Bond Valuation

• A technique for determining the fair value of a particular bond.

–  Bond valuation includes calculating the present value of the bond's
future interest payments, also known as its cash flow,
– and the bond's value upon maturity, also known as its face value or par
value.
– Bond valuation is only one of the factors investors consider in
determining whether to invest in a particular bond. Other important
considerations are:
• the issuing company's creditworthiness,
• whether a bond is investment-grade or junk;
• the bond's price appreciation potential,
• issuing company's growth prospects
•  prevailing market interest rates
• whether they are projected to go up or down in the future.
 Bond-Risk
• Interest rate risk - The interest rates tend to vary over time.
– leading to fluctuation of bond prices.
– A rise in interest rate will depress the market price of the outstanding bonds,
– Whereas a fall in the interest rate will push the market price up

• Interest rates are a function of several factors such as

– the demand for, and supply of money in the economy,
– the inflation rate,
– the stage that the business cycle is in as well as the government's monetary
and fiscal policies.
• Reinvestment Risk
The interest received from the Bond investment may be reinvested in
lower interest rate instrument
 Bond Risk
• Call RiskA bond may have a call option. This is more beneficial to the issuer
of the bond. The issuer will usually call when the interest rates decline. The
investor may not find an alternate investment with similar rate of interest
rate.

Default Risk

The risk that the bond's issuer will be unable to pay the contractual
interest or principal on the bond in a timely manner, or at all. Credit ratings
services such as  CRISIL, CARE and ICRA give credit ratings to bond issues,
which helps to give investors an idea of how likely it is that a payment
default will occur.
 Bond Risk
• Inflation risk:

• When the inflation is higher than expected, the borrower gains at the
expense of the lender and vice versa.
• The inflation risk is higher for long term bonds. This has the greatest
effect on fixed bonds, which have a set interest rate from inception.
– For example, if an investor purchases a 5% fixed bond and then inflation rises
to 10% a year, the bondholder will lose money on the investment because
the purchasing power of the proceeds has been greatly diminished. The
interest rates of floating-rate bonds are adjusted periodically to match
inflation rates, limiting investors' exposure to inflation risk
• Liquidity Risk: In India, the bond market is not large. Hence apart
from the popular G-secs, the corporate debt does not have liquidity
 Rating of Bonds
• Rating are designed for the purpose of grading bonds
according to the investment qualities.
• Elements of rating are
– Yield to maturity
– Risk tolerance of the investor
– Credit risk of the security
• But debt rating is not a recommendation for purchasing/selling
• Debt rating is not a evaluation of the company, but only the
debt instrument
• Debt rating does not create fiduciary relationship between
rating agencies and the investors
 Rating agency
• Rating agencies does not conduct audit
function
• But the rating agencies evaluate various facets
of the workings of the company
• The credit rating is a one time evaluation of
the debt instrument, valid till the life of the
instrument
 Functions of debt rating
• Provide superior information
• Offer low-cost information
• Serve as a risk-return tradeoff
• Impose healthy discipline on corporate
borrowers
• Lend greater to financial and other
representations
• Facilitate the formulation of public policy
 Bond Portfolio Management
• Passive Strategy: Investors know their rate of
return and risk are evenly distributed.
– Buy and hold strategy: After selecting a portfolio,
he holds to maturity. He does not churn the
portfolio.
– Indexing strategy: Here the portfolio mirrors a well
known bond index. They are usually bought at low
prices and churned based on market indiactors.
 Bond Portfolio management
• Active Strategy: The investor buys bonds for their price
appreciation potential and not for income protection
– Bond prices and interest rates are inversely proportional
– If the interest rates are expected to fall, the investor should buy
bonds with longer maturity period
– If the interest rates are expected to rise, Heshould avoid/sell his
bonds
• Interest Rate Forecasting Models: This model is based on
forecasting inflation rate on which the interest rates are
dependent on. These models are simple and easy but not
very useful for short term forecasting.
 Bond Portfolio management
• Horizon Analysis: Is the method of forecasting
the total return on a bond over the given
holding period.
– Select the bond price at maturity period
– Estimate the future value of coupons income
earned over the investment period
– Add the predicated capital gain or loss to the
above to get the total return of the bond.
– Annualise the holding period return.
 Bond Portfolio management
• Exploiting Mis-pricings:
• Bond managers regularly monitor the bond
market to identify the relative mis-pricings.
• They swap bonds- purchase and sale of bond to
improve the rate of return.
– Substitution Swap
– Pure yield pickup swap
– Intermarket spread swap
– Tax swap