 years from now at @ 8% interest per annum
Sol:
Future value = PV (1+r) n
= 5.0000 X 2.1589 = Rs 10,974.50

BOND CONVEXITY:

As bond yields go higher, price goes lower, this relationship between price and yield has a
convex structure in nature. The term used to describe this relationship is also known as
convexity.
Convexity relates to the interaction between a bonds price and its yield as it experiences
changes in interest rates.

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 MEASUREMENT OF BOND RETURNS

The purpose of investment is to get a return or income on the funds invested in different
financial assets. The most important characteristics of financial assets are the size and
variability of their future returns. Since the return on income varies, various statistical
techniques are used to measure it. Over the years, many methods were adopted for
quantifying returns. These are now categorized as traditional and modern techniques of
measurement.

Bond Return:

The investor in bond typically receives income from the following:

 Interest payment at a contracted rate i.e., coupon rate

 Capital gain or loss arising out of sale of the bond
 Cash realization on the sale of bond
 Redemption of the bond by the issue at a contracted value

The return on bond can be measured in terms of

1. Holding period Return

2. Current yield and
3. Yield to Maturity and Yield to Call

Holding Period Return:

An investor buys a bond and sells it after holding for a period. The rate of return in that
holding period is calculated as follows:
𝑃𝑟𝑖𝑐𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 +𝐶𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 (𝑖𝑓 𝑎𝑛𝑦)
Holding Period Return(HPY) = 𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑

The holding period rate of return is also called as the one period rate of return. The holding
period return can be calculated daily or monthly or annually. If the fall in the bond is greater
than the coupon payments, then the holding period return will turn to negative.

SAMPLE PROBLEM:

 An investor ‘A’ purchased a bond at a price of Rs. 900 and earned Rs 100 as coupon
before solding it at Rs 1000. What is his holding period return?
Sol:
𝑃𝑟𝑖𝑐𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 +𝐶𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 (𝑖𝑓 𝑎𝑛𝑦)
Holding Period Return (HPY) = 𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑

(1000 −900)+100
=
900

100 +100 200

= 900
= 900
= 0.2222 or 22.22%

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Current Yield:

The current yield is an annual cash flow measure of return based on current market price.
It is the coupon payment as a percentage of current market prices and is computed as
follows:
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡
Current Yield = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒
= 𝐶
𝑃

With this measure, the investor can find out the rate of cash flow from the investments
energy year. The current yield differs from the coupon rate, which is also called as Nominal
Yield.

Yield to Maturity (YTM):

The concept of Yield to Maturity (YTM) is one of the widely used tools in bond investment
management. The current way of computing the return on any asset involves considering
the entire sequence of cash flows with their timing and calculating the internal rate of return.

In case of bond, there is a cash outflow (equal to the price of the bond) when the bond is
bought but there are cash inflows. When the periodic interest coupons are received another
cash inflow is the redemption value is received on maturity.

Calculating the IRR of this stream of cash flows gives the true return on the bond which is
known as the yield to maturity (YTM).

Therefore YTM is the single discount factor that makes present value of future cash flows
from a bond equal to the current price of t he bond. To find out the yield to maturity, present
value technique is adopted. The formula is
𝑐𝑜𝑢𝑝𝑜𝑛1 𝑐𝑜𝑢𝑝𝑜𝑛2 𝑐𝑜𝑢𝑝𝑜𝑛3 (𝑐𝑜𝑢𝑝𝑜𝑛𝑛 + 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒)
Present value = + + + ----------- +
(1+𝑌 )1 (1+𝑌 )2 (1+𝑌 )3 (1+𝑌 )𝑛

Or P0 = C (PVIFA y, t ) + F (PVIF y, t )

And here y = YTM

Assumptions underlying YTM:

The YTM of a bond represents the expected or required rate of return on a bond. While
computing the YTM, the following assumptions are made:

All coupon and principal payments are made on schedule

The coupon payments are fully and immediately reinvested at precisely the same interest
rate as the promised YTM.

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Approximate YTM: Approximate yield to maturity commonly calculate at maturity date
based on average annual return and average investment

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛

AYTM = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐶 + 𝑀−𝑃
= 𝑀 +
𝑁
𝑃
2

C = Annual coupon amount

M = Maturity of par value / face value of bond

P = Purchase Price

N = no of year remaining to Maturity

Yield to Call:

Sometimes issuer of a bond has the option to call (or redeem) to bond before it reaches
maturity. This is likely to occur when the coupon interest rate on similar new bonds is
substantially below the coupon interest on existing bonds because the corporation can save
money on future interest payment and such callable bonds, the discount rate that equates
the present value of the cash flow to first call of a callable bond its market value can be
termed as yield to call.

When a bond has an excellent chance of being called, an investor may want to calculate the
yield to call for the bond which is the discount rate that equates the present value of cash
flows to first call of a callable bond to its market value.

Definition: Yield to call (YTC) is the rate of return earned on a bond from its valuation date
to its call date. It is the compound interest rate at which the present value of its future coupon
payments and call price is equal to the current market price of the bond.

𝐶 + 𝐶𝑃 −𝑀𝑉
Approximate yield to call formula = 𝐶𝑃 +
𝑁
𝑀𝑉
2

C = Coupon interest amount

CP = Call Price

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MV = Market value of bond

N = No of Years until call

𝑐𝑜𝑢𝑝𝑜𝑛1 𝑐𝑜𝑢𝑝𝑜𝑛2 𝑐𝑜𝑢𝑝𝑜𝑛3 (𝑐𝑜𝑢𝑝𝑜𝑛𝑛 + 𝐶𝑎𝑙𝑙 𝑝𝑟𝑖𝑐𝑒)
Present value = (1+𝑘 )1
+ (1+𝑘 )2
+ (1+𝑘 )3
+ ----------- + (1+𝑘 )𝑛

Or P0 = C (PVIFA k, t ) + CP (PVIF k, t )

k = yield to call

CP = callable price

P0 = Present value of bond

YTM > AYTM, then the bond is underpriced

YTM < AYTM, then the bond is overpriced

YTM = AYTM, then the bond is said to be fairly priced

MACAULAY’S DURATION/BOND DURATION/ DURATION OF BOND:

This model is developed by F.R Macaulay in 1938, so is known as Macaulay’s Duration. It is

also called as continuous Model.

Duration measures the time structure of a bond and the bond’s interest rate risk. The time
structure of investment in bonds is expressed in two ways. The common way to state is how
many years he has to wait until the bond matures and the principal money is paid back.

This is known as asset’s time to maturity or its years to maturity. The other way I to measure
the average time until all interest coupons and the principal is recovered.

This weight average of time periods to maturity, weight being present values of the cash flow
in each time period. The formula for duration is,
𝐶1 𝐶1 𝐶𝑡
D= (1+𝑟)1
+ (1+𝑟)2
+ −−−−−− + (1+𝑟)𝑡
* T
𝑃0 𝑃0 𝑃0

This can be summarized as

𝑡
𝑃𝑉 ( 𝐶𝑡 )
D = ∑ *t Where
𝑡=1 𝑃0

D = Duration

C = Cash flow

r = Current yield to maturity

T = Number of years

PV (C) = Present value of the cash flow

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𝑃0 = Sum of the present values of cash flow

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Modified Macaulay’s Duration:

The relationship between Changes in the price of a bond relative to change in its yield to
maturity is usually referred to as Modified Macaulay’s duration.

The Modified Macaulay’s duration determined as follows:

𝑀𝐷
MMD = 1 +𝑌𝑇𝑀

MMD = Modified Macaulay’s duration

MD = Macaulay’s Duration

YTM = Yield to maturity

Bonds Vs Debentures

Basis Bonds Debentures

1. Nature Bonds can be either secured or Debentures are only unsecured
unsecured
2. Safety Rank higher than debentures Not protected by a specific
particularly government bonds. mortgage on the property of the
With credit rating PSU bonds. company and hence less secure.
3. Liquidity Can be encashed after initial lock in
Freely tradable and transferable.
period. N O facility for nominationRestricted liquidity due to lack of
or bank loan except in specific depth in secondary market. NO
cases. Weak secondary market. facility of premature
encashment. No nomination
facility. Banks do not accept
these as collateral against loan.
4. Yield High yield ranging from 9 % to Highest rating from 10% to 14%.
12%. Interest usually paid half –
yearly.

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