Valuing fixed claims - bond valuation

Aravind Sampath
September 12, 2022

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 Outline
Refresh
What next?
Bond - definitions and terminologies
The views from issuer and investor
Yield to Maturity
Bond Pricing
Treasury Bonds
Clean vs Dirty Pricing
The Price-Yield Relationship
Premium and Discount bonds
Current Yield
Zero Coupon Bonds
Warm up exercises
Duration
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Refresh
 So far

• Different sources of capital - debt and equity.

• Time value of money.

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What next?
 TVOM applications - valuing cash flows

• Valuing fixed claims - debt (bond) valuation.

• Valuing residual claims - equity (stock) valuation.

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Bond - definitions and terminologies
 What is a bond?

• Bond - debt security issued by corporations/government bodies to raise funds.

Issuer - entity that needs funds, and would issue the bond in exchange for cash.
• Typically, the issuer announces the issue, and the security gets sold either publicly
(to everyone) or privately. Subscriber/Investor - entity that has cash, and is
willing to exchange cash for the bond issue (fixed claim on future cash flows).

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 Components of a bond

• The issuer requires funds, therefore the fund requested is the principal equivalent of a loan. In bonds, this
is called the face value. This is normally denoted in 100/1000.
• As this is a debt security, the issuer is obligated to pay periodical interest on the principal i.e. on the face
value. This interest is called as a coupon payment. Coupon rate is the interest rate that the issuer pays
on the face value, using which the coupon payment which is the currency value, is derived.
• Issue date is the date of issue of the bond.
• Maturity date is the date of maturity of the principal payment i.e. face value.
• Note - typically, in a bond, the principal is paid in one full bulk payment at the end.
• Issue size - total rupee value being raised, calculated by number of bonds × face value.
• Yield rate is the discounting rate that equates the market price of the bond with the cash flows of the
bond.
• At the time of issue, issue date, maturity date, face value, coupon rate, and the number of times coupon
payment per year are all known.
• The only unknown - yield rate.

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The views from issuer and investor
 The issuer view of bonds

• Bonds are methods for firms to raise capital to run business.

• Therefore, the total market value of bonds add to the debt component of a firm’s
balance sheet.
• Bonds are cash flow claims on a firm.
• And, therefore, value of bonds, is part of firm value.
• Bonds are part Debt value. Therefore, if bond prices fluctuate in the market, it
directly impacts the firm value.
• When a firm’s debt gets revalued, it directly affects firm value.
• As the firm knows exactly how much it owes investors in terms of principal and
interest, the only factor that changes debt value, is therefore the yield rates.

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 The investor view of bonds

• The investor of a bond is investing in a debt security that guarantees a payment

structure i.e. the asset/investment guarantees a set of obligatory promised cash
flows till the maturity of the security.
• Unlike equity, here the actual cash that the investor is going to receive in the
future is certain and known.
• Then, the only question that remains is, how much do I pay today, to receive a set
of known cash flows in the future?
• As every other variable is known, the only unknown for an investor to price the
bond, is the yield rate.

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 Which investment to choose?

• You are an investor who has received the offer from two firms that both issue
bonds with face value of | 100, paying yearly coupon of 10%, maturing in 5 years.
How much would you be willing to pay today, to receive | 10 per year for 5 years,
and | 100 at the end of 5th year?
• Imagine, one of the firm makes jets for airlines. The other firm is a bank.
• Which firm would you be willing to pay lower amongst the two?

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Yield to Maturity
 Yield Rate

• In the earlier example, you are more likely to seek a greater return from the jet
maker than the banker due to the risks associated with the businesses.
• Your chances of getting money back is better with the bank than the jet maker
due to the nature of risks.
• When the cash payments are fixed for both firms, how do you ensure you get the
premium for a riskier business?
• You get the premium by paying less today for getting | 100 in the future from the
Jet, against paying more today for getting | 100 in the future from the bank.
• As the coupons, and the | 100 face value are fixed, only way for you to ensure you
get a greater premium for the risk is via the price you pay for the bond today.
• This is one of the components of the yield rate - discounting rate for bond cash
flows. Greater the yield, lesser you pay to get more in the future, and vice-versa.
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 Components of the Yield Rate

• In the earlier example, we were attempting to measure a firm’s ability to repay

debt - thus, assessing the credit worthiness of a firm.
• Greater the associated credit risk, greater the premium charged by investor, and
greater the yield, thus lower the bond prices - this is similar to the discussion on
TVOM and discounting rates (greater the future risk, lesser the value today).
• The credit risk and associated premium is bond specific i.e. company specific.
• On the other hand, there’s another important component of yield rate - the
interest rates in the market. This is common regardless of the credit risk of the
bond as it captures inflation and the general interest rates.
• Biggest risk in a bond is the interest rate risk, as it single handedly can alter the
yield rate.
• Of course credit risk is also important, but it is very rare for a risky firm to get
bond subscription (but not unheard of).
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Bond Pricing
Bond Pricing
n
X Ci FV
P= +
(1 + y)i (1 + y)n
i=0

Where i is the period, C is the period specific coupon payment, y is the period specific
yield rate, FV is the face value and n is the total number of periods.

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 How can an investor profit via bond?

1. Investor can hold the bond till maturity - in which case, the profit would be
measured via yield to maturity. The investor can either purchase it on issue, or in
secondary market.
2. Investor can buy and sell bond in the secondary market. Bond, like equity is a
claim on the firm’s cash flow, therefore, is traded in the market.

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Treasury Bonds
 Treasury bonds

• When credit risk of issuer is zero, technically the bond is a risk-free security.
• Government bodies’ issued bonds are risk-free, and are called treasury bonds/bills.

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 G-Sec
India

• Government Security (G-Sec) is a tradeable instrument issued by the Central

Government or the State Governments.
• Treasury bills – short term maturity (less than a year).
• T-bills currently have three tenors.
• 91 day, 182 day and 364 day.
• These securities do not pay any periodic interests i.e. coupons, thus are called
zero-coupon securities.

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Clean vs Dirty Pricing
 Quoted price and accrued interest

• Bond prices quoted in financial pages (Bloomberg, Reuters etc.) are not actual
prices investors pay.
• Quoted price does not include accrued interest between coupon dates.
• If purchased between coupon payments, buyer must pay seller the accrued interest
(prorated basis).
• E.g. if 30 days passed since last coupon payment and semi annual payments due
every 182 days, seller entitled to payment of (30/182) times semi annual coupon.
• Sale or Invoice price of bond is the slated (flat) price plus accrued interest.
• Also, called Dirty (Invoice) and Clean (flat) prices.

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The Price-Yield Relationship
 Bond Prices and Yields

• Suppose there’s a 10% annual coupon paying bond, maturing in 30 years, with a
FV of | 1000. Chart a graph with bond prices on Y axis, and yield rates (interest
rates) on X axis. Vary the yield rates in 1% increments from 1% to 20%.

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Bond Prices and Yields

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 Bond Prices and Yields

• Prices and yields (required rates of return) have an inverse relationship.

• The curve is a convex curve - progressive increase in interest rate results in
progressively smaller reductions in bond price.
• The longer the maturity, the more sensitive the bond’s price to changes in market
interest rates.

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Premium and Discount bonds
 Premium Bonds

• Think of a bond that pays a coupon of 10%, but selling at a yield of 8%, maturity
in 10 years with annual coupon payment.
• If its face value is | 1000, what is the bond price?
• Price comes to | 1134.20.
• How do you interpret this price?
• This bond pays an interest of 10% when the market interest is only 8%, thus,
every coupon of this bond is a premium coupon as it sells at a 2% premium to the
market. This bond, is therefore called a premium bond, and is priced over the face
value.

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 Discount Bonds

• Think of a bond that pays a coupon of 10%, but selling at a yield of 12%,
maturity in 10 years with annual coupon payment.
• If its face value is | 1000, what is the bond price?
• Price comes to | 887.
• How do you interpret this price?
• This bond pays an interest of 10% when the market interest is 12%, thus, every
coupon of this bond is a discount coupon as it sells at a 2% discount to the
market. This bond, is therefore called a discount bond, and is priced less than the
face value.

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 Premium or Discount: The rule

• If Coupon rate > YTM, it is a premium bond.

• If Coupon rate < YTM, it is a discount bond.

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Current Yield
 Current Yield

• Suppose, you purchase a bond, own it for a year only and sell it.
• The return that you as an investor get in the one year that you hold the bond, is
called current yield.
Annual Coupon
• Calculated as, Current Yield = Current Market Price . This is a very simple measure -
the currency earning in the bond divided by the price paid to purchase the bond.
• Note - suppose bond pays coupon semi-annually, you have to still estimate the
annual coupon (i.e. multiply it by two), and divide by market price. Essentially,
the idea is to estimate the cash inflow for one year by holding the bond divided by
the current market price.
• However, this is different from YTM - which is the actual return for an investor
holding a bond to maturity. Current yield merely suggests “a” yearly return rather
than the actual return on a bond.
• For premium bonds: Coupon rate > Current yield > YTM.
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• For discount bonds: YTM > Current yield > Coupon rate.
Zero Coupon Bonds
 Pricing a ZCB

• Zero Coupon Bond aka ZCB are bonds that pay no coupons.
• ZCB are also called deep discount bonds.
• Pricing: P = FV
(1+y )n ; where FV is face value, y is YTM and n is number of periods.
• You may wonder, what is in it for me to purchase this bond?
• e.g. compare two bonds: Both maturing in 10 years, both with YTM of 10%.
One pays coupon of 8%, another is a ZCB. How much do you have to pay to buy
both bonds today (assume annual coupons)?

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Warm up exercises
 Small problem set

1. What is the price of a bond that pays an annual coupon of 8%, with a YTM of
10%, maturing in 12 years, with a FV of | 1000?
2. In the earlier example, suppose the bond pays a semi-annual coupon, what is the
price?
3. In problem 2, suppose, you want to sell the bond 7 years after purchase, what
price would you get in the market?

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Duration
 Measuring Interest Rate Risk
Duration

• Duration - when do I get my invested capital back (obviously accounting for

TVOM)?
Duration Formula
n
P
Duration = Wt × t
t=1
CFt
(1+y )t
Where, Wt = Price , and Price is the price of the bond.

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 Measuring Interest Rate Risk
How does Duration help?

∆×(1+y )
• ∆P
P = −D × (1+y )
• D is called Macaulay Duration.
• ∆P
P = −D ∗ × ∆y
• Where D ∗ is called modified duration. D ∗ = D
1+y
• As evident, the impact on changes in yield negatively impacts returns in bond, but
crucially, this relationship is moderated by the duration of the bond.
• Higher the duration, lower the changes in bond prices due to changes in yield.
Most important implication!

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 Duration and Interest Rate Risk

1. The duration of a zero-coupon bond equals its time to maturity.

2. Holding maturity constant, a bond’s duration is higher when the coupon rate is
lower.
3. Holding the coupon rate constant, a bond’s duration generally increases with its
time to maturity.
4. Holding other factors constant, the duration of a coupon bond is higher when the
bond’s yield to maturity is lower.
(1+y )
5. The duration of a level perpetuity is y .

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