9.

Bond Valuation

Bond Meaning

Bonds refer to the debt instruments issued by governments or corporations to acquire

investors’ funds for a certain period. These are fixed-income securities that allow the
bondholders to earn periodic interest as coupon payments. Thus, the bond issuers are the
borrowers, while the bondholders are the lenders or investors.  

Yield to call
An yield to call is the annualized rate of return that bondholders will realize if the bond is
called at the sated date before the maturity.
Coupon Interest
The coupon rate is stated as an annual percentage rate based on the bond’s par, or face value
Yield to maturity
An yield to call is the annualized rate of return that bondholders will realize if the bond is held
until it’s maturity.
Bond’s Duration
The duration of a bond does not represent the duration for which an investor holds a bond.
Instead, it refers to the relationship between the price of a bond and interest rates of the
bond after considering its different characteristics such as yield, coupon rate, maturity, etc.
Usually, the duration of a bond shows the number of years in which an investor can recover
the present value of the cash flows of a bond. It can also represent a percentage that is a
measure of how sensitive the value of the bond is to changes in interest rates.

Features of a Bond
All bonds share certain characteristics. They include the following:

 Face value: The worth of the bond upon maturity. It is also the base amount on which
interest is calculated.
 Coupon rate: The interest rate on the bond paid by the issuers of the bond to the
investors. Coupon payments are made annually or semi-annually.
 Coupon dates: The dates on which the investors receive the coupon payment.
 Maturity date: The date on which the bond issuer pays back the face value of the bond to
the investor. It indicates repayment of the loan taken.
 Issue price: The price at which the bond is initially sold to the investor by the issuer. In other
words, it is the price at which investors buy them. When the interest rate rises, the issue
price will go down. Similarly, the issue price will go up when the bond rates (interest rates)
fall.
 Bond duration: Duration measures the sensitivity of a bond‘s price to the interest rate
changes. It is not an indicator of the length of time until maturity.
 Credit quality: Credit quality is one of the principal determinants of a coupon rate. If the
issuer of the bond has a low credit rating, the default risk is greater, and as a result, these
bonds pay more interest. The credit rating agencies frequently keep updating the ratings of a
bond. Usually, bonds issued by the governments are very stable and are considered to be the
highest quality. These are called investment-grade bonds. On the other hand, bonds that are
 not investment grade, but are not in default, are known as high yield or junk bonds. These
junk bonds have a high risk of default in the future. Also, to compensate for the risk,
investors demand higher coupon payments. 
 Time to maturity: Certain bonds have long maturity dates. Hence, they tend to pay higher
interest rates. A high-interest rate is paid because the bondholder is exposed to inflation risk
and interest rate risk for an extended period. As interest rates change the value of bond and
bond portfolio will either rise or fall.

Some important formulas

1. Required rate of return on bond

r j=r ¿ + IP + RP
Where r j=required rate of return
r ¿ =real rate of return
IP = inflation premium
RP= risk premium
2. Rate of return on bond
Coupon payment +( Ending price−Beginning price)
Rate of return=
Beginning Price

3. Value of Bond
1) Perpetual Bond
I
V 0=
Y
Where V 0= Value of bond
I = coupon amount
Y= required rate of return
2) Zero coupon bond
M
V 0=
(1+ y)2
Where V 0=value of bond
I = coupon amount
Y= required rate of return
M= maturity value of bond
n= no of period to maturity
3) Value of redeemable and coupon payment bond
V 0=Ix (PVIF A y ,n )+ M x (PVI F y ,n)
4) Value of callable bond
BP ¿ I × ( PVIF A y ,n ) + Call Price ×( PVI F y ,n )
5) Value of semiannual bond
I
V 0= ×( PVIF A y/ 2,2 n)+ M ×(PVI F y/ 2,2 n)
2
Coupon interest
6) Current yield= Current Market Price of Bond
7) Capital Gain Yield= YTM-Current yield
Or
 (Ending price−Beginning price)
Capital Gain=
Beginning Price

M − price
I+
n
8) Approximate YTM= ¿ M +2 Price
3
1+ y ( 1+ y )+ n(c− y)
9) Duration= y –
C¿¿

Maculay' s Duration∈a year

10) Modification duration=
(1+Yield¿ maturity)

11) ∆ P=−1× D M ×∆I

Descriptive Answer Questions

2078Q. No 14
Consider a bond selling at its par value of Rs 1000 with three
years to maturity and a 7 % rate with annual interest
payments.
a. What is the yield to maturity on this bond ?
b. Calculate the bond’s duration.
c. Calculate the bond’s modified duration.
d. If market interest rate increases to 7.5 % , what is the %
price change on this bond?
2077Q. No 13
New national corporation’s (NNC) bond has 9 years until
maturity a coupon rate of 9 % and sells for Rs 950.
a. What is the current yield on the bond?
b. What is the yield to maturity?
c. If NCC’s bond YTM declines to 7 % ,1 year from now, at
what price it will be selling?