INTRODUCTION

INTRODUCTION TO
TO BOND
BOND
VALUATION
VALUATION

1
 Introduction
Introduction to
to Bond
Bond Valuation
Valuation
 Valuing
Valuing aa bond
bond isis very
very similar
similar to
to valuing
valuing an
an
annuity.
annuity.
 As
As before,
before, we we care
care about
about the
the size,
size, timing,
timing, and
and risk
risk
of
of the
the cash
cash flows.
flows.
 The
The basic
basic idea
idea in
in bond
bond valuation
valuation isis discounting
discounting aa
stream
stream of of level
level cash
cash flows
flows with
with return
return of
of principal
principal
at
at the
the end
end ofof the
the bond’s
bond’s life.
life.

2
 What
What isis aa Bond
Bond
 A
A bond
bond isis aa loan,
loan, typically
typically made
made by
by investors
investors to
to aa
corporation
corporation or
or government.
government.
 The
The indenture
indenture spells
spells out
out the
the terms
terms of
of the
the loan:
loan:
Coupon
Coupon
 Maturity
 Maturity

Seniority
Seniority
 A
A corporation
corporation can
can deduct
deduct the
the interest
interest payments
payments on
on
bonds
bonds (dividends
(dividends paid
paid on
on stock
stock are
are not
not
deductible).
deductible).

3
 Corporate
Corporate Bonds
Bonds
 Generally
Generally have
have Rs.1000
Rs.1000 par
par value,
value, semiannual
semiannual
coupons.
coupons.
 Default
Default risk
risk isis rated
rated by
by agencies
agencies such
such as
as Moody’s
Moody’s
and
and S&P.
S&P.
 Other
Other features
features maymay include:
include:

Call
Callprovision
provision
 Convertibility
 Convertibility

Floating rate
Floating rate
Option features
Option features

4
 Junk
Junk Bonds
Bonds

 Junk
Junk bonds
bonds are
are high-yield
high-yield instruments
instruments with
with aa
significant
significant probability
probability of
of default.
default.
 Made
Made popular
popular byby Michael
Michael Milken
Milken ofof Drexel
Drexel
Burnham
BurnhamLambert
Lambert inin the
the 1980’s.
1980’s.
 Often
Often used
used inin “Leveraged”
“Leveraged” transactions
transactions such
such as
as
LBO’s,
LBO’s, Mergers,
Mergers, Acquisitions.
Acquisitions.

5
 Characteristics
Characteristics of
of Bond
Bond Prices
Prices
The
The cash
cash flows
flows onon aa bond
bond are
are constant
constant (“fixed
(“fixed
income”).
income”).
AA bond’s
bond’s market
market price
price changes
changes in
in response
response to
to the
the
market
market interest
interest rate.
rate.
When
When market
market rates
rates increase,
increase, the
the fixed
fixed payments
payments from
from
the
thebond
bondare
areworth
worthless
lessso
sothe
theprice
pricefalls.
falls.
 If rates decrease, the fixed payments are now worth
 If rates decrease, the fixed payments are now worth

more.
more.

[A
[Abond’s
bond’sprice
pricealso
alsochanges
changesininresponse
responsetotochanges
changesininthe
therisk
riskof
ofthe
the
cash
cashflows,
flows,but
butwe
weare
arenot
notquite
quiteready
readyfor
forthat
thatdiscussion.]
discussion.]
6
 Basics
Basics of
of Bond
Bond Valuation
Valuation
 The
Thebond
bondpricing
pricingequation
equationconsists
consistsof
oftwo
twocomponents
components
 PV of Coupons
 PV of Coupons

 PV of Face Value
 PV of Face Value

 The price of a bond (these PV’s) depends on:

 Number of Periods (N)

 Size of Cash Flows (C and P )

N
C PN C 1  PN
B0     1  N 

n 1 (1  r ) n
(1  r ) N
r  (1  r )  (1  r ) N

7
 Yield
Yield to
to Maturity
Maturity

 The
The yield
yield to
to maturity
maturity isis an
an important
important number
number in
in
bond
bond valuation.
valuation.
 It
It isis the
the rate
rate which
which equates
equates the the market
market price
price of
of the
the
bond
bond with with the
the value
value of
of the
the discounted
discounted cashcash flows.
flows.
 That
That is, is, YTM
YTM isis the
the rr such
such that
that the
the bond
bond equation
equation
holds.
holds.
 Finding
Finding the the YTM
YTM requires
requires aa financial
financial calculator,
calculator, aa
goal-seeking
goal-seeking solver,solver, or
or trial
trial and
and error.
error.
8
 Example
Example -- Annual
Annual Coupon
Coupon
 Rs. 1000/- 10 year bond paying a 10% annual coupon
Rs. 1000/- 10 year bond paying a 10% annual coupon

What
Whatisisthe
thevalue
valuewhen
whenthe
theinterest
interestrate
rateisis10%?
10%?
100  1  1000
B0  1  10 
 10
 1000.00
.10  (1.10)  (1.10)

100  1  1000
11%? B0  .11 1  (1.11)10   (1.11)10  941.11
IfIfrr==11%?


 

100  1  1000

IfIfrr==9%?
9%? B0  1 10 
 10
 1064.18
.09  (1.09)  (1.09)

9
 Example
Example -- Semiannual
Semiannual Coupon
Coupon
 Now
Now the
the coupon
coupon isis split
split semiannually
semiannually
50  1  1000

At
At10%
10% B0  1 20 
 20
 1000.00
.05  (1.05)  (1.05)

50  1  1000

At 11% B0  .055 1  (1.055) 20   (1.055) 20  940.25
At11%
 

50  1  1000

At 9% B0 
At9% 1 20 
 20
 1065.04
.045  (1.045)  (1.045)

10
 YTM
YTM and
and the
the Coupon
Coupon Rate
Rate
 Relationship
Relationship between
between YTM
YTM and
and Coupon
Coupon Rate
Rate

YTM Coupon
YTM==Coupon bond
bondisisselling
sellingat
atpar
par(P
(P00==PPNN).).
 YTM > Coupon  bond is at a discount (P < P ).
 YTM > Coupon  bond is at a discount (P00 < PNN).

YTM
 Coupon
YTM<<Coupon bond
bondisisatataapremium
premium(P
(P00>>PPNN).).

 Why
Why does
does the
the YTM
YTM differ
differ from
from the
the coupon?
coupon?
The
Thecoupon
couponisisset
setwhen
whenthe
thebond
bondisisissued.
issued.
 The YTM is the market’s required interest rate. It may
 The YTM is the market’s required interest rate. It may

change
changeas
aseconomic
economicfundamentals
fundamentalsshift.
shift.

11
 Remembering
Rememberingthe
theYTM-Coupon
YTM-CouponRelationship
Relationship
 Zero
Zero Coupon
Coupon Bonds
Bonds
Pays
Pays no
no coupon
coupon soso interest
interest comes
comes in in the
the form
form of
of aa
discount
discountfrom
fromthe
therepayment
repayment(P (P00<<PPNN).).
Since Coupon = 0, YTM must be greater than Coupon.
Since Coupon = 0, YTM must be greater than Coupon.

 Capital
Capital Gains
Gains
IfIf the
the YTM
YTM isis greater
greater than
than the
the Coupon,
Coupon, the
the extra
extra return
return
must
mustbe becoming
comingfrom
fromsomewhere.
somewhere.
 The extra return comes from capital gains (P < P ).
 The extra return comes from capital gains (P0 < PN ).
0 N

12
 Example
Example -- Solving
Solving for
for YTM
YTM
 Consider
Consider aa Rs.1000
Rs.1000 55 year
year bond
bond with
with aa 8%
8%
coupon
coupon

What
Whatisisthe

theYTM
YTMififititisisselling
sellingfor
forRs.
Rs.1000?
1000?

IfIfititisisselling

sellingfor
forRs.
Rs.900?
900?

IfIfititisispriced
 pricedatatRs.
Rs.1100?
1100?

13
 Duration
Duration

 As we
As we have
have seen,
seen, bonds
bonds have
have value
value from
from two
two sources:
sources:
coupons
couponsandandreturn
returnof
ofprincipal.
principal.
 Intuitively, bonds with high coupon rates or short
Intuitively, bonds with high coupon rates or short
maturities
maturities will
will return
return value
value more
more quickly
quickly than
than those
those with
with
low
lowcoupons
couponsor orlong
longmaturities.
maturities.
 At the extreme is a zero coupon bond, which returns all
At the extreme is a zero coupon bond, which returns all
value
valueatatmaturity.
maturity.
 Duration is a measure of how quickly the (present) value
Duration is a measure of how quickly the (present) value
of
ofaabond
bondisisreturned.
returned.

14
 Duration
Duration
 To calculate duration:
To calculate duration:

 Find
Findthe
thepresent
presentvalue
valueofofeach
eachcash
cashflow
flowindividually
individually
 Sum these to get the present value of all cash flows
 Sum these to get the present value of all cash flows

(price)
(price)
 Calculate the proportion of the total value from each
 Calculate the proportion of the total value from each

individual
individualcash
cashflow
flow
 Multiply each proportion by the corresponding number
 Multiply each proportion by the corresponding number

of
ofperiods
periodsand
andsum
sum
 The answer will give a measure of the average life of the
The answer will give a measure of the average life of the
bond
bondin inaapresent
presentvalue
valuesense.
sense.
 A bonds with a low duration gets most of its value from
A bonds with a low duration gets most of its value from
cash
cashflows
flowsoccurring
occurringearly.
early.
15
 Types
Types of
of Risk
Risk Bondholders
Bondholders Face
Face
 Interest Rate Risk
Interest Rate Risk
The
The risk
risk of
of aa bond
bond changing
changing inin value
value when
when interest
interest rates
rates change.
change.
This
This affects
affects allall bonds
bonds regardless
regardless ofof credit
credit quality,
quality, but
but isis more
more
severe
severefor
forlonger
longermaturity
maturitybonds.
bonds.
 Reinvestment Risk
Reinvestment Risk
The
The risk
risk that
that investors
investors will
will bebe unable
unable toto reinvest
reinvest the
the coupon
coupon
payments
payments atat the
the coupon
coupon rate.
rate. This
This isis more
more important
important for
for high
high
coupon
couponbonds.
bonds.
 Default (Credit) Risk
Default (Credit) Risk
The
Therisk
riskthat
thatthe
thefirm
firmwill
willgo
gobankrupt
bankruptand
andnot
notmake
makeall
allpayments
paymentstoto
bondholders.
bondholders.
 Other Risks: Inflation, Call, Liquidity
Other Risks: Inflation, Call, Liquidity
16
 Inflation
Inflation and
and Interest
Interest Rates
Rates

 Inflation
Inflation isis the
the increase
increase in
in the
the nominal
nominal (or
(or cash)
cash) cost
cost of
of
goods
goodsandandservices
servicesoverovertime.
time.
 Put
Put differently,
differently,itit isis the
the decrease
decrease ininpurchasing
purchasingpower
powerover
over
time.
time.
 In
In the
the end,
end, we
we are
are generally
generally concerned
concerned with
with consumption
consumption
in
infinance
finance(and(andin
inlife).
life). The
Theamount
amountof ofRupees
Rupeesyouyouhave
haveisis
really
reallymuch
muchlesslessimportant
importantthan thantheir
theirpurchasing
purchasingpower.
power.
 Nominal rates are the rates observed in the market and
Nominal rates are the rates observed in the market and
quoted
quotedin incontracts.
contracts.
 Real
Real rates
rates are
are actually
actually veryvery illusive
illusive since
since measuring
measuring
inflation
inflationaccurately
accuratelyisisdifficult.
difficult.
17
qq AND
AND a

18