Unit 6: Bond Valuation

Course Contents:

T.N.Acharya 1
 Concept of Bond

• A bond is a fixed charge bearing long term debt security

issued by the government and non government
organization to collect long term debt capital. Or
• Bond is a long term contract between borrower and lender
under which borrower agrees to make payments of interest
and principal on the specific dates to the holder of bond
instrument.

T.N.Acharya 2
 CHARACTERISTICS OF BOND
Bond = 10%, 5 years, Rs1000
• Par value
• Coupon interest rate
• Maturity
• Call Provision
• Call premium
• Call Price
• Trustee
• Sinking fund provision
• Bond rating
• Convertibility
• Bond Indenture etc. T.N.Acharya 3
 BOND VALUATION / FNANCIAL ASSETS
VALUATION
Bond valuation is a process of determining present value of
a bond based on future benefits associated with the bond
by using an appropriate discount rate. Future benefits
consist of interest and principal amount. Therefore,
Bond Value = Present value of interest + Present value of
principal

0 1 2 3 n

I1 I2 I3 In+ Mn

Value of a Bond = xxx T.N.Acharya 4

 Bond Valuation

I1 I2 In Mn
Intrinsic Value of bond , V0    ...  
1  K d  1
1  K d  2
1  K d  n
1  K d n

Where,
V0 = Intrinsic value of a bond today.
It = Annual rupee interest for time period t.
Kd = Investors’ required rate of return/appropriate discount
rate/going rate of interest/ yield to maturity/ market interest
rate.
Mn = Maturity value/par value/face value/ principal
n = Number of years remaining until the bond matures
T.N.Acharya 5
 Contd…

Why valuation?
• To determine maximum amount to be paid for the
bond

T.N.Acharya 6
 Investment Decision:

Particular Condition Decision

PV of benefit (Vo) > PV of cost (Po) Under priced Better to purchase

PV of benefit (Vo) < PV of cost (Po) Overpriced Better to sale

PV of benefit (Vo) = PV of cost (Po) Equilibrium Wait and see

Po = market price of the bond or PV of cost or Purchase price

T.N.Acharya 7
 TYPES OF BONDS AND THEIR VALUATION
A. Perpetual/Consol/Irredeemable Bonds [ 10%, Rs1000]
Perpetual bonds are issued without specifying fixed time period
which takes a form of perpetual cash flow.
I1 I2 I
V0    ... 
1  K d 1 1  K d 2 1  K d 

I
Above equation can be written as, V0 
Kd

T.N.Acharya 8
 Contd…
B. Zero Coupon Bonds [ 0%, 5 years, Rs1000]
• As its name implies that zero coupon bonds do not pay any
interest. Zero coupon bonds are always sold at discount
and redeemed at par.
Mn
V0 
1  K d n

T.N.Acharya 9
 Contd…
C. Redeemable Bonds with Fixed Coupon Rate [ 10%, 5 years, Rs1000]

 1 
1  1  K n  Mn
V0  I  d 
 Kd  1  K d n
 
 

V0  I x PVIFAKd%, n  Mn x PVIFKd%,n

T.N.Acharya 10
 Contd…
D. Callable Bonds [ 10%, 5 years, Rs1000 bond called in 3 years at
Rs1080]
 1 
1  
V0  I 
1  K d nc

CP
 Kd  1  K d nc
 
 
V0  I x PVIFAKd%, nc  CP x PVIFKd%,nc

Nc = call period
CP = Call price i.e. Par value + call premium

T.N.Acharya 11
 Conditions

Except callable bond due to call premium:

a. If kd = interest rate, Vo = face value i.e Rs1,000
b. If kd > interest rate, Vo < face value .
c. If kd < interest rate, Vo > face value.

T.N.Acharya 12
 RETURN ON BOND
1. Current Yield/Coupon yield
• Current Yield = I/P0

P0 = Market price of a bond i.e. purchase price or investment

T.N.Acharya 13
 2. Yield to Maturity (YTM)
• Yield to maturity refers to the total rate of return earned
from a bond if the bond is purchased at available price and
held up to maturity period.
• In another words yield to maturity is that discount rate at
which present value of future benefit (Vo) and present
value of cost (Po) are equal.

How do we determine YTM?

Step 1: Approximate Yield to Maturity, AYTM
Mn  P0
I
Approximate YTM  n
Mn  2 x P0
T.N.Acharya 3 14
 YIELD TO MATURITY CONTD…
Step 2: Trial and Error

V0  I x PVIFAKd%, n  Mn x PVIFKd%,n

Step 3: Interpolation

 P0
HR  
V0 at LR
YTM  LR  LR
V0 at LR  V0 at HR

T.N.Acharya 15
 CONTD…
Where,
LR = Lower rate.
HR = Higher rate.
V0 at LR = Value of a bond at lower rate
V0 at HR = Value of a bond at higher rate
P0 = Market price of a bond or present value of cost.
Conditions:
• If P0 = Par, YTM = Coupon rate
• If P0 < Par, YTM > Coupon rate
• If P0 > Par, YTM < Coupon rate
Note:
Total rate of return, YTM = Current yield + Capital gain yield

T.N.Acharya 16
 3. Yield to Call (YTC)
• Yield to call refers to the total rate of return earned from a bond if
the bond is purchased at available price and held up to call period.
• In another words yield to call is that discount rate at which present
value of future benefit (Vo) and present value of cost (Po) are equal.
How do we determine YTC?
Step 1: Approximate Yield to Call, AYTC

CP  P0
I
Approximate YTC  nc
CP  2 x P0
3

T.N.Acharya 17
 Contd…
Step 2: Trial and Error

V0  I x PVIFAKd%, nc  Cp x PVIFKd%,nc

Step 3: Interpolation

 P0
HR  
V0 at LR
YTC  LR  LR
V0 at LR  V0 at HR

T.N.Acharya 18
 Bond Prices Over Time

Value in Rs

Int. rate> Kd
1125

Premium

Int. rate = Kd
1000

Dis c ount

893
Int. rate < Kd

5
Maturity period

T.N.Acharya 19
 Contd…
To sum up, above discussions illustrate the following key points:
• There is inverse relationship between value of a bond and market
interest rate.
• Whenever the going rate of interest is equal to the coupon rate, a
bond will sell at its par value. Such a bond is called an equilibrium
bond.
• Market interest rate does not remain same over time but the bond’s
coupon rate remains same after the bond has been issued.
• Whenever the going rate of interest is greater than the coupon rate, a
bond’s price will fall below its par value. Such a bond is called a
discount bond.
• Whenever the going rate of interest is less than the coupon rate, a
bond’s price will rise below its par value. Such a bond is called a
premium bond.
• The market value of a bond always will approach its par value as its
maturity dates approaches. T.N.Acharya 20
 Bonds with Semiannual Coupons
Calculation of value of a bond and return on bond for semiannual coupon
bond is as like bond with annual payment. The only differences between
them are;

• Divide the annual interest payment by 2 to i.e. I/2.

• Divide the required rate of return by 2 i.e. Kd/2.
• Multiply the years to maturity by 2 i.e. N x 2.

T.N.Acharya 21
 Contd…

I
V0  x PVIFA kd%  M x PVIFkd%
2 2
,2n
2
,2n

 1 
1  2n 
 1  K d  
I   2   Mn
V0     n
2  Kd   Kd 
 2  1  
 2 
 
 

T.N.Acharya 22