Chapter 9 Bond valuation

 C.J. Timalsena

 The behavior of market interest rates:

We know that required return for bondholder has three (the real risk free rate, expected
inflation premium and risk premium) components. Risk free rate of return consists the
real rate of return and expected inflation premium. Risk premium is the return for the
bearing additional risk in the investment. Risk premium depends upon the quantity of
risk involve in the investment. It means investor wants higher premium for bearing the
more risk. In this way required rate of return on bond depends on the degree of risk
involve in the investment. Risk on bond depends on the specific characteristics. For
example types of bond, term to maturity, call features, bond rating etc. Three factors
drive the required rate of return on bonds which is given by
rj = r* + IP + RP
Where,
rj = Required rate of return
r* = Real rate of return
IP = Inflation premium
RP = Risk premium
Risk free rate addresses interest rate risk and purchasing power risk and risk premium
addresses business risk, financial risk, liquidity risk and call risk. From the prospective
of the market all these components in aggregate are known market interest rate. Market
interest rates affect the price of the bond.
 The term structure of interest rates and yield curves
The term structure of interest rate shows the relationship between interest rates and term
to maturity of the securities. Most of the times short term interest rates are lower than
long term rates. The relationship between term to maturity and interest rate for a given
period can be depicted graphically by the yield curve. The shape of yield curve can be
upward sloping, downward sloping and flat. Generally yield curve can be upward
sloping. It indicates that yields tend to increase with longer maturities. Occasionally the
interest rate of short term securities may be higher than long term securities. In such
situation the shape of yield curve becomes downward slopping. Sometimes the yield
curve may be flat. The flat yield curve indicates that the yield of short term and long
term securities is the same.
 Theories of term structure of interest rates
There are three common theories that explain more reasons for general shape of yield
curve.
 The expectation theory: It suggests that the yield curve reflects the investors’
expectation about future interest rates and inflation. Under expectation theory an
increasing inflation rate expectation results in an upward sloping yield curve, a
decreasing inflation expectation results in a downward sloping yield curve and a
stable inflation expectation results a flat yield curve.
 Liquidity preference theory: It explains the term structure is a result of the
preference of investors for short term securities due to higher liquidity. Most of
the investors hold long term securities only when they expect to receive higher
return due to lower liquidity. So, it states that long term interest rates are higher
than short term rates due to the lower liquidity.
 Market segmentation theory: Market segmentation theory suggests that the debt
market is segmented on the basis of maturity preferences of different types of
investors and institutions. It explains the yield curve change as the supply and
demand for the funds within each maturity segment. When supply exceeds
demands for short term loans, short term interest rates are lower than long term
interest rates. Similarly, when demand for long term loan is higher than the supply
of long term loans, the long term interest rates will increase. Lower interest rates
in the short term segment and higher interest rates in the long term segment cause
an upward sloping yield curve and vice versa.

 Pricing of bonds
The Value of financial assets are the present value of all the expected benefits or cash
flows of that asset over its life. The price of bond is the present value of coupon payments
plus present value of maturity value. The price of bond depends upon four variables.
They are coupon payments, maturity value, term to maturity and market interest rate.
 The basic bond valuation model
Cash flows of a bond depend on its contractual features as described in the indenture.
Corporation can issue different types of bond. For example- perpetual bonds, zero
coupon bonds, floating interest bonds, income bonds etc. A Perpetual bond pays coupon
interest forever. Zero coupon bond does not pay any coupon interest during the life but
it pays maturity value at maturity. Income bond pays coupon interest only when
company earns profit. Floating interest bond’s interest rates varies overtime. Generally,
bonds or debentures are issued with specified maturity period with fixed interest rate.
An investor receipts periodic interest during the maturity period and principal or
maturity value at the end of the maturity period.

 Value of perpetual bond

Vd = I/y
Where,
Vd = Intrinsic value, theoretical value, of the bond
I = Coupon payment
y = Required rate of return for the investor, Market interest rate.
 Value of Zero coupon bond
Vd = M/(1+y)n
Where,
Vd = Intrinsic value, theoretical value, of the bond
M = Maturity value of the bond
y = Required rate of return for the investor, Market interest rate.
n = Years to maturity.
 Value of redeemable bond
Vd = I (PVIFAy,n) + M (PVIFy,n)
Or, Vd = I {1-1/(1+y)n} /y + M/(1+y)n
 Value of callable bond
Vd = I (PVIFAy,n) + call price (PVIFy,n)
Or, Vd = I {1-1/(1+y)n} /y + call price/(1+y)n
Where,
n = called period
 Value of bond with semiannual interest
Vd = I/2 (PVIFAy/2,n×2) + M (PVIFy/2,n×2)
Or, Vd = I/2 {1-1/(1+y/2)n×2} /y/2 + M/(1+y/2)n×2
 Discount bond: If a bond is selling at a price below its par value it is called
discount bond.
Premium bond: If a bond is selling at a price above its par value it is called
premium bond.
Par bond: If a bond is selling at a price equal to its par value it is called par bond.

 Required returns and bond values

There is inverse relationship between required rate of returns and value of bond.
Whenever the required return on a bond differs from the bond’s coupon rate the value
of bond differs its par value. When the required rate of return is higher than coupon rate
then the value of bond is less than its par value. The bond is traded at a discount. When
the required rate of return falls below the coupon rate the value of bond is higher than
its par value. It is traded at a premium. When the required rate of return is equal to
coupon rate then the value of bond is equal to its par value.
 Measurement of yield and Returns
𝐶𝑜𝑢𝑝𝑎𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡+𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐶𝑜𝑢𝑝𝑎𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡+𝐸𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒−𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
Or, 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

Current yield = Coupon interest/ Current market price of bond

Capital gain (loss) yield = (Ending price – Beginning price)/Beginning price
Yield to maturity (YTM) : It is the rate of return earned on the bond if investor
buy the bond and hold it until maturity. YTM is a discount rate that makes the
present value of a bond’s payments equal to its price.

YTM of perpetual bond = Coupon interest/ Purchase price of bond

YTM of Zero coupon bond = (M/ Purchase price)1/n – 1

YTM for redeemable bond

Approximate YTM = {I +(M- Price)/n} /(M+2×Price)/3

At actual YTM the value of bond is equal to its purchase price
Vd = I (PVIFAy,n) + M (PVIFy,n)
Now,
YTM = LR + [(VLR – Price)/ (VLR-VHR)] ×(HR-LR)
Yield to call (YTC): It is the rate of return earned on the bond if investor buy the
bond and hold it until the called period.

Approximate YTC = [I +(Call price- Purchase Price)/n] /[(Call price+2×Purchase Price)/3]

At actual YTC the value of bond is equal to its purchase price

Vd = I (PVIFAy,n) + Call price (PVIFy,n)

Where,
n= called period

Now,
YTC = LR + [(VLR – Price)/ (VLR-VHR)] ×(HR-LR)

 Duration: It is a measure of the average maturity of the stream of payments

associated with bond. It is the weighted average of the lengths of time until the
remaining payments are made. Duration is a measure of bond price volatility
which captures price risk and reinvestment risk and it is used to indicate how a
bond will react in different interest rates environment. It is also called Macaulay’s
duration because Frederick Macaulay developed it in 1938.

 Measuring duration

D = ∑𝑇𝑡=1 𝑃𝑉(Ct) × t]/P0

Where,
PV(Ct) = Present value of the cash flow to be received at time t,
P0 = Current market price of the bond
T = Remaining life of bond
D = Macaulay duration

Year Cash flow PVIF@ y% PV PV × t

1
2
…
….
n
Duration …….
 Or,
𝑇
D = ∑𝑡=1 [ PV(Ct)/P0 × t]

Year Cash flow PVIF@y% PV(Ct) PV(Ct)/P0 PV(Ct)/P0× t

1
2
…
….
n
Duration …….

Formula
D = (1+y)/y – [(1+y) + T(c-y)] / [c{(1+y)T-1} +y]
Where,
y = Yield to maturity of the bond
c = Coupon rate
T= Years to maturity
Duration of Perpetual or consol bond
D = (1+y)/y

Duration of par bond

D = (1+y)/y [1– 1/(1+y)T]
Duration for bonds portfolio
Dp = W1×D1 + W2×D2 +……….+ Wn×Dn
Where.
W1, W2 = Weight of bond 1, bond 2 and so on.
D1, D2 = Duration of bond 1 bond bond 2 and so on.
n= No. of bonds in the portfolio.
Modified duration= D/(1+y)

Bond duration and price volatility

% change in bond’s price = - 1 × Modified duration × Change in YTM

Notes:
 The duration of zero coupon bond is equal to its years to maturity.
 Holding years to maturity constant , a bond’s duration is higher when coupon rate
is lower
 Holding other factors constant the duration of a coupon bond is higher when the
bond’s yield to maturity is lower.
 Holding the coupon rate is constant, the duration of bond’s increases with its years
to maturity.