Security Analysis and Portfolio

Management
Valuation of Bonds
 Bond
• Legal document containing an
acknowledgement of indebtedness by a
company; formal legal evidence of debt
• Contains a promise to pay a stated rate of
interest for a defined period and then to repay
the principal at a given date of maturity
• ‘senior securities’ of a company
 Reasons for issuing bonds
• To reduce cost of capital
• To gain the benefit of leverage
• When financial leverage is used, changes in EBIT translate into
larger changes in EPS
• To effect tax saving
– Interest on bonds is tax deductible
• To widen the sources of funds
– Attract funds from individual investors and especially
from investing institutions which are reluctant or not
permitted to purchase equity shares
• To preserve control
 Reasons for buying bonds
• Competitive interest rates
• Guaranteed minimum return
• Tax exemptions
• Peace of mind
• Easy to buy
• No commissions or fees on redemption
• Reliability
 Bond Terminology
4. Redemption
3.1.Maturity
Face Value
Premium
Date
5. Basis Points
Principal
Bonds areamount
Date on 2.
not always
onwhichCoupon
which
redeemed
the rateatisispar
interest
bond paid
onby
repaid thethe
maturity
issuer
One date. Some bonds
hundredths of onepay a premium
percent. Changes in addition to rate
in interest the
The annualbetween
and difference rate atface
which
two interestrates
value
interest is paid
are usually
stated in terms of basis points.
 Types of bonds

Registered
Senior
Secured and
v/sv/s Un-registered
Sub-ordinate bonds
Unsecured bonds
Convertible and non-convertible debentures
On the dimension of transferability…..
Holders
Unsecuredof senior
bondsbonds
have no
havecharge
to beon
paid
anyinspecific
full before
assets
Unregistered
Conversion bonds
into areshares
equity freely at
negotiable
the can and
option of can
theabe
bondtransferred by
the
of the
sub-ordinate
company while
bond secured
holders bonds
be carry
paid fixed holders.
or
aCan
simple endorsement. or partially convertible
befloating
fully-convertible
charge on the assets of the company
Registered bonds can be transferred only by executing a transfer
deed and filing a copy with the company
 Bond Market Innovations
Indexed
Junk Bonds
Bonds
Floating
Preferred stockRate Bonds
or Preference
International Bonds Share
Corporate
Treasury
Principal Issued
and coupon Bonds
Bonds are linked to
payments
by companies.
Interest
At the
Issued rates
time
by of are floating
liquidation,
borrowing with
company some
priority
in reference
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country
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Considered index
highly like inflation
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issued in the
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 Bond Valuation
• To understand how a bond may be valued,
consider the following illustration:
A debenture of Rs. 100 face value that carries
and interest rate of 14% is redeemable after 6
years at a premium of 2%. Assume a
discounting rate of 16%
The cash flow for the owner of this debenture is……
End of year Interest Income Principal
1 14 ---
2 14 ---
3 14 ---
4 14 ---
5 14 ---
6 14 102

@ a discounting rate of 16%, the PV is given by

= 14*PVIFA(16,6) + 102*PVIF(16,6)
= 93.41
 In general…..
Value of a bond
= Annual Interest Payable * PVIFA
+
Redemption Value * PVIF
Bonds with semi annual interest

V = I/2*PVIFA(k/2,2n) + F*PVIF(k/2,2n)
 Bond Yield Measures
The bond investor typically receives income
from the following:
1. Interest payments at a contracted rate i.e. coupon interest

2. Capital gain or loss arising out of a sale of a bond

3. Cash realization on sale of bond
4. Redemption of the bond by the issuer at a contracted
value
Returns to the bond investor
1. Interest payments at a contracted rate i.e. coupon interest
2. Capital gain or loss arising out of a sale of a bond

Principal Recoveries
3. Cash realization on sale of bond
4. Redemption of the bond by the issuer at a contracted value

If a bond is held to maturity…..

1. Interest payments at a contracted rate i.e. coupon interest
4. Redemption of the bond by the issuer at a contracted value

If it is sold before maturity…..

1. Interest payments at a contracted rate i.e. coupon interest

2. Capital gain or loss arising out of a sale of a bond

3. Cash realization on sale of bond

 Current Yield
Coupon Interest
CY =
Prevailing Market Price

Drawbacks:
Considers only coupon income as source of return;
ignores capital gains (losses)
 Yield to Maturity
Measured by comparing the present values of
1. Interest payments at a contracted rate i.e. coupon interest
4. Redemption of the bond by the issuer at a contracted value

Considers the entire sequence of cash flows and their

timing
Based on IRR: Cash outflow when bond is purchased
Cash inflow when periodic coupon
payments are issued
YTM: discount rate that equals the PV of all cash flows
from a bond to the cost (CMP)
 Assumptions underlying YTM
• All coupon and interest payments are made as
per schedule
• Bond is held to maturity
• The coupon payments are fully and
immediately re-invested at precisely the same
interest rate as the promised YTM
 YTM
n
It Pt
Po =
Σt=1
+
(1+r)t (1+r)n

Po : Cost of bond

Pt: Terminal Value

It : Annual interest in `
r = discount rate = YTM

t = time period
A bond with an annual coupon rate of 12.5%
redeemable on 1-10-2014 is selling at ` 80.60
on 1-10-2010. What is the return earned by
the investor who buys the bond on 1-10-2010
and holds it till maturity?
Year 2010 2011 2012 2013 2014
Cash Flow -80.60 12.5 12.5 12.5 12.5
Since calculation is cumbersome we use,
Annual Coupon Discount
Interest +
# years to maturity
YTM =
(Current Price + Par Value)

Annual Coupon Premium

Interest -
# years to maturity
YTM =
(Current Price + Par Value)

2
The previous problem……

100-80.6
12.5 +
3
YTM =
(100+80.6)

= 20.99%
Zero Coupon Bond
Maturity Value
P =
(1+r)n
 Duration
• Weighted average term to maturity of a
bond’s cash flows
• Assess a bond price’s sensitivity to interest
rate volatility
• For zero coupon bonds, duration = actual
years to maturity
• For all others, duration < actual maturities
 n
PV(CFt)
Duration = Σ
t=1 Po
* t

PV(CFt) PV of a future coupon or principal payment

Po CMP

t Year in which the cash flow is received

 Steps in calculating YTM
1. Find the PV of each annual coupon or
principal payment
2. Divide each by CMP
3. Multiply this relative value by the year in
which the cash flow is to be received
4. Repeat steps 1 to 3 for each year in the life of
the bond and then add up the values
computed
 Price-Yield Relationship
• Price of a bond is the PV of cash flows.
• If the required yield increases, PV of cash
flows decreases.
• Hence bond value declines
 Coupon rate = 10%; par value = 100; maturity = 10 years

Value of a bond = Annual Interest Payable * PVIFA + Redemption Value * PVIF

= 10*PVIFA(4,10) + 100*PV(4,10)

= 10*8.111 + 100*0.676
= 148.7

Yield (%) Price (`)

4 148.7
6 129.4
Convex curve
8 113.4
10 100.05
12 88.7
14 79.16
16 71.53
18 64.04
 Bond Immunization
• Investment strategy used to minimize the
interest rate risk of bond investment by
adjusting the portfolio duration to match the
inventors‘ investment time horizon
• Locks in fixed rate of return during the
amount of time an investor plans to keep the
investment without cashing it in
 For example….
• If you need `50,000 5 years from now, you can
– Buy one zero-coupon bond
– Several coupon bonds each with a 5-year duration
– Several bonds that average a 5-year duration