Corporate Finance

Bond Valuation
Dr Avinash Ghalke, CFA
What is a Bond?
 Fixed Income Security
 Financial obligation for the Issuer
 Interest Payment
 Principal Repayment
 Bond carries covenants
 Positive covenant
 Negative covenant
Bond Terminology
 Par Value
 Maturity Period
 Coupon
 Yield
Modes of repayment of Bond
 Bullet Bond
 Interest payment as per schedule
 Principal repayment at maturity
 Amortizing Securities
 Principal payment gradually over the bond life
 Callable bonds
 American
 Bond can be redeemed at any time after first call date
 European
 Bond can be redeemed at specified call date
 Putable Bond
 Bondholder has right to sell back the bond
Yield of a Bond
 What is bond yield?
 Anticipated return on bond investment
 Expressed as %
 Current yield
 Annual interest / Bond Price * 100
 Yield to maturity (YTM)
 Anticipated return if bond held till maturity
 Yield to Call (YTC)
 Anticipated return if bond held till next call date
 Yield to Worst
 Min (YTM, YTC)
Types of Bond
 Issuer Type
 Government Bond
 Corporate Bond
 Features
 Straight Bond
 Zero Coupon Bonds
 Deferred Coupon Bonds
 Floating Rate Securities
 Cap and Floor
 Inverse Floater Bonds
 Payment in Kind (PIK)
 Index Linked Bonds
 Inflation indexed
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.

n Ct
V  t
t  1 (1  k )
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
 n
t 1 (1  Y ) (1  Y )
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
 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
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?
 Yes 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
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%
Numerical
 You own bonds with a $1,000 par value and a coupon of
5%. The bond matures in three years. The bond is callable
in two years at 105% of par. Compute the yield to call
(YTC). Current price for the bond is $980.
 Yield to call 8.527%.
Yield Price Relationship
Price 800 1000 1200
Yield 8.38% 5%

 Inverse Relationship
Bond – Par, Premium or Discount?
 YTM = Coupon
 Fair Value = Par Value
 Bond at Par
 YTM > Coupon
 Fair Value < Par Value
 Bond at Discount
 YTM < Coupon
 Bond at Premium
 Fair Value > Par Value
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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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

 A bond has a face value of $8,00, a coupon rate of 9% and

a maturity of two years. The bond makes monthly coupon
payments, and the yield to maturity is 5%. Compute the
price for the bond
 $ 860.78
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
Risks in bond investing
 Credit Risk
 Interest Rate Risk
 Reinvestment Risk
 Inflation Risk
 Liquidity Risk
Numericals
 A bond has an 8% coupon rate (semi-annual interest), a
maturity value of $1,000, matures in 5 years, and a current
price of $1,200. What is the bond’s yield-to-maturity?
 [YTM = 3.594%]
 A bond has a current price of $800, a maturity value of
$1,000, and matures in 5 years. If interest is paid semi-
annually and the bond is priced to yield 8%, what is the
bond's annual coupon rate?
 [Coupon = 3.068%]