BOND VALUATION

Bond Definitions

Bond
Par value (face value)
Coupon rate
Coupon or Coupon payment
Maturity date
Yield or Yield to maturity
Provisions

Bond Valuation

1
1
t

(1 r)
Bond Value C
r

F

n
(1 r)

BV = C * PVIFA(r,t) + PVIF(r,n)

Consider a bond issued by XYZ corporation with a maturity

date of 2020 and a stated coupon rate of 7% and a face value
of Rs.1000. In 2000, with 20 years left to maturity, investors
owning the bonds are requiring a 7.5% rate of return. What is
the value of the bond?
Rs. 949.00
Alaskan airlines bonds are maturing in 14 years that pay
Rs.68.75 per year (but disbursed semi-annually) and a face
value of Rs.1000. If the Investors required rate is 7.2%,
what is the Value of this bond?
Rs. 972.00

Bond valuation
Compute the price of a 9% semi-annual
coupon bond with 20 yrs to maturity and
par value of Rs.1000, if the required yield is
12%.

Zeros or DDBs
Makes no periodic interest payments
The entire YTM comes from the difference
between the purchase price and par value
Cannot sell for more than the par value

Valuation of Zero Coupon Bonds

Price the zero that matures in ten years and
has a maturity value of Rs.1000, if the
required yield is 8.6%.

Pricing the Bond when the settlement

date falls between coupon periods
Days until next coupon payment
Determine the PV of CFs received over
fractional periods
Buyers compensation to seller for the
coupon interest earned for the fraction of
period it was held by the seller

Day Count
Actual/Actual convention, 30/360
convention
Consider a bond whose last coupon
payment was March 1; the next would be
Sep 1. Suppose the bond was purchased
with settlement date of say July 17
A/A = 46 days, 30/360 = 44 days

compounding
Determine the days in the coupon period
Calculate the fractional period
W= days in settlement and next coupon day/
days in coupon period

calculate the price

P = c/(1+i)w + c/(1+i)1+w + c/(1+i)2+w + . + c/
(1+i)n-1+w + M/(1+i)n-1+w

Bond valuation
A corporate bond with coupon of 10%
maturing March 1, 2022 is purchased with a
settlement date of July 17, 2016. If the yield
is 6.5%, price the bond.

Accrued Interest
Accrued interest is interest that is recognized but
not yet paid or received due to the difference in
timing of cash flows. It is added on to the face
value of bonds in order to compensate the former
bondholder for their period of ownership.
Accrued interest depends on the number of days
from the last coupon payment to the settlement
day

Accrued Interest
Full Price (dirty price) and clean price (flat
price)
AI = c (days from last coupon to settlement
date) / number of days in coupon period)
Or AI = P *(C/F)*(D/T)
Clean Price = Dirty Price AI
example

Yield
Potential return for an investor in a bond
The coupon
Any capital gain / loss when bond matures/called/sold
Income from reinvestment of coupons

Three yield measures

Current Yield
YTM
YTC

Current Yield
CY = Annual Coupon Interest / Price
For ex. 18-year, 6% coupon bond selling at
700.89 per 1000 par is.
60/700.89 = 8.56%

Yield to Maturity (YTM)

Rate of return investors earn if they buy
the bond at P0 and hold it until maturity.

YTM is the discount rate that equates the

PV of a bonds cash flows with its price.

Computing Yield-to-maturity
Yield-to-maturity is the rate implied by the current
bond price
Face Value Rs.1000, coupon rate 9%, time to
maturity 8 yrs, market price Rs. 800, find YTM
Suppose you are offered a 14-year, 10% annual
coupon, Rs.1000 par bond at Rs.1494.93, find
YTM
The YTM for a zero selling for 274.78 with par
Rs.1000, maturing in 15 years is.

 YTC
Suppose the bond stated above had a call
provision, to call the bond 10 yrs after the
issue date at a call price of Rs.1100. suppose
further that the interest rates had fallen and
one year after the issue, the decline in interest
rate caused the bonds to rise to 1494.93, the
return to the investor is...
An 18-year, 6% coupon bond callable in 5
yrs priced at Rs.1030, is selling at 700.89,
find YTC.
.

 YTP
YTW - Yield to worst is the lowest yield an
investor can expect when investing in a callable
bond
YTW may be the same as yield to maturity, but
it can never be higher!!
Can the YTM be less that YTC?

BEY
The bond equivalent yield (BEY) allows
fixed-income securities whose payments are not
annual to be compared with securities with annual
yields.
The BEY is a calculation for restating semi-annual,
quarterly or monthly discount bond or note yields into
an annual yield, and is the yield quoted in
newspapers.
BEY = ((F P)/P)*(365/days to maturity)

BEY
A bond with a $1,000 par value purchased at a
discounted price of $980, and with 200 days to
maturity. Calculate BEY.
The bond equivalent yield is the yield financial
institutions quote. If the semi-annual or quarterly yield
to maturity of a bond is known, an investor can use the
annual percentage rate calculation as an alternative.
BEY vs. EAY

Relationship / Theorem - 1
Bond prices and market interest rates move in opposite
directions
The Value of a bond is inversely related to changes in
the investors present RRR.
The Interest rate increases (decreases), the value of the
bond decreases (increases)
RRR 12%, Par value Rs.1000, Annual Interest Rs. 120.
Time to maturity 5 years, RRR 9%, 12% and 15%, find the
Value of the bond.

Graphical Relationship Between Price and

Yield-to-maturity
1500
1400
1300
1200
1100
1000
900
800
700
600
0%

2%

4%

6%

8%

10%

12%

14%

Relationship / Theorem - 2
When a bonds coupon rate is (greater than / equal to /
less than) the markets required return, the bonds
market value will be (greater than / equal to / less than)
its par value
When coupon rate = YTM, price = par value.
When coupon rate > YTM, price > par value (premium
bond)
When coupon rate < YTM, price < par value (discount
bond)

YTM and Bond Value

$1400

Bond Value

When the YTM < coupon, the bond

trades at a premium.

1300

1200

When the YTM = coupon, the

bond trades at par.

1100

1000

800
0

0.01

0.02

0.03

0.04

0.05

0.06
0.07
6 3/8

0.08

0.09

0.1

Discount Rate

When the YTM > coupon, the bond trades at a discount.

Relationship / Theorem - 3
As the Maturity Date approaches, the Market
value of a bond approaches its Par Value.
At maturity, the value of any bond must equal its
par value
Assuming no changes in the current interest rate, find
the value of both the premium and discount bonds (15%
and 9% respectively) over time of 5,4,3,2,1 year to
maturity.

Bond Value

rd = 7%.

1,372
1,211

rd = 10%.

1,000

837

rd = 13%.

775
30

25

20

15

10

Years remaining to Maturity

Relationship / Theorem - 4
Long-term Bonds have greater Interest rate Risk
than do Short term Bonds
Given two bonds identical but for maturity, the
price of the longer-term bond will change more
than that of the shorter-term bond, for a given
change in market interest rates.
A bond with longer maturity has higher relative
(%) price change than one with shorter maturity
when interest rate (YTM) changes. All other
features are identical

Find the Bond value if Face Value RS. 1000, Term to

maturity,
Scenario 1 5 years
Scenario 2 10 years
RRR Current interest rate 9%, 12% and 15%, Coupon
Rate 12%
RRR

5 yrs

10yrs

9%

1116.80

1192.16

12%

1000.00

1000.00

15%

899.24

849.28

Bond Value

Maturity and Bond Price

Volatility

Consider two otherwise identical bonds.

The long-maturity bond will have much more

volatility with respect to changes in the
discount rate

Par
Short Maturity Bond

Discount Rate
Long Maturity
Bond

Relationship / Theorem - 5
Given two bonds identical but for coupon, the price
of the lower-coupon bond will change more than
that of the higher-coupon bond, for a given change
in market interest rates.
A lower coupon bond has a higher relative price
change than a higher coupon bond when YTM
changes. All other features are identical

Bond Value

Coupon Rate and Bond Price

Volatility

Consider two otherwise identical bonds.

The low-coupon bond will have much more

volatility with respect to changes in the
discount rate

High Coupon Bond

Discount Rate
Low Coupon Bond

Risks with bonds

The investor with realise the YTM stated at
the time of purchase only if
1. The coupon payments can be reinvested at the
YTM
2. If the bond s held to maturity

Reinvestment rate risk

The risk that CFs will have to be
reinvested in the future at lower rates,
reducing income.
Illustration: Suppose you just won
500,000 playing the lottery. Youll
invest the money and live off the
interest. You buy a 1-year bond with a
YTM of 10%.

Year 1 income = 50,000. At year-end

get back 500,000 to reinvest.
If rates fall to 3%, income will drop
from 50,000 to 15,000. Had you
bought 30-year bonds, income
would have remained constant.

Interest rate risk

If the bond is not held to maturity, the price
at which the bond may have to be sold is
less than its purchase price, resulting in a
return less than the YTM. The risk that a
bond will have to be sold at a loss because
interest rates rise is interest rate risk.

Interest Rate Risk

Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than
short-term bonds

Reinvestment Rate Risk

Uncertainty concerning rates at which cash
flows can be reinvested
Short-term bonds have more reinvestment rate
risk than long-term bonds

If we take longer maturities and changes in

interest rates,
Coupon rate 10%,
Face Value Rs. 1000,
Interest rate 5, 10, 15 and
20%,
Maturity 1 and 30 years

 Long-term bonds: High interest rate risk,

low reinvestment rate risk.
Short-term bonds: Low interest rate risk,
high reinvestment rate risk.
Nothing is riskless!

Duration
It is a measurement of how long, in years, it
takes for the price of a bond to be repaid by
its internal cash flows. It is an important
measure for investors to consider, as bonds
with higher durations carry more risk and
have higher price volatility than bonds with
lower durations.

Macaulay Duration
Duration = sum (t * Ct / (1+Y)^t)/P0
t year the cash flow is to be received
Ct Cash flow to be recd in year t
Y Bond holders RRR
P0 the bonds PV
For all bonds, duration is shorter than maturity except zero
coupon bonds, whose duration is equal to maturity

Duration
Consider a 3yr, Rs.1000 bond that pays
10% coupon once a year. The YTM is 5%.
Calculate duration of the bond.
Volatility = D/(1+Y)

Relationship with pattern of Cash Flow

The sensitivity of a bonds value to changing interest
rates depends not only on the time to maturity, but also
on the pattern of cash flows
A change in interest rates always has a greater
impact on the PV of later cash flows than on earlier
cash flows. Bonds with cash flows coming later, will
be more sensitive to interest rate changes than bonds
with earlier cash flows.

Duration
A measure of how responsive a bonds price is to
changing interest rates estimate of price volatility.
Greater the relative percentage change in a bond
price in response to a given percentage change in
interest rate, the longer the duration

 Newly issued bond which makes semiannual coupon

payments
Market interest rates for this bond demand 8 percent interest
The bond makes a final repayment of Rs.1,000 after 10 years
Annual coupon
rate

Semiannual coupon
payment

0%

456

10 years

30

864

7.45

40

1,000

7.07

10

50

1,135

6.77

Bond value Bond duration

Market rate Drops to 7%

Market rate rises to 9%
Annual
coupon
rate

Bond
duratio
n

0%

Market rates
drop to 7
percent
Bond
price

Change
in price

10 years

503

10.3%

7.45

929

7.07

10

6.77

Initial price at 8
percent market rate

Market rates rise to 9

percent

Bond price

Change in Price

456

414

-9.2%

7.5

864

805

-6.8

1,071

7.1

1,000

935

-6.5

1,213

6.9

1,135

1,065

-6.2

In the above table, bonds with higher durations had a bigger loss
when interest rates rose
Similarly, bonds with higher durations had a bigger gain when
interest rates fell
the rule of thumb for interest rate risk associated with bonds:
When interest rates rise one percent, the percentage loss in a
bond's value equals the bond's duration
The same holds true for appreciation in a bond's price when
interest rates fall

Modified Duration
Modified duration is a modified version of the
Macaulay model that accounts for changing interest
rates. Because they affect yield, fluctuating interest
rates will affect duration, so this modified formula
shows how much the duration changes for each
percentage change in yield.
Mod.Duration = Macaulay Duration / (1+yield/k))
K = number of compounding periods per year.

Convexity
Bond prices and yields are inversely related. But,
the relationship is not linear for small changes in
yield, duration does a good job. When large changes
in yield occur, the convex nature of the price/yield
curve becomes apparent.
A measure of the curvature in the relationship
between bond prices and bond yields

Immunization
The investment of the assets in such a way that the existing
business is immune to a general change in the rate of interest.
Immunization is accomplished by calculating the duration of
the promised outflows and then investing in a portfolio of
bonds that has identical duration.
These strategies aim to match the durations of assets and
liabilities within a portfolio for the purpose of minimizing
the impact of interest rates on the net worth

The Bond Indenture

Contract between the company and the
bondholders and includes

The basic terms of the bonds

The total amount of bonds issued
A description of property used as security, if applicable
Sinking fund provisions
Call provisions
Details of protective covenants

Bond Ratings Investment

Quality
High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is very strong

Medium Grade
Moodys A and S&P A capacity to pay is strong, but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more impact on
the firms ability to pay

Bond Ratings - Speculative

Low Grade
Moodys Ba, B, Caa and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to capacity to pay.
The B ratings are the lowest degree of speculation.

Very Low Grade

Moodys C and S&P C income bonds with no
interest being paid
Moodys D and S&P D in default with principal and
interest in arrears

What factors affect default risk

and bond ratings?
Financial performance
Debt ratio
Coverage ratios, such as interest
coverage ratio or EBITDA coverage
ratio
Current ratios

Types of Bonds
Bonds Vs Debentures
Security : Secured / Mortgaged bond, and Unsecured Bonds
/ Subordinated Debentures
Transferability : Registered and Unregistered (bearer) Debentures
Conversion: Convertible, partly convertible, Non-Convertible
Debentures
Country and Currency Foreign Bonds, Eurobonds and
Masala Bonds
Coupon : very low coupon bonds, Zero coupon Bonds
/Zeroes, Deep discount Bonds
Credit rating : Junk / high-yield bonds

Redemption : Callable and Puttable Bonds

LYONs, ZIFCD, Warrants, SPN, TOCD etc.,

Bond Markets
Primarily over-the-counter transactions with
dealers connected electronically
Extremely large number of bond issues, but
generally low daily volume in single issues
Makes getting up-to-date prices difficult,
particularly on small company or municipal
issues
Treasury securities are an exception

Term Structure of Interest Rates

Term structure is the relationship between time to
maturity and yields, all else equal
It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
Yield curve graphical representation of the term
structure
Normal upward-sloping, long-term yields are higher
than short-term yields
Inverted downward-sloping, long-term yields are
lower than short-term yields

Upward-Sloping Yield Curve

Downward-Sloping Yield Curve

Overview of Term Structure

The relationship between yield to maturity and

maturity.

Information on expected future short term rates

can be implied from yield curve.
The yield curve is a graph that displays the
relationship between yield and maturity.
Three major theories are proposed to explain the
observed yield curve.

Theories of Term Structure

Expectations Theory
This theory suggest that the shape of the yield curve
reflects investors expectations about the future
direction of inflation and interest rates.
Therefore, an upward-sloping yield curve reflects
expectations of higher future inflation and interest
rates.
In general, the very strong relationship between
inflation and interest rates supports this theory.

Expectations Theory
Observed long-term rate is a function of
todays short-term rate and expected future
short-term rates.
Long-term and short-term securities are
perfect substitutes.
Forward rates that are calculated from the
yield on long-term securities are market
consensus expected future short-term rates.

Liquidity Premium Theory

Long-term bonds are more risky.
Investors will demand a premium for the risk
associated with long-term bonds.
The yield curve has an upward bias built into the
long-term rates because of the risk premium.
Forward rates contain a liquidity premium and are
not equal to expected future short-term rates.

Theories of Term Structure

Liquidity Preference Theory
This theory contends that long term interest rates tend to be
higher than short term rates for two reasons:
long-term securities are perceived to be riskier than
short-term securities
borrowers are generally willing to pay more for longterm funds because they can lock in at a rate for a longer
period of time and avoid the need to roll over the debt.

Market Segmentation and Preferred

Habitat
Short- and long-term bonds are traded in distinct markets.

Trading in the distinct segments determines the various

rates.
Observed rates are not directly influenced by expectations.
Preferred Habitat:
Modification of market segmentation
Investors will switch out of preferred maturity segments
if premiums are adequate.

Theories of Term Structure

Market Segmentation Theory

This theory suggests that the market for debt at any

point in time is segmented on the basis of maturity.
As a result, the shape of the yield curve will depend on the
supply and demand for a given maturity at a given point in
time.

Factors Affecting Bond Yields

Key Issue:
What factors affect observed bond
yields?
Real rate of interest
Expected future inflation
Interest rate risk
Default risk premium
Liquidity premium