Valuation of Bonds

Bonds

• Government or companies borrow money by issuing bond.

• A bond is long term debt where you receive a fixed set of cash
payoffs till maturity at certain rate of interest plus the face
value of the bond.
• Face value of the bond is knows as “Principal”.
• Hence when bond matures an investor receives interest and
principal amount.
• Fixed income securities: where the cash flows are according to
a predetermined amount of interest, paid on a fixed schedule.
Popularly known as Debt instrument.
 Bonds
• Coupon: The interest rate stated on a bond when it is
issued. The coupon is typically paid semiannually.
• Face value: The principal amount of a bond that is
repaid at the end of the term. Also known as par
value.
• Maturity: Specified date on which the principal
amount of a bond is paid.
• Issued by government and corporate, for eg.
Government securities such as treasury bills,
corporate bonds.
 Issuers of corporate bonds

• Bonds issued by Local Bodies

• Bonds issued by Public Sector Units
• Bonds issued by Financial Institutions
• Bonds issued by Banks
• Bonds issued by Corporate
 Key components of bonds

• Issue Price is the price at which the Corporate Bonds are

issued to the investors.
– Issue price is mostly same as Face Value in case of coupon bearing
bond.

• Face Value (FV) is also known as the par value or principal

value.
– Coupon (interest) is calculated on the face value of bond.
– FV is the price of the bond, which is agreed by the issuer to pay to
the investor, excluding the interest amount, on the maturity date.
– Sometime issuer can pay premium above the face value at the time
of maturity.
 Key components of bonds

• Coupon / Interest is the cash flow that are offered by

a particular security at fixed intervals / predefined
dates. The coupon expressed as a percentage of the
face value of the security gives the coupon rate.

• Coupon Frequency means how regularly an issuer

pays the coupon to holder. Bonds pay interest
monthly, quarterly, semi-annually or annually.
 Key components of bonds
• Maturity date is a date in the future on which the
investor's principal will be repaid. From that date, the
security ceases to exist.

• Maturity / Redemption Value is the amount paid by

issuer other than coupon payment is called redemption
value. If the redemption proceeds are more than the face
value of the bond/debentures, the debentures are
redeemed at a premium. If one gets less than the face
value, then they are redeemed at a discount and if one
gets the same as their face value, then they are
redeemed at par.
 Example

• Security with FV of Rs.1000/- issued on April 01, 2011,

for a period of 10 years at Rs. 1000/- Coupon of 12%
p.a. is paid every 6 month on April & October 01, 2011.
• Issue price = ?
• Face value = ?
• Coupon rate=?
• Coupon frequency = ?
• Maturity date = ?
• Redemption value = ?
 Bonds based on maturity period
• Short Term Maturity: - Security with maturity period
less than one year. Commonly referred to as bills.
• Medium Term: - Security with maturity period
between 1year and 5 year. Referred to as notes.
• Long Term Maturity: -Such securities have maturity
period more than 5 years. Referred to as bonds.
• Perpetual: - Security with no maturity. Currently, in
India Banks issue perpetual bond.
 Based on Coupon

• Zero-coupon Bonds:- no coupons are paid.

The bond is issued at a discount to its face
value, at which it will be redeemed. There are
no intermittent payments of interest
• Fixed Rate Bonds/Plain Vanilla bonds:-have a
coupon that remains constant throughout the
life of the bond.
• Floating Rate Bonds: - Coupon rates are reset
periodically based on benchmark rate.
 Credit quality
• Credit quality is an indicator of the ability of
the issuer to pay back his obligation. The
credit quality of fixed income securities is
usually assessed by independent rating agency
such as CRISIL, ICRA etc.
 Bonds
• Bond is normally an interest-only loan, meaning
that the borrower will pay the interest every
period, but none of the principal will be repaid
until the end of the loan.
 Bonds
• Suppose ABC bank wants to borrow $1000 for 30 years.
The interest rate on similar debt issued by similar
corporation is 12%.
• ABC corporation need to pay (1000*0.12)= $120
• Interest every year for 30years and at the end of 30 years
repay $1000 as principal amount.
• Here $120 is coupon payments. The amount paid at the
end is called bond’s face value or par value.
• Coupon rate is the ratio of coupon payment to the par
value of the bond.
• Here coupon is constant and paid every year, this type of
bond is knows as level coupon bond.
 Bonds
• Maturity: Number of years until par value is paid. In
this case its 30 years.
• Once bond is issued, the no of years to maturity
declines as time goes by.
• Interest rates in the market place keeps changing,
therefore though the cash flow from a bond remains
constant, the present value of bond’s remaining cash
flows declines as interest rate increases.
• Hence as interest rate falls, the bond is worth more.
Bond valuation model
Fixed rate bonds
Fixed rate bonds
 Fixed rate bonds

Discount rate ( r ) reflects the riskiness of the bond.

 Bonds
• Value of the bond is determined using following factors:
 Number of time periods remaining until maturity.
 The face value
 The coupon rate
 Market interest rate for bonds with similar features.
– The interest rate required in the market on a bond is
knows as “Yield to maturity” or simple “Yield”.
– YTM is basically the discount rate at which the present value
of the bond payments equals the bond price.

• The present value of the cash flows from bond can be

estimated using these information that estimates the bond’s
current market value.
• Suppose XYZ corporation is willing to issue $1000 par value
bond with 10 year to maturity with an annual coupon
payment of $80 . Similar bonds have yield to maturity of 8%.

• Bond’s value=Present value of coupon payments + present

value of face value
– If the coupon rate and YTM is same, bond is selling at par
value
– If coupon rate < YTM, the bond is selling at discount
– If coupon rate > YTM, the bond is selling at premium
 Corporate bonds

Source: www.nseindia.com
 Corporate Bond market in India

Corporate bonds are issue in two ways:

• Public issue: Corporations issue bonds to the market
as a whole. Institutions as well as retail investors can
participate in this issue. The cost of borrowing is little
high in case of public issue.
• Private placement: In private placement corporate,
generally park the bond issuance with few
institutions. In India, more than 90% of the corporate
bonds are issued through private placement. It is an
easiest and cheapest way of borrowing corporate
bonds.
 Features of bond

• To protect bond holder’s interest it is common for the

bond contract to contain Covenants (agreements that
describe actions the issuer must perform or is
prohibited from performing).

• The bond contract gives bondholders the right to take

legal action if the issuer fails to make the promised
payments or fails to satisfy other terms specified in
the contract.
 Features of bond
• In the event that the company is liquidated,
assets are distributed following a priority of
claims, or seniority ranking. This priority of
claims can affect the amount that an investor
receives upon liquidation.
 Features of bond
• Because debt represents a contractual liability
of the company, debt holders have a higher
claim on a company’s assets than equity
holders.
• Not all debt holders have the same priority of
claim: borrowers often issue debt securities
that differ with respect to seniority ranking.
• Bonds may be issued in the form of secured or
unsecured debt securities.
 Secured debt securities
• Secured borrowings: When a borrower issues debt
securities by pledging specific assets as collateral to
the bondholders.
• Collateral is generally a tangible asset, such as
property, plant, or equipment.
• In the event of default, the bondholders are legally
entitled to take possession of the pledged assets.
• The collateral reduces the risk that bondholders will
lose money in the event of default because the
pledged assets can be sold to recover some or all of
the bondholders’ claim (missed coupon payments
and par value).
 Unsecured debt securities
• Unsecured debt securities are not backed by
collateral.
• Bondholders will typically demand a higher coupon
rate on unsecured debt securities than on secured
debt securities.
• A bond contract may also specify that an unsecured
bond has a lower priority in the event of default than
other unsecured bonds.
• A lower priority unsecured bond is called
subordinated debt. Subordinated debt holders
receive payment only after higher-priority debt
claims are paid in full.
 Market

• At issuance, investors buy bonds directly from an

issuer in the primary market.

• The bondholders may later sell their bonds to

other investors in the secondary market.

• When investors buy bonds in the secondary

market, they are entitled to receive the bonds’
remaining promised payments, including coupon
payments until maturity and principal at maturity.
 Zero coupon bonds
• Bonds that makes no periodic interest payments.
• Investors buy zero coupon bonds at a deep discount
from their face value, which is the amount a bond will
be worth when it "matures“.
• There will be only one cash flow which can be
discounted based on the appropriate discounting
rate.
• Bond value= Maturity value / (1+r)^n
• Where n= number of periods
• R = yield to maturity or discount rate.
 Zero coupon bonds
• The difference between the issue price and the par
value received at maturity represents the investment
return earned by the bondholder over the life of the
zero-coupon bond, and this return is received at
maturity.
 Zero coupon bonds

• XYZ company plans to issue a zero coupon bond that has a

face value of $1000 and matures in 3 years. The current
interest rate is 10%. What will be value that you as an investor
would be willing to pay for the bond.
 Zero coupon bonds
• Par value = $1000
• r = 10%
• N = 3 years
• PV of bond = maturity value/(1+r)^n =
= 1000/(1+0.10)^3
= $751.31

• Hence when bond matures the investor will receive $1000

if currently he/she purchase the bond at the $751.31.

• Interest is earned via gradual appreciation of security.

 Zero coupon bonds

• These bonds are common and traded in the stock

exchanges.
• However zero coupon bonds are riskier than regular
coupon paying bonds because if issuer defaults on
zero coupon bonds, the investor may not receive
anything, unlike coupon paying (receives regular
interest) bonds.
 Zero coupon bonds

• These are long term investment bonds usually

expiring in 10 or more years.
• Investors with long term perspective tend to
invest in these bonds (meeting educational
expenses), as deep discounts enable investors
to grow small amount of money into a sizable
sum over several years.
 Fixed rate bonds

• Long term investment with bi-annual or

quarterly interest payments. Also known
as Plain Vanilla bond.
• Characterized by its fixed coupon or
interest rate
• Long term on the maturity date of the
bond.
 Fixed rate bonds
• Generally pay out interest every six months until the
maturity date of the bond, when the principal amount is
reimbursed and the bond is liquidated. 
• Eg. 8% Savings (Taxable) Bonds, 2003:issued by the RBI,
carry sovereign guarantee. There is no investment ceiling
and the lock-in period is six years. 
the interest rate offered is 8% per annum, which is taxable. 
• Post Office Time Deposit Account (POTD): Available for
tenures of 1, 2, 3 and 5 years, the 5-year deposit currently
offers an interest rate of 7.8 per cent per.
 Fixed rate bonds
• On 16 August 2011, the Walt Disney Corporation, a
US company, raised $1.85 billion in capital with three
debt issues. It issued $750 million in 5-year fixed-rate
bonds offering a coupon rate of 1.35%, $750 million
in 10-year fixed-rate bonds offering a coupon rate of
2.75%, and $350 million in 30-year fixed-rate bonds
offering a coupon rate of 4.375%. Coupon payments
are due semiannually (twice per year) on 16 February
and 16 August. The following table summarizes
features of these issues. On the maturity date, each
bondholder will receive $1,000 per bond plus the
final semiannual coupon payment.
 Fixed rate bonds
5 Year bond 10-year, 30-year

Total par value

(Millions)
Par value of one
bond
Annual coupon rate

Coupon payment
per bond

Maturity date
 Yield to Maturity (YTM)
• Discounted cash flow (DCF) approach to estimate
the discount rate implied by a bond’s market price.
• The discount rate that equates the present value of
a bond’s promised cash flows to its market price is
the bond’s yield to maturity, or yield.
• An investor can compare this yield to maturity with
the required rate of return on the bond given its
riskiness to decide whether to purchase it.
 Yield to Maturity (YTM)

When a bond’s payments are known, as in the case of

fixed-rate bonds and zero-coupon bonds, the yield to
maturity can be inferred by using the current market
price.
Yield to Maturity (YTM)
 Yield to Maturity (YTM)
• bond prices and bond yields to maturity are
inversely related
• as bond prices fall, their yields to maturity
increase, and
• as bond prices rise, their yields to maturity
decrease.
 Yield Curve
• When Investors determine the appropriate discount
rate (yield to maturity or required rate of return) for a
particular bond, they often begin by looking at the
yields to maturity offered by government bonds.
• The term structure of interest rates, often referred to
simply as the term structure, shows how interest rates
on government bonds vary with maturity.
• The term structure is often presented in graphical form,
referred to as the yield curve.
 Yield Curve
• The yield curve graphs the yield to maturity of
government bonds (y-axis) against the maturity of
these bonds (x-axis).
• It is important when developing a yield curve to
ensure that bonds have identical features other than
their maturity, such as identical coupon rates.
• The bonds considered should only differ in maturity.
Yield Curve
 Yield Curve
• The yield curve is upward sloping, indicating that
longer-maturity bonds offer higher yields to
maturity than shorter-maturity bonds (Exhibit 2).
• Yield to maturity on a 30-year Treasury bond is
3.50%, but the yield to maturity on a 1-year
Treasury bill is only 0.11%.
• The yield curve may be flat, indicating that YTM
of US Treasury bonds is the same no matter what
the maturity date is.
 Yield Curve

• Yield curve with downward sloping (inverted), indicates that

interest rates are expected to decline in the future.

• The term structure for government bonds, such as Treasury

bonds, provides investors with a base yield to maturity,
which serves as a reference to compare yields to maturity
offered by riskier bonds.

• Relative to Treasury bonds, riskier bonds should offer higher

yields to maturity to compensate investors for the higher
credit or default risk.
 Relationship between the coupon rate and the
discount rate (required rate of return)

• if the bond’s coupon rate and the required rate of return are
the same, the bond’s value is its par value. Thus, the bond
should trade at par value.

• if the bond’s coupon rate is lower than the required rate of

return, the bond’s value is less than its par value. Thus, the
bond should trade at a discount (trade at less than par value)

• if the bond’s coupon rate is higher than the required rate of

return, the bond’s value is greater than its par value. Thus,
the bond should trade at a premium (trade at more than par
value).
 Floating rate bonds
• A floating rate note is a bond with a coupon that is
indexed to a benchmark interest rate.
• Also referred to as variable-rate bonds or floaters.
• Possible benchmark rates include US Treasury rates,
LIBOR, prime rate, municipal and mortgage interest
rate indexes.
• The London Interbank Offered Rate (Libor) is a widely
used reference rate.
• Refers to an instrument whose coupon is based on a
short term rate (3-month T-bill, 6- month LIBOR).
• The basic semi-annual coupon floating rate note has
the coupon indexed to the 6-month interest rate.
 Floating rate bonds
• The calculation of the floating rate reflects the reference
rate and the riskiness (or creditworthiness) of the issuer
at the time of issue.
• The floating rate is equal to the reference rate plus a
percentage that depends on the borrower’s (issuer’s)
creditworthiness and the bond’s features.
• The percentage paid above the reference rate is called
the spread and usually remains constant over the life of
the bond.
• The spread used to calculate the coupon payment does
not change to reflect any change in creditworthiness that
occurs after issue.
Floating rate = Reference rate + Spread
 Floating rate bonds
• In bond markets, the practice is to refer to percentages in
terms of basis points.
• One hundred basis points (or bps, pronounced bips) equal
1.0%, and one basis point is equal to 0.01%, or 0.0001.
• The floating rate would be stated as Libor plus 75 bps.
• A floating-rate bond’s coupon rate will change, or reset, at each
payment date, typically every quarter.
• Floating-rate coupon payments are paid in arrears—that is, at
the end of the period on the basis of the level of the reference
rate set at the beginning of the period.
• On a payment date, the coupon rate is set for the next period
to reflect the current level of the reference rate plus the stated
spread that will determine the amount of the payment at the
next payment date.
 Floating rate bonds
Only the next coupon is known at the current date. The
later ones are random.
• On 31 March, a UK company raises £2 million by
issuing floating-rate notes with a maturity of nine
months. The coupon rate is three-month Libor plus
140 bps (1.40%). Note that even though it is called
three-month Libor, the rate quoted is an annual
rate. It is standard practice to quote interest rates as
an annual rate. Therefore, the total rate (Libor +
1.40%) must be divided by four to calculate the
quarterly coupon payment. The coupon rate is reset
every quarter.
 Inflation linked/Index linked securities
• It is a particular type of floating-rate bond.
• Adjusts the bond’s par value for inflation.
• Act as a hedge and to safeguard the investor against
macroeconomic risks.
• Changes to the par value reduce the effect of inflation
on the investor’s purchasing power from bond cash
flows.
• The par value—not the coupon rate—of the bond is
adjusted at each payment date to reflect changes in
inflation (which is usually measured via a consumer
price index or retail price index for a country).
 Inflation linked/Index linked securities
• The bond’s coupon payments are adjusted for inflation
because the fixed coupon rate is multiplied by the inflation-
adjusted par value.
• The coupon rate on an inflation-linked bond is lower than
the coupon rate on a similar fixed-rate bond.
• Treasury Inflation-Protected Securities (TIPS) in the United
States, index-linked gilts in the United Kingdom, and iBonds
in Hong Kong.
• To know more about inflation indexed bonds in India, please
refer the following link:
 https://rbi.org.in/scripts/FAQView.aspx?Id=91
 http://indianexpress.com/article/business/economy/infla
tion-indexed-bonds-down-but-not-out/
 Debt securities
• Also known as bonds, notes and debenture.
• Indenture: Written agreement between the
corporation (the borrower) and its creditors. It
is sometimes referred to as the deed of trust
and is a legal document.
• A trustee (a bank, perhaps) is appointed by the
corporation to represent the bondholders.
 Debt securities

• Indenture is an important document and

includes these following provisions:
– Terms of bond
– Total amount to be issued
– Description of property used as security
– The repayment arrangements
– The call provisions
– Details of the protective covenants
 Difference between equity and debt

Source: www.nseindia.com
• A Rs 1000 Par value bond bears a coupon rate
of 10% and matures after 5 years. Interest is
payable semi-annually. Compute the value of
the bond if the required rate of return is 15%,
compounded semi-annually.
• The market value of a Rs 1000 par value bond,
carrying a coupon rate of 14% and maturing
after 10 years is Rs. 750. What is yield to
maturity on this bond?
• A Rs.500 par value bond bearing a coupon rate
of 12 percent will mature after 5 years. What
is the value of the bond, if the discount rate is
15%?

• What will be price of bond if discount rate is

12%.

• What will be price of the bond if the discount

rate is 10%.
• A Rs 100 Par value bond bears a coupon rate
of 12% and matures after 6 years. Interest is
payable semi-annually. Compute the value of
the bond if the required rate of return is 16%,
compounded semi-annually.
• A Rs 100 Par value bond bears a coupon rate of 12% and
matures after 6 years. Interest is payable semi-annual. The
current price of the bond is 84.93. Calculate the yield to
maturity of the bond.

• Hint: Calculate the discount when the present value of

bonds coupon payment and Redemption value is equal to
current bond price
• The market value of a Rs 1000 par value bond,
carrying a coupon rate of 14% and maturing
after 10 years is Rs. 750. What is yield to
maturity on this bond?

• The market value of a Rs 1000 par value bond,

carrying a coupon rate of 14% and maturing
after 10 years is Rs. 750. What is yield to
maturity on this bond? The coupons are paid
semi-annually.
• A company’s bonds have a par value of Rs100,
mature in 7 years and carry a coupon rate of
12% payable semi annually. If the appropriate
discount rate is 16%, what price should the
bond command in the market.