Bond Valuation

Sony Thomas
A bond is a………

 ……. security that obligates the issuer

to make specified interest and
principal payments to the holder on
specified dates.

 Bonds are sometimes called fixed

income securities
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Issuers
 Government – state as well as central
govt.s
 Corporates

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The bond terminology
1. Par value: Face amount; paid at maturity

2. Coupon interest rate: Stated interest rate. Multiply by

par value to get interest in rupee terms. Generally
fixed.

3. Maturity: Years until bond must be repaid and as time

elapses this declines.

4. Issue date: Date when bond was issued.

5. Default risk: Risk that issuer will not make interest or

principal payments.
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Basis point defined
 A basis point (bp) is 1% of 0.01 or
0.0001.
 The difference between a rate of
5.00% and 5.01% is one basis point

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Basic Valuation premise

The (market) value of any investment

asset is simply the present value of
expected cash flows
In a coupon paying bond, the stream of future cash
flows include interest payments (i.e., coupon
payments) and the repayment of principal.
Therefore value of a bond
= PV of all expected interest and principal payments.
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A ZCB’s value …

In the case of a zero coupon bond the value of the

bond is given as

V = FV/(1+ k)n

where FV is the price at which the bond will be

redeemed

k is the required rate of return

n is the number of years to maturity

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Bond Valuation contd….

V0 = CF1 + CF2 + … + CFn

(1 + k)1 (1 + k)2 (1 + k)n
Where:
V0 = value of the asset at time zero
CFt = cash flow expected at the end of year t
k = appropriate required return (discount rate)
n = relevant time period

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Bond Valuation contd….
Assume a company’s bonds have a Rs.1,000 face value
 The promised annual coupon is 10%
 The bonds mature in 10 years
 The market’s required return on similar bonds is 10%

Financial Management I 9
Bond Valuation contd….
1. Calculate the present value of the face value
= Rs.1,000 x [1/1.1010 ] = Rs.1,000 x 0.3855 =
Rs.385.50

2. Calculate the present value of the coupon payments

= Rs.100 x [1 - (1/1.1010)]/.10 = Rs.100 x
6.1446
= Rs. 614.46

3. The value of each bond = Rs. 1,000 (barring rounding off errors)

Financial Management I 10
Let’s dig a little deeper

Suppose you purchase the corporate bond

described earlier and immediately
thereafter expected inflation rose by
3%, causing k = 13%?
When the interest
PV of annuity 543.315
rate goes up, the
PV of principal 295.85 bond price will
always go down.
Bond value 839.165

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Contd…

 What would happen if inflation fell,

and k declined to 7%?

PV of annuity 702.4 When interest rates

PV of principal 508.0 go down, bond
prices will always
Bond value 1210.4 go up.

Financial Management I 12
Bond Prices and Interest Rates

115.00

110.00

105.00
Bond Price, %

100.00

95.00

90.00

85.00

80.00
0

10
Interest Rates, %
Financial Management I
Bonds and Coupon

Bond prices are inversely related to interest rates (or

yields).

What is the relationship between Bond prices and

Coupon?

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Contd…

 A bond sells at par only if its coupon rate equals

the required return.

 A bond sells at a premium if its coupon is above the

required return.

 A bond sells at a discount if its coupon is below the

required return.

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Price Converges to Par at Maturity

It is also important to note that a bond’s price will approach

par value as it approaches the maturity date, regardless of
the interest rate and regardless of the coupon rate.

10% Coupon Bond

Interest Price Price
Rate 20 Years 1 Year
0% $ 3,000 $ 1,100
10% $ 1,000 $ 1,000
20% $ 513 $ 917
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Pulled to par
Bond price

Premium bond

1000

Discount bond

Maturity

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 Yields

 The Current Yield measures the annual return to an investor

based on the current price.

Current = Annual Coupon Interest

Yield Current Market Price

For example, a 10% coupon bond which is currently selling at Rs.

1,150 would have a current yield of:

Current = 100 = 8.7%

Yield 1,150

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The YTM story
We have seen how to value a bond. Can we reverse
the dynamics?? i.e., lets find out return on a bond
given its price

PV = CF1 + CF2 + … + (CFn + Pn)

(1+k)1 (1+k)2 (1+k)n
This is the same equation we saw earlier when we solved for
price. In this case, we know the market price but are solving
for return.

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 Yields

 The yield to maturity measures the compound annual return to an

investor and considers all bond cash flows. It is similar to the
IRR in capital budgeting context

 In other words it is the single rate that when used to discount a

bond’s cashflows produces the bond’s market price

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Computing YTM

YTM computation involves one of the following

methods
(1) Interpolation technique (trial and error by yourself)
(2) Calculator
(3) Excel

Of course you have to use solver from the Tools menu on

Excel to determine YTM or you may use IRR function also

Financial Management I 21
 The Reinvestment Rate Assumption

 It is important to note that the computation of the YTM implicitly

assumes that interest rates are reinvested at the YTM.
 In other words, if the bond pays a Rs. 100 coupon and the YTM
is 8%, the calculation assumes that all of the Rs. 100 coupons
are invested at that rate.
 If market interest rates fall, however, the investor may be forced
to reinvest at something less than 8%, resulting in a realized
YTM which is less than promised.
 Of course, if rates rise, coupons may be reinvested at a higher
rate resulting in a higher realized YTM.
Financial Management I 22
Reinvestment rate…

A 3-year 10% bond trades at Rs. 951.9634 implying a YTM

of 12%.

-951.9634 100 100 1100

@12% for 1year

112
1337.44

@12% for 2 years

125.44

 1.4049   1  11.99%
1337.44
Return realized 
13

951.9634
Financial Management I 23
Bond prices on Nov 17, 2014 on RBI’s NDS - OM

Security
Trades TTA LTP LTY
Description

08.40 GS 2024 574 5065.0000 101.4875 8.1718

08.60 GS 2028 486 4400.0000 102.7825 8.2541

08.27 GS 2020 66 870.0000 100.1250 8.2396

08.83 GS 2023 88 645.0000 103.4800 8.2743

08.12 GS 2020 19 240.0000 99.1700 8.2952

09.20 GS 2030 16 215.0000 107.9000 8.2935

08.28 GS 2027 19 115.0000 99.9200 8.2879

08.24 GS 2027 16 115.0000 99.6200 8.2873

08.35 GS 2022 10 90.0000 100.2650 8.3013

08.13 GS 2022 2 55.0000 98.9500 8.3118

07.80 GS 2020 3 30.0000 97.8400 8.2988

07.16 GS 2023 3 15.0000 93.1300 8.3024

24
Malkiel’s Theorems
 In 1962, Burton Malkiel Proposed and provided
proofs for five theorems that depict the relationship
between bond prices, time to maturity and interest
rates

Financial Management I
Malkiel’s theorems
1. Bond prices move inversely with interest rates
2. For a given bond the absolute rupee price increase
caused by a fall in yields will exceed the price decrease
caused by an increase in yields of the same magnitude
3. Bonds with longer maturity experience greater
percentage change for a given change in interest rates
4. The price sensitivity of bonds increases with maturity
but it increases at a decreasing rate
5. Bonds with lower coupon rates experience higher
percentage changes for a given change in interest rates
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Bond price volatility
Time to Bond prices at different YTMs
maturity 6.00% 8.00% 10.00% 12.00% 14.00%
1 1038.27 1018.86 1000 981.67 963.84
5 1170.6 1081.11 1000 926.4 859.53
10 1297.55 1135.9 1000 885.3 788.12
15 1392.01 1172.92 1000 862.35 751.82
20 1462.3 1197.93 1000 849.54 733.37
30 1553.51 1226.23 1000 838.39 719.22
Change in BP for10 year as YTM moves down to 8% from 10%
- 13.59% while it is 11.47% when it moves up by 2% to 12%

Change in BP for 20 year bond as YTM moves down to 8% from 10%

- 19.793% while it is 15.046% when it moves by 2% to 12%

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Maturity Effect

7-28 Financial Management I

Implications of Malkiel’s theorems
 A bond buyer in order to receive the maximum price
impact of an decrease in interest rates should
purchase low coupon and long maturity bonds(when
interest rates goes down)

 A bond buyer in order to receive the least price

impact of an expected increase in interest rates
should purchase high coupon and low maturity bonds
(when interest rates goes up)

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Maturity Effects
 Bonds with longer maturity experience greater
percentage change for a given change in interest
rates

 Accordingly a 10 year bond with 5% coupon will gain

more than an 8 year bond with 5% coupon when
rates decline by a given amount

 Bonds with longer maturity are more sensitive to

price changes than bonds with lesser maturity

Financial Management I
Coupon Effects
 Bonds with lower coupon rates experience more
percentage of change for a given change in interest
rates

 A 8% 5-year bond will gain more than a 10% 5-year

bond when the rates decline by a given amount

 Bonds with lower coupon are more sensitive to price

changes than bonds with higher coupon

Financial Management I
From Malkiel’s theorems to …
 In trading world one may have to compare
dissimilar bonds like the price sensitivity of an
8% 5-year bond versus 10% 7-year bond

 Which one is more interest rate sensitive?

 To address such questions Malkiel’s theorems

may not be sufficient.

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Duration?
 The higher price in the lower coupon will be
dampened by the shorter maturity

 Consequently one cannot be sure as to which bond

will gain due to combined effects. Hence duration.

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 Bond Duration

 Bond Duration is extensively used by practitioners in

hedging

 Initially proposed by Fredrick Macaulay in 1936 and

defined as the weighted average maturity of the
bond

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Duration contd..
 Duration is shorter than maturity for all bonds
except zero coupon bonds

 Duration of a zero-coupon bond is equal to its

maturity since 100% of its present value is
generated by the payment of the face value, at
maturity.

 Weighted sum of the number of periods in the

future of each cash flow, (weighted by respective
fraction of the PV of the bond as a whole).

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Interest Rate Sensitivity
Bond Coupon Maturity Initial
YTM
A 12% 5 years 10%
B 12% 30 years 10%
C 6% 30 years 10%
D 3% 30 years 6%

0 A
B
C
Change in yield to maturity (%)
D
Financial Management I
Duration: Calculation

t
CF t (1  y)
wt 
PV of cash flows

Price
as a % of bond
price

T
D  t w
t 1
t

CFt= Cash Flow for Period

Financial Management I
 Duration Calculation example
Eg. Face Value=1000 Coupon = 8%, yield = 10%, years to maturity = 4
Interest is compounded annually
8% Time Payment PV of CF Weight C1 X
Bond years (10%) C4

1 80 72.73 .08 .08

2 80 66.12 .07 .14

3 80 60.11 .06 .19

4 1080 737.65 .79 3.15

sum 936.60 1.000 3.56

Financial Management I
DURATION