Bond Valuation

Bond
Long term debt instrument issued by the
borrower committed to pay a certain amount
of money to its holder at some time in future
with a fixed coupon interest.
 Types of Bond

1. Debenture
2. Subordinated debenture
3. Mortgage bond
4. Euro bond
5. Zero and very low coupon bond
6. Junk bond
DEBENTURES
The term debenture applies to any unsecured
long-term debt. Because these bonds are
unsecured, the earning ability of the issuing
corporation is of great concern to the bondholder.
They are also viewed as being riskier than secured
bonds and as a result must provide
investors with a higher yield than secured bonds
provide.
Subordinated debenture
A debenture that is subordinated to other
debentures is being paid in the case of
insolvency.
Mortgage bond
A bond secured by a lien on real property
Eurobonds

A Eurobond is an international bond that is

denominated in a currency not native to the country
where it is issued.
That is, Bonds issued in a country different from the
one in whose currency the bond is denominated.
For instance, a bond issued in Bangladesh in USD
that pays interest and principal to the lender in U.S.
dollars.
Zero and very low coupon bonds
Zero-coupon bonds are issued at a discount
and the full face value is received by the
investor at the time of maturity. There is no
interest or coupon paid for zero-coupon
bonds. Instead, zero-coupon bond investors
receive the face value when the bond reaches
maturity. The difference between the issued
price and the final maturity amount is the
profit that the investors make on these kinds
of bonds.
This is how the zero-coupon bond price is
determined.
Price = Maturity amount / (1 + rate of
interest)^number of years
Zero-coupon bonds are for long term
investment, usually around 10 years. Investors
who are looking to have long term goals with
their investment go for zero-coupon bonds
Zero Coupon Bond from Company’s
Perspective
Companies issue zero-coupon bonds to raise
capital without making interest payments.
These bonds are sold at a discount to their face
value and provide a fixed return at maturity.
Zero-coupon bonds allow companies to finance
long-term projects without incurring periodic
interest expenses, making them an attractive
financing option.
Zero Coupon Bond from Investors’ Perspective
Zero-Coupon bonds come with both pros and cons.
However, the features can have a different effect on
different investors. Investors with long-term
investment goals find this bond suitable, but
investors with short-term investment goals may think
otherwise. Therefore, investors should decide to go
or not go for Zero-Coupon Bonds as per their
investment objective.
Zero-Coupon Bonds can be highly beneficial if
purchased when the interest rate is high.
Zero-coupon bonds are often purchased to
meet a long term future predetermined
expenses such as for buying an Apartment,
Car, Debt payment and or any other
anticipated expenditure in retirement.
Junk or high-yield bonds
A junk bond is debt that has been given a low
credit rating by a ratings agency, below
investment grade. As a result, these bonds are
riskier since chances that the issuer will
default or experience a credit event are higher
 Credit rating agency

A credit rating agency (CRA, also called a ratings

service) is a company that assigns credit ratings,
which rate a debtor's ability to pay back debt by
making timely principal and interest payments
and the likelihood of default. An agency may
rate the creditworthiness of issuers of
debt obligations, of debt instruments, and in
some cases, of the servicers of the underlying
debt.
A credit rating agency attempts to describe the
risk with a credit rating such as AAA, AA, A, BBB,
BB, B, CCC, CC, C, with the additional rating D for
debt already in arrears.
Government bonds and bonds issued
by government-sponsored enterprises (GSEs)
are often considered to be in a zero-risk
category above AAA; and categories like AA and
A
Credit rating is a highly concentrated industry,
with the "Big Three" credit rating
agencies controlling approximately 95% of the
ratings business. Moody's Investors
Service and Standard & Poor's (S&P) together
control 80% of the global market, and Fitch
Ratings controls a further 15%.
The debt instruments rated by CRAs
include government bonds, corporate
bonds, municipal bonds, preferred stock, and
collateralized securities, such as mortgage-
backed securities etc.
John Moody first began to rate bonds in 1909.
Since that time three rating agencies Moody's,
Standard & Poor's, and Fitch Investor Services-
have provided ratings on corporate bonds.
The thumb rule is that,
“The poorer the bond rating, the higher the
rate of return demanded in the capital
markets”
Different type Types of Rating

AAA
AA
A
BBB
BB
B
CCC
CC
C
Determinants of Value of Financial Assets

1. The amount & timing of the assets expected

cash flows
2. The riskiness of these cash flows
3. The investors’ required rate of return for
undertaking the investment
 Characteristics of Bond
1. Claim on assets and earnings
2. Par value
3. Coupon interest rate
4. Maturity
5. Bond Indenture
6. Current yield
7. Bond rating
 Some Terminologies

Book Value
Liquidation value
Fair Market value
Intrinsic or economic value
Efficient market
Market depth
Book value
The value of an asset as shown on a firm's
balance sheet. It represents the historical cost
of the asset rather than its current market
value or replacement cost.
Liquidation value
The amount that could be realized if an asset
were sold individually and not as a part of
a going concern.
Market value
The observed value for the asset in the
marketplace.
Intrinsic or economic value
The present value of the asset's expected
future cash flows. This value is the amount the
investor considers to be a fair value, given the
amount, timing, and riskiness of future cash
flows.
Efficient market
A market in which the values of securities at
any instant in time fully reflect all available
information, which results in the market
value and the intrinsic value being the same.
 BOND VALUATION: FIVE IMPORTANT
RELATIONSHIPS
A financial manager needs to know more in
order to understand how the firm's bonds will
react to changing conditions.
FIRST RELATIONSHIP
The value of a bond is inversely related to
changes in the investor's present required rate
of return (the current interest rate). In other
words, as interest rates increase (decrease),
the value of the bond decreases (increases).
 Example
To illustrate, assume that an investor's
required rate of return for a given bond is 12
percent. The bond has a par value of $1,000
and annual interest payments of $120,
indicating a 12 percent coupon interest
rate .Assuming a five-year maturity.
Find the Value of bond ?
If, however, the investor's required rate of
return increases from 12 percent to 15 percent,
Then what happens to bond value?
And
In contrast, if the investor's required rate of
return decreases to 9 percent,
what happens to bond value?
Bond Value Calculation
Present value of an annuity
= annuity amount × [1 - {1 / (1 + i)}n] / i
= PMT X PVIFAi,n

Where,
i- Rate of Interest
n - Number of years
=PMTXPVIFA, i=9%, n=10yrs @ 9% RRR
= 90X6.418
= 577.62
=FVXPVIF, i=9%, n=10yrs
=1000$X0.422
=422
Total Value =577.62+422
= 999.62
@ 7% RRR
Annuity value= 90$X7.024
= 632.16
Present Value = FVXPVIF
= 1000$x0.508
= 508$
Total Value = 1140.16$
SECOND RELATIONSHIP
The market value of a bond will be less than
the par value if the investor's required rate is
above the coupon interest rate; but it will be
valued above par value if the investor's
required rate of return is below the coupon
interest rate
 Example
1. The bond has a market value of $1,000,
equal to the par or maturity value, when the
investor's required rate of return equals the
12 percent coupon interest rate.).
required coupon then Market Par value
rate rate, value
12% 12% Then $1000 $1000
2. When the required rate is 15 percent, which
exceeds the 12 percent coupon rate, the
market value falls below par value
 required coupon then Market Par value
rate rate, value

15% 12% Then $899.24 $1000

In this case, the bond sells at a discount below par value; thus, it is called a
discount bond.
3. When the required rate is 9 percent, or less
than the 12 percent coupon rate, the market
value, $1,116.80, exceeds the bond's par
value.
 required coupon then Market Par value
rate rate, value
9% 12% Then $1,116.80 $1000

In this case, the bond sells at a premium above the par value; thus, it is
called a premium bond.
THE BONDHOLDER'S EXPECTED RATE OF RETURN
(YIELD TO MATURITY)

Expected rate of return

The discount rate that equates the present
value of the future cash flows (interest and
maturity value) with the current market price
of the bond. It is the rate of return an
investor will earn if a bond is held till the
maturity. Yield to maturity
The same as the expected rate of return.
Kb
NPV = PVIFA I,n –IO =0
THIRD RELATIONSHIP
As the maturity date approaches, the market
value of a bond approaches its par value.
1. The premium bond sells for less as maturity
approaches. The price decreases from
$1,116.80 to $1,053.08 over the three years.
2. The discount bond sells for more as
maturity approaches. The price increases from
$899.24 to $951.12 over the three years
.
 FOURTH RELATIONSHIP
Long-term bonds have greater interest rate
risk than do short-term bonds.
Interest rate risk is the potential for
investment losses that result from a change in
interest rates. If interest rates rise, for
instance, the value of a bond or other fixed-
income investment will decline.
Interest rate risk can be reduced by holding
bonds of different durations.
 A change in current interest rates (required
rate of return) causes a change in the market
value of a bond. However, the impact on value
is greater for long-term bonds than it is for
short-term bonds.
For example, if we vary the current interest
rates (the bondholder's required rate of
return) from 9 percent to 12 percent and then
to 15 percent, as we did earlier with the five-
years bond, the values for both the five-year
and the 10-year bonds would be as follows:
Required rate 5 years ($) 10 years
9% 1,116.80 1,192.16
12% 1,000 1,000
15% 899.24 849.28
The figure clearly illustrates that the price of
the long-term bond (say, 10 years) is more
responsive or sensitive to interest rate
changes than the price of a short-term bond
(say, five years).
 Why does it happen?
Assume an investor bought a 10-year bond with 12% coupon
rate.
If the current interest rate for bonds of similar risk increased
to 15 percent, the investor would be locked into the lower rate
for 10 years. If, however, a shorter-term bond had been
purchased-say, one maturing in two years-the investor would
have to accept the lower return for only two years and not the
full 10 years. At the end of year 2, the investor would receive
the maturity value of $ I,OOO and could buy a bond offering
the higher 15 percent rate for the remaining eight years. Thus,
interest rate risk is determined, at least in part, by the length
of time an investor is required to commit to an investment.
FIFTH RELATIONSHIP
The sensitivity of a bond's value to changing
interest rates depends not only on the length
of time to maturity, but also on the pattern of
cash flows provided by the bond.
It is not at all unusual for two bonds with the
same maturity to react differently to a change in
interest rates. Consider two bonds, A and B, both
with 10-year maturities. Although the bonds are
similar in terms of maturity date and the
contractual interest rate, the structure of the
interest payments is different for each bond.
Bond A pays $100 interest annually, with the
$1,000 principal being repaid at the end of the
tenth year.
Bond B is a zero-coupon bond; it pays no
interest until the bond matures. At that time,
the bondholder receives $1,593.70 in interest
plus $1,000 in principal. Therefore, Bond B will
assumed to receive 2593.70USD. The value of
both bonds, assuming a market interest rate
(required rate of return) of 10 percent, is
$1,000.
However, if interest rates fell to 6 percent,
bond A’s market value would be $1,294,
compared with $1,447 for bond B. Why the
difference? Both bonds have the same
maturity, and each promises the same 10
percent rate of return.
The answer lies in the differences in their cash
flow patterns. Bond B's cash flows are
received in the more distant future on average
than are the cash flows for bond A.
Because a change in interest rates always has
a greater impact on the present value of later
cash flows than on earlier cash flows (due to
the effects of compounding), bonds with cash
flows coming later, on average, will be more
sensitive to interest rate changes than will
bonds with earlier cash flows.
This phenomenon was recognized by Macaulay
in 1938, who devised the concept of Duration.
 Duration
Duration is a measure of the sensitivity of the
price of a bond or other debt instrument to a
change in interest rates.
 How Duration Works
Duration measures how long it takes, in years,
for an investor to be repaid the bond’s price
by the bond’s total cash flows. In general, the
higher the duration, the more a bond's price
will drop as interest rates rise (and the
greater the interest rate risk).
As a general rule, for every 1% change in
interest rates (increase or decrease), a bond’s
price will change approximately 1% in the
opposite direction, for every year of duration. If
a bond has a duration of five years and interest
rates increase 1%, the bond’s price will drop by
approximately 5% (1% X 5 years). Likewise, if
interest rates fall by 1%, the same bond’s price
will increase by about 5% (1% X 5 years).
 Concept Check
1. What are some of the important features of a
bond? Which features determine the cash flows
associated with a bond?
2. What restrictions are typically included in an
indenture in order to protect the bondholder?
3. How does the bond rating affect an investor's
required rate of return? What actions could a
firm take to receive a more favorable rating?
 Concept Check
1. Explain the relationship between bond value and investor's
required rate of return.
2. As interest rates increase, why does the price of a long-term
bond decrease more than the price of a short-term bond?
3. Why does a bond sell at a premium when the coupon rate is
higher than the required rate of return, and vice versa?
4. As the maturity date of a bond approaches, what happens to
the price of a discount bond? Is the result the same if the bond
is a premium bond?
5. What bond characteristics influence the duration
measurement? Why is duration the more appropriate measure
of a bond's sensitivity to interest rates than term to maturity?