FMI

Debt Markets and Valuation of Debt

Securities
Dr. Avinash Ghalke, CFA
What is a debt security?
 Fixed Income Security
 Financial obligation for the Issuer
 Interest Payment
 Principal Repayment
 Security carries covenants
 Positive covenant
 Negative covenant

Dr Avinash Ghalke, CFA © 2022

Debt security terminology
 Par Value
 Maturity Period
 Coupon
 Yield
 Zero Coupon instruments

Dr Avinash Ghalke, CFA © 2022

Modes of repayment of debt security
 Bullet repayment
 Interest payment as per schedule
 Principal repayment at maturity
 Amortizing Securities
 Principal payment gradually over the security life

Dr Avinash Ghalke, CFA © 2022

Yield of a debt security
 What is debt security yield?
 Anticipated return on debt security investment
 Expressed as %
 Current yield
 Annual interest / Security Price * 100
 Yield to maturity (YTM)
 Anticipated return if security held till maturity

Dr Avinash Ghalke, CFA © 2022

Classification of Debt

Government, Public debt

Based on
borrower Corporate debt, Private debt

Short term
Based on tenure
based Long term

Floating
Based on
interest rate Fixed
Based on Open ended
availability for
transaction Close ended
Dr Avinash Ghalke, CFA © 2022 6
Money Markets
 Markets that trade debt securities or instruments with
maturities of less than one year
 Characteristics of money market instruments
 Generally sold in large denominations
 Low default risk
 Original maturity of one year or less

Dr Avinash Ghalke, CFA © 2022 7

Money Market instruments
 Treasury Bills
 Commercial Paper
 Certificate of Deposit
 Repurchase agreements
 Call Money

Dr Avinash Ghalke, CFA © 2022 8

Bond Market
 Bonds are long-term debt obligations issued by
corporations and government units
 Bond markets are traditionally classified into three
types:
 Treasury notes and bonds
 Municipal bonds
 Corporate bonds

Dr Avinash Ghalke, CFA © 2022 9

Bond Characteristics
 Bearer bonds
 Bonds on which coupons are attached. Coupons need to be
presented for coupon payment
 Registered bonds
 Issuer pays the coupon to the registered owner
 Term bonds
 Entire issue matures on a single date
 Serial bonds
 Bonds that mature on a series of dates, with a portion of the
issue paid off on each.
 Mortgage bonds
 Issued to finance specific projects that are pledged as collateral
for the bond issue

Dr Avinash Ghalke, CFA © 2022 10

Bond Characteristics
 Debentures
 Bonds backed solely by the general credit of the issuing firm and
unsecured by specific assets or collateral.
 Subordinated debentures
 Unsecured debentures, junior in their rights to mortgage bonds
and regular debentures
 Convertible bonds
 Bonds holder has the choice to exchange the bond for another
security, usually Equity
 Stock warrants
 Bond holder an opportunity to purchase common stock at a
specified price up to a specified date.
 Callable bonds
 Issuer can buy back the bonds from the holder at specific price,
usually above the par value (at the call price)

Dr Avinash Ghalke, CFA © 2022 11

Bond Ratings and Interest Rate Spreads

Dr Avinash Ghalke, CFA © 2022 12

Credit spreads in India

Source: Reserve Bank of India Bulletin - October 2022

Dr Avinash Ghalke, CFA © 2022 13
Valuation of Assets in General
 The following applies to any financial asset:
V = Current value of the asset
Ct = Expected future cash flow in period (t)
k = Investor’s required rate of return
Note: When analyzing various assets (e.g., bonds,
stocks), the formula below is simply modified to fit the
particular kind of asset being evaluated.

nCt
V =
t = 1 (1 + k )
t

Dr Avinash Ghalke, CFA © 2022

Bond Valuation
Pb = Price of the bond
It = Interest payment in period (t), (Coupon
interest)
Pn = Principal payment at maturity (par value)
Y = Bondholders’ required rate of return or
yield to maturity
Annual Discounting:
n
It Pn
Pb =  +
t =1 (1 + Y ) (1 + Y )
t n

Dr Avinash Ghalke, CFA © 2022

Numerical
 A 3 year bond, with a face value of 100, carries a
coupon of 8%. The coupon is paid annually.
Assuming the bond holders required return is 7.5%,
calculate the price of the bond.
 Current Value - 101.3

Dr Avinash Ghalke, CFA © 2022

 Valuing a Bond as an Annuity
PV(bond) = PV(annuity of coupons) + PV(principal)

PV (bond) = (cpn  PVAF) + (final payment  discount factor)

 1 1  100
= 8  − 3
+
 .075 .075(1 + .075 )  (1 + .075 )3

Dr Avinash Ghalke, CFA © 2022

Numerical
 A 5 year Zero coupon bond, with a face value of 1000, is
trading in the market at 680. Your expectation of return
on bond investment is 7.5%. Should you buy the bond?
 Bond Value – 696.559, YTM = 8.02%

 Fearing inflation, RBI raises the benchmark rates by 75

bps. RBI action comes in before you could purchase the
bond. Assume your seller is still ready to offer the same
at 680. Do you go ahead with the purchase ?
 Bond Value – 672.76 YTM = 8.02%, Now you
expectation will be 8.25% Better avoid the purchase

Dr Avinash Ghalke, CFA © 2022

Numerical
 Suppose a bond has a price today of $800, a coupon
rate of 4%, and six years remaining to maturity. Bond
par value is $1000. If interest is paid annually, what
is this bond's yield to maturity?
 Yield to maturity = 8.38%
 Suppose a bond has a price today of $1,000, a
coupon rate of 5% and six years remaining to
maturity. Bond par value is $1000. If interest is paid
annually, what is this bond's yield to maturity?
 Yield to maturity = 5%

Dr Avinash Ghalke, CFA © 2022

Valuing a Bond

Q: How do the calculation change, given semi-annual

coupons versus annual coupon payments?

Twice as many payments, cut in half, over the same

time period.
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Dr Avinash Ghalke, CFA © 2022

Numerical
 A bond has a face value of $1,000, a coupon rate of
8% and a maturity of two years. The bond makes
semi-annual coupon payments, and the yield to
maturity is 6%. Compute the price for the bond
 $1,037.17

Dr Avinash Ghalke, CFA © 2022

Numerical
 An issuer issues a bond for 5 years at par value of
100 and a yearly coupon of 8.83%. The coupon will
be paid only for first 3 years. Principal payments will
be done in proportion of 25%, 25% and 50% in the
last 3 years. The 5 year Government bond is trading
at 6.7%. The issuers’ bond that are traded in the
market carry a spread of 112 bps over the equivalent
G-bond. Compute the bond price.
 95.5882

Dr Avinash Ghalke, CFA © 2022