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Original Title: bond valuation

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Anita Raman

A debenture of Rs.100 face value that carries an interest rate of 14 percent is redeemable after 6 years, at a premium of 2 percent. If you own this debenture, you will enjoy the following benefits:

End of year 1 2 3 4 5 6

102

Value of a bond =

Present Annual value Redemption Discount interest annuity + value factor payable factor

illustration

Investor requires a rate of return of 16 percent from this debenture, the present value of it to you will be: Rs.14 (PVAF16%, 6 yrs) + Rs.102 (DF16%, 6 yrs) = Rs.14 (3.685) + Rs.102 (0.41) = Rs.51.59 + Rs.41.82 = Rs.93.41

Calculation of returns

The return to the bond investor can be measured in terms of the following: a. Current Yield (CY) b. Yield to Maturity (YTM) c. Realized Yield (RY)

CY is measured by comparing (i) with the prevailing market price. Thus, CY =

An 8% bond (Face value of Rs.100) selling for Rs.96, would have a current yield of, CY = 8.33% Current yield of bonds selling at par would be equal to the coupon interest rate. Current yield of bonds selling at a premium (discount) would be less (more) than the coupon interest rate. An important drawback of current yield is that it considers only coupon income as a source of return to the investor, ignoring interest and capital gains (loss) that would also accrue to him.

Yield-To-Maturity (YTM)

The correct way of computing the return on any asset involves considering the entire sequence of cash flows and their timing and calculating the Internal Rate of Return (IRR). For a bond, there is a cash outflow when the bond is bought cash inflows when the periodic interest coupons are received and a redemption value on maturity. Calculating the IRR of this stream of cash flows gives the true return on the bond, which is known as YieldTo-Maturity (YTM).

Consider a bond with an annual coupon rate of 12.5% redeemable on 1/7/20x5 selling at Rs.80.60 on 1/7/20x2. What is the return earned by the investor, who buys the bond on 1/7/20x2 and holds it till maturity? The investor incurs a cash outflow on 1/7/20x2 of Rs.80.60 and receives interest of Rs.12.50 each on July 1, 20x3, 20x4 and 20x5. On maturity (1/7/20x5), he also receives Rs.100.

IRR of this stream of cash flows works out to 22% as shown by the following calculation.

20x2 80.60

20x3 12.5

20x4 12.5

20x5 112.5

Approximation to YTM

C (F P)/n

(F P)/2 where C is the coupon, F is the redemption value and P is the purchase price. [1] Average investment is equal to half the redemption price and purchase price i.e., (F + P)/2.

PRICE-YIELD RELATIONSHIP

For a bond, the relationship between the price and the required yield is opposite. This is because, the price of the bond is the present value of cash flows. If the required yield increases, the present value of the cash flow declines and hence the bond value also declines.

Let us compute the relationship between the price and the required yield for a bond with coupon rate of 10% with par value of Rs.100 maturing after 10 years for different required yields as per the table given below:

Yield (in %)

4

Price in Rs.

148.7

6

8 12

129.4

113.4 88.7

10 100.05

14

16 18

79.16

71.53 64.04

(If Interest Rates are Constant) The bond price remains constant when the bond moves towards its maturity, and if the interest rates remain constant. If the bond is quoted at a premium, the price of the bond decreases when it approaches maturity. Discount bonds increase their prices when they approach maturity. In both the cases, the bonds will reach par value at the time-of-maturity.

illustration

Discount bond (5 yr. bond with 10% coupon) (expected rate yield at 12%) 5 4 3 2 1 0 92.6 93.8 95.1 96.5 98.2 100 Premium bond (expected yield at 7.8%)

a. The market price of the bond will be equal to the par value of the bond, if the YTM equals its coupon rate. market price of a Rs.1,000 par value bond bearing a 10% coupon rate with an expected YTM of 10% and a maturity of 10 years is equal to 100 PVIFA10%,10 + 1,000 PVIF10%,10 = 100 x 6.145 + 1,000 x 0.386 = Rs.1,000.50 Thus, when the YTM is equal to the coupon rate, the market value is equal to the face value of the bond.

b. If the YTM increases above the coupon rate, then the market value drops below the face value. If the YTM of the above bond increases to 12%, then the market value of the bond will drop to Rs.887. 100 PVIFA12%,10 + 1,000 PVIF12%,10 = 100 x 5.65 + 1,000 x 0.322 = Rs.887.

c. Inversely to the above principle, if YTM drops below the coupon rate, the market value will be more than the face value of the bond. In the case of the above bond, if the YTM falls to 8%, then the market value of the bond will rise to, = 100 PVIFA8%,10 + 1,000 PVIF8%, 10 = 100 x 6.71 + 1,000 x 0.463 = Rs.1,134.

PRINCIPLES OF BOND PRICE MOVEMENTS As YTM determines a bonds market price and vice versa, we can say that the bonds price will fluctuate in response to the changes in market interest rates in the following ways:

i. A bonds price is inversely proportional to its yield-to-maturity. The present value principle states that the present value of a cash flow varies in inverse proportion to the interest rate used as a discount rate. As such, if the YTM of the bond rises, the bonds market price drops and if the YTM falls, the bonds market price rises.

The YTM of a Rs.1,000 par value bond bearing a coupon rate of 10% and maturing in 10 years is 12%. Thus, the market value of the bond is Rs.887 If the YTM increases to 14%, the market value of the bond will drops to Rs.791.60, 100 PVIFA14%,10 + 1,000 PVIF14%,10 = 100 x 5.216 + 1,000 x 0.270 = Rs.791.60 If the YTM of the same bond comes down to 8%, then the market value of the bond rises to Rs.1,134.

For a given difference between the YTM and the coupon rate of the bonds, the longer the term to maturity, the greater will be the change in price with change in the YTM.

illustration

A B

Face value

Coupon rate YTM Years to maturity

Rs.1,000

10% 10% 3

Rs.1,000

10% 10% 6

Rs.1,000

Rs.1,000

957.69 4.2%

The percentage price change described above increases at a diminishing rate as the bonds maturity time increases. Let us take the case of bond B with face value of Rs.1,000, coupon rate and YTM of 10% and maturity period of 6 years. Suppose the YTM changes to 11% at the end of the fifth year, i.e., when the time to maturity of the bond is 1 year, then the value of the bond will fall to Rs.991.1.

Time to Maturity

Change %

1 2

991.1 982.87

0.89 0.83

3

4 5

975.4

969.2 963.04

0.76

0.64 0.635

The yield-to-maturity is inversely related to the price of the bond. As yieldto-maturity increases, the price of the bond decreases and as the yield-tomaturity decreases, the price of the bond increases. For a difference between the coupon and the YTM, the extent of change in the price of the bond depends on the remaining term to maturity. The larger the period, the greater will be the price change. The increase in the price of a bond associated with the changes in the interest rates will be at a diminishing rate as the term to maturity increases. For every change in the interest rate, there will be a corresponding change in the price of the bond. However, for the same change in the interest rate in either direction (that is, if the interest rate increases or decreases by say 1%), the corresponding change in the price is not by the same magnitude. The price increase caused by a yield decrease is always more than the decrease caused by a yield increase. For a given change in a bonds yield-to-maturity, the percentage price change will be higher for low coupon bonds than for high coupon bonds. A change in YTM affects the bonds with a higher YTM more than it affects the bonds with a lower YTM

Duration

Duration is a measure of the approximate sensitivity of a bonds value to rate changes. More specifically, it is the approximate percentage change in value for a 100 basis point change in rates. Some times to improve the estimate provided by duration, a measure called convexity is used.

Duration example

Date 1/7/2002 1/7/2003 1/7/2004 1/7/2005 1/7/2006 Total

No

of Years

12.5

12.5

12.5

12.5

117.5

10.87

9.45

8.22

7.15

58.42

94.11

10.87

18.9

24.66

28.59

292.09

375.11

Divide the sum of the products (Rs.375.11) by the present value (Rs.94.11) to get the duration. Duration = 375.13/94.11 = 3.99

Bond immunization is the strategy of matching the bonds duration (and not the term-to-maturity) with the time horizon of the investor. So assuming that an investor wants his investment in a bond to yield 6% (YTM) in order to cover a known liability maturing after 10 years, he would be better off choosing a bond with a duration of 10 years rather than a bond with a term to maturity of 10 years.

When the duration of a bond is set equal to the investment time horizon, any unexpected change in the market value of the unmatured bond at the end of the investment horizon (price effect) will be exactly equal in magnitude, but opposite in direction, to any unexpected change in the reinvestment income (reinvestment effect).

Immunization will provide a compound rate of return over the period immunized that equals the bonds YTM, irrespective of changes in market rates. Thus, the year can be locked in over the investment horizon.

Thank you

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