Bond Valuation

Anita Raman

• A debenture of Rs.100 face value that carries an interest rate of 14 percent is redeemable after 6 years, at a premium of 2 percent. If you own this debenture, you will enjoy the following benefits:

End of year 1 2 3 4 5 6

Interest income Rs. 14 14 14 14 14 14

Principal repayment Rs.


• Value of a bond =  Present   Annual    value   Redemption   Discount        interest   annuity  +  value factor      payable       factor  .

14 (PVAF16%.102 (DF16%.685) + Rs.93.51. 6 yrs) • = Rs. 6 yrs) + Rs.14 (3.59 + Rs.41) • = Rs.82 • = Rs.41.41 .102 (0. the present value of it to you will be: • Rs.illustration • Investor requires a rate of return of 16 percent from this debenture.

Current Yield (CY) • b. Realized Yield (RY) . Yield to Maturity (YTM) • c.Calculation of returns • The return to the bond investor can be measured in terms of the following: • a.

Thus. • CY = Coupon interest Prevailing market price .Current Yield (CY) • CY is measured by comparing (i) with the prevailing market price.

96. would have a current yield of.100) selling for Rs.33% • Current yield of bonds selling at par would be equal to the coupon interest rate. ignoring interest and capital gains (loss) that would also accrue to him. • Current yield of bonds selling at a premium (discount) would be less (more) than the coupon interest rate. .Current Yield (CY) • An 8% bond (Face value of Rs. • CY = 8. • An important drawback of current yield is that it considers only coupon income as a source of return to the investor.

which is known as YieldTo-Maturity (YTM).Yield-To-Maturity (YTM) • The correct way of computing the return on any asset involves considering the entire sequence of cash flows and their timing and calculating the Internal Rate of Return (IRR). • Calculating the IRR of this stream of cash flows gives the true return on the bond. there is a cash outflow when the bond is bought • cash inflows when the periodic interest coupons are received • and a redemption value on maturity. • For a bond. .

5% redeemable on 1/7/20x5 selling at Rs. 20x3.80. .50 each on July 1.60 on 1/7/20x2. What is the return earned by the investor.100.80. he also receives Rs.12. who buys the bond on 1/7/20x2 and holds it till maturity? • The investor incurs a cash outflow on 1/7/20x2 of Rs.60 and receives interest of Rs. 20x4 and 20x5.• Consider a bond with an annual coupon rate of 12. On maturity (1/7/20x5).

5 20x4 12.60 20x3 12. Year Cash flow 20x2 –80.5 20x5 112.5 .IRR of this stream of cash flows works out to 22% as shown by the following calculation.

e.Approximation to YTM C  (F  P)/n • (F  P)/2 • where ‘C’ is the coupon. (F + P)/2. ‘F’ is the redemption value and ‘P’ is the purchase price.. • [1] Average investment is equal to half the redemption price and purchase price i. .

PRICE-YIELD RELATIONSHIP • For a bond. • If the required yield increases. • This is because. the relationship between the price and the required yield is opposite. . the price of the bond is the present value of cash flows. the present value of the cash flow declines and hence the bond value also declines.

53 64.7 10 100.7 6 8 12 129.100 maturing after 10 years for different required yields as per the table given below: Yield (in %) 4 Price in Rs.• Let us compute the relationship between the price and the required yield for a bond with coupon rate of 10% with par value of Rs.16 71. 148.4 88.4 113.05 14 16 18 79.04 .

Price and yield relationship .

• Discount bonds increase their prices when they approach maturity.Relationship between Bond Price and Time • (If Interest Rates are Constant) • The bond price remains constant when the bond moves towards its maturity. • In both the cases. and if the interest rates remain constant. • If the bond is quoted at a premium. the bonds will reach par value at the time-of-maturity. . the price of the bond decreases when it approaches maturity.

bond with 10% coupon) (expected rate yield at 12%) 5 4 3 2 1 0 92.6 93.2 100 Premium bond (expected yield at 7.8 104 102 100 .8%) 109 107.4 105.5 98.8 95.1 96.illustration Discount bond (5 yr.

. The market price of the bond will be equal to the par value of the bond.145 + 1. if the YTM equals its coupon rate.10 = 100 x 6.000 x 0.COUPON-PRICE YIELD RELATIONSHIP • a.1. • market price of a Rs.386 = Rs.000.000 par value bond bearing a 10% coupon rate with an expected YTM of 10% and a maturity of 10 years is equal to • 100 PVIFA10%.10 + 1.1.000 PVIF10%.50 • Thus. the market value is equal to the face value of the bond. when the YTM is equal to the coupon rate.

then the market value drops below the face value.887.10 = 100 x 5. then the market value of the bond will drop to Rs.65 + 1.• b. If the YTM increases above the coupon rate.10 + 1. • If the YTM of the above bond increases to 12%.887. .322 = Rs. • 100 PVIFA12%.000 PVIF12%.000 x 0.

10 = 100 x 6.000 PVIF8%. if YTM drops below the coupon rate. the market value will be more than the face value of the bond.• c.134. if the YTM falls to 8%.10 + 1. then the market value of the bond will rise to.71 + 1.1. Inversely to the above principle.463 • = Rs. • = 100 PVIFA8%. • In the case of the above bond. .000 x 0.

we can say that the bond’s price will fluctuate in response to the changes in market interest rates in the following ways: .PRINCIPLES OF BOND PRICE MOVEMENTS • As YTM determines a bond’s market price and vice versa.

• As such. the bond’s market price drops and if the YTM falls. . A bond’s price is inversely proportional to its yield-to-maturity. • The present value principle states that the present value of a cash flow varies in inverse proportion to the interest rate used as a discount rate. the bond’s market price rises. if the YTM of the bond rises.i.

887 • If the YTM increases to 14%.1.10 • = 100 x 5. Thus.000 par value bond bearing a coupon rate of 10% and maturing in 10 years is 12%. then the market value of the bond rises to Rs.000 x 0.216 + 1. .270 = Rs.60 • If the YTM of the same bond comes down to 8%. the market value of the bond is Rs.791.1. the market value of the bond will drops to Rs.000 PVIF14%.10 + 1.791.60.• The YTM of a Rs.134. • 100 PVIFA14%.

the longer the term to maturity.• For a given difference between the YTM and the coupon rate of the bonds. the greater will be the change in price with change in the YTM. .

3 100 PVIFA11%.illustration A B Face value Coupon rate YTM Years to maturity Rs.000 10% 10% 3 Rs.1.1.000 PVIF11%.5% 957.3 + 1.000 Rs.1.69 – 4.6 975.000 10% 10% 6 Market value at YTM of 10% Rs.2% .1.56 Change in price –2.000 Market value at YTM of 11% 100 PVIFA 11%.6 + 1.000PVIF11%.

then the value of the bond will fall to Rs.1.. coupon rate and YTM of 10% and maturity period of 6 years.000. .e.• The percentage price change described above increases at a diminishing rate as the bond’s maturity time increases. when the time to maturity of the bond is 1 year. Suppose the YTM changes to 11% at the end of the fifth year.991. i.1. • Let us take the case of bond B with face value of Rs.

83 3 4 5 975.635 .76 0.89 0.1 982.) Change % 1 2 991.2 963.4 969.04 0.64 0.Time to Maturity Bond Price (Rs.87 0.

As yieldto-maturity increases. For a given change in a bond’s yield-to-maturity. The price increase caused by a yield decrease is always more than the decrease caused by a yield increase. However. the percentage price change will be higher for low coupon bonds than for high coupon bonds. The larger the period. the corresponding change in the price is not by the same magnitude. the price of the bond increases. For a difference between the coupon and the YTM.Box 1: Principles of Bond Price Movements The yield-to-maturity is inversely related to the price of the bond. For every change in the interest rate. The increase in the price of a bond associated with the changes in the interest rates will be at a diminishing rate as the term to maturity increases. there will be a corresponding change in the price of the bond. A change in YTM affects the bonds with a higher YTM more than it affects the bonds with a lower YTM . if the interest rate increases or decreases by say 1%). the extent of change in the price of the bond depends on the remaining term to maturity. the price of the bond decreases and as the yield-tomaturity decreases. for the same change in the interest rate in either direction (that is. the greater will be the price change.

More specifically. • Some times to improve the estimate provided by duration. it is the approximate percentage change in value for a 100 basis point change in rates. a measure called convexity is used.Duration • Duration is a measure of the approximate sensitivity of a bond’s value to rate changes. .

5 12.09 375.66 28.5 12.5 117.42 94.5 10.9 24.45 8.87 9.11 .87 18.15 58.59 292.22 7.5 12.11 10.Duration example Date 1/7/2002 1/7/2003 1/7/2004 1/7/2005 1/7/2006 Total No of Years 1 2 3 4 5 Cash flow Present Value Year x P V 12.

11 = 3.375.11) by the present value (Rs. • Duration = 375.• Divide the sum of the products (Rs.11) to get the duration.94.99 .13/94.

So assuming that an investor wants his investment in a bond to yield 6% (YTM) in order to cover a known liability maturing after 10 years. .• Bond immunization is the strategy of matching the bond’s duration (and not the term-to-maturity) with the time horizon of the investor. he would be better off choosing a bond with a duration of 10 years rather than a bond with a term to maturity of 10 years.

. any unexpected change in the market value of the unmatured bond at the end of the investment horizon (price effect) will be exactly equal in magnitude.• When the duration of a bond is set equal to the investment time horizon. but opposite in direction. to any unexpected change in the reinvestment income (reinvestment effect).

the year can be locked in over the investment horizon. Thus. irrespective of changes in market rates.• Immunization will provide a compound rate of return over the period immunized that equals the bond’s YTM. .

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