Valuation of Bonds

Rakesh Arrawatia
What is a bond?

A bond is a certificate showing that a borrower owes

a specified sum.
A debt instrument in which a borrower agrees to
make payments of principal and interest, on specific
dates, to the holders of the bond.
Key Features of a Bond
Par value – face amount of the bond, which
is paid at maturity (assume Rs1,000).
Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply by
par to get dollar payment of interest.
Maturity date – years until the bond must be
repaid.
Issue date – when the bond was issued.
Yield to maturity - rate of return earned on
a bond held until maturity (also called the
“promised yield”).
Types of bonds
Treasury Bonds
Corporate Bonds
Municipal Bonds
Foreign Bonds
A samurai bond is a corporate bond issued in Japan by a non-Japanese company. In
May 2016, French bank Societe Generale SA sold $1.1 billion in samurai bonds,
including senior and subordinated bonds maturing in seven years. The sale followed
Bank of America Corporation’s $1.08 billion offering in a euro-yen format earlier
that month.
Masala Bonds are rupee-denominated borrowings issued by Indian entities in
overseas markets. 
Pure Discount Bonds or Zero Coupon Bonds
Coupon Bonds
Perpetuities
Recent Issue of Bonds: Sovereign Gold Bonds, SDG Bonds
 The Importance of Bond Markets
Fundamental reason for the slowdown in the economy (last few years) ?
India’s companies have been bogged down by high debt
the balance sheet of India’s public sector banks (historically financed economic growth)
Slowdown in credit cycle
New sources: ECBs, commercial papers and corporate bond
Alan Greenspan: Bond market ‘The Spare tyre ’ of credit market.
Non-bank credit to debt: 20% in 2015 to 53% in 2016, 2018:57%
Rs 4.33 trillion in 2014 to around Rs 6.7 trillion in 2016 (36% jump over last
year)
2017: total: 8.6 trillion, debt: 7 trillion
2018: total: 6 trillion, debt: 5.1 trillion (4.8 trillion and 0.28 trillion by public
issue)
Pvt placements preferred. 95 per cent of borrowers have taken the private
placement route to issue bonds in the last two years
SEBI intervention: electronic book mechanism for large private placements
RH Patil Committee in 2005, the Percy Mistry Committee in 2007, Committee
on Financial Sector Reforms in 2008, and most recently the HR Khan
Simultaneous buy and sell by RBI. Why??
Open market operation (OMO)?
The Reserve Bank of India (RBI) said it bought ₹10,000 crore of long-
term bonds and simultaneously sold ₹6,825 crore of short-term papers
under a special open market operation (OMO).
“It looks like the RBI is working towards lowering the long-term yields
further because they had a cut-off of 6.54% for the long-term bond. The 10-
year bond yield stood at 6.6% on Friday. I think there will be a series of such
operations till the time RBI is satisfied with the yield," said Madan Sabnavis,
chief economist at CARE Ratings.
“..is expected to dampen term premium to stimulate private sector borrowing,
as well as aid the government’s borrowing programme by making it cheaper.”
https://www.business-standard.com/article/economy-policy/rbi-conducts-first-e
ver-omo-in-state-bonds-buys-rs-10-000-cr-under-scheme-120102201275_1.ht
ml
https://washingtonnewsday.com/news/bond-yields-in-india-are-up-6-16-as-rbi-r
esumes-its-federal-reserve-style-operation-twist/
https://www.livemint.com/industry/banking/rbi-buys-10-000-crore-bonds-sells-
6-825-crore-short-term-securities-11577125488763.html
Other types (features) of bonds
Convertible bond – may be exchanged for common
stock of the firm, at the holder’s option.
Income bond – pays interest only when interest is
earned by the firm.
Indexed bond – interest rate paid is based upon the
rate of inflation or some other index.
Callable bonds
Govt Bonds in India
T-bills and Government Bonds
Central Govt bonds and state govt bonds
Fixed Rate Bonds – These are bonds on which the coupon
rate is fixed for the entire life of the bond.  Most
Government bonds are issued as fixed rate bonds.
Floating Rate Bonds – Floating Rate Bonds are securities
which do not have a fixed coupon rate. The coupon is re-
set at pre-announced intervals (say, every six months or
one year).
Zero Coupon Bonds – Zero coupon bonds are bonds with
no coupon payments.
What is the value of a 10-year, 10% annual coupon
bond, if kd = 8% and Face Value Rs1000?

0 1 2 n
k ...
VB = ? 100 100 100 + 1,000
Pure Discount Bond and Perpetual
Bonds
A company issues a Rs 1000 pure discount bond with
a maturity period of 5 years and yield to maturity of
14%. What is the present value of the bond?

A 10%, Rs 1000 bond will pay annual interest till

perpetuity. What would be the value of the bond if it’s
market yield is 15%?
What is the YTM on a 10-year, 9% annual
coupon, Rs. 1,000 par value bond, selling for Rs.
887?

INT INT M
VB   ...  
(1  k d )1
(1  k d ) N
(1  k d ) N
90 90 1,000
Rs. 887   ...  
(1  k d )1
(1  k d )10
(1  k d )10
Current yield

Find the current yield and the capital gains yield for a 10-
year, 9% annual coupon bond that sells for Rs. 887, and has
a face value of Rs. 1,000.

Current yield = $90 / $887

= 0.1015 = 10.15%
Capital Gains yield = (Rs 893.79 – Rs 887)/Rs 887
= .765%
Total yield (yield to maturity) = 10.91%
 Semiannual bonds

What is the value of a 10-year, 8% semiannual coupon

bond, if kd = 10%?
Premium bond, par value or discount bond?
An example:
Increasing inflation and kd

Suppose inflation rises by 3%, causing kd = 13%.

Suppose inflation falls by 3%, causing kd = 7%.

Bond values over time

At maturity, the value of any bond must equal its

par value.
If k remains constant:
d
The value of a premium bond would decrease over
time, until it reached Rs.1,000.
The value of a discount bond would increase over time,
until it reached Rs.1,000.
A value of a par bond stays at Rs1,000.
 The price path of a bond
What would happen to the value of a 30 year, 10% coupon rate bond over the
period of time if its required rate of return remained at 7% until maturity?
What would happen to the value of a 30 year 10% coupon rate bond over the
period of time if its required rate of return remained at 13% until maturity?
What would happen to the value of a 30 year 10% coupon rate bond over the
period of time if its required rate of return remained at 10% until maturity?

VB

1,372 kd = 7%.
1,211
kd = 10%.
1,000
837
775 kd = 13%.
Years
to Maturity
30 25 20 15 10 5 0
Yield to Call

A 10-year, 10% semiannual coupon bond selling

for Rs. 1,135.90 can be called in 4 years for Rs.
1,050, what is its yield to call (YTC)?
The bond’s yield to maturity can be determined to be
8%. Solving for the YTC is identical to solving for
YTM, except the time to call is used for N and the
call premium is FV.
 What is interest rate (or price) risk?

Interest rate risk is the concern that rising k will

d
cause the value of a bond to fall.

Consider two bonds with Face Value of Rs 1000 and coupon

rate of 10%. One has a maturity of 10 years and other has a
maturity of 2 years. Calculate the value of the bond at discount
rates: i) 5% ii) 8% iii) 12% and iv) 15%

The 10-year bond is more sensitive to interest rate

changes, and hence has more interest rate risk.
What is reinvestment rate risk?

Reinvestment rate risk is the concern that kd will

fall, and future CFs will have to be reinvested at
lower rates, hence reducing income.
Reinvestment rate risk example

You may invest in either a 10-year bond or a series

of ten 1-year bonds. Both 10-year and 1-year bonds
currently yield 10%.
If you choose the 1-year bond strategy:
After Year 1, you receive Rs. 50,000 in income
and have Rs. 500,000 to reinvest. But, if 1-year
rates fall to 3%, your annual income would fall to
Rs. 15,000.
If you choose the 10-year bond strategy:
You can lock in a 10% interest rate, and Rs.
50,000 annual income.
 Conclusions about interest rate and
reinvestment rate risk
Short-term AND/OR Long-term AND/OR
High coupon bonds Low coupon bonds
Interest
Low High
rate risk
Reinvestment
High Low
rate risk

CONCLUSION: Nothing is riskless!

Cost of debt capital
The discount rate (ki ) is the opportunity cost of
capital, and is the rate that could be earned on
alternative investments of equal risk.
ki = k* + IP + MRP + DRP + LP
Ki = required return on a debt security
K* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
Cost of Debt capital for various bond types
Short-Term (S-T) Treasury: Only IP for S-T
inflation

Long-Term (L-T) Treasury: IP, MRP

Short-Term corporate: IP, DRP, LP

Long-Term corporate: IP, DRP, MRP, LP

Problems
The real risk-free rate of interest is 4%. Inflation is
expected to be 2% this year and 4% during the next 2
years. Assume that the maturity risk premium is zero.
What is the yield on 2-year Treasury securities? What
is the yield on 3-year Treasury securities?
A Treasury bond that matures in 10 years has a yield
of 6%. A 10-year corporate bond has a yield of 9%.
Assume that the liquidity premium on the corporate
bond is 0.5%. What is the default risk premium on
the corporate bond?
Evaluating default risk:
Bond ratings
Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

Bond ratings are designed to reflect the

probability of a bond issue going into default.