BOND VALUATION

POOJA GUPTA

What is a Bond?

Bonds (a.k.a fixed income securities) are simply loans. A bond is a security that obligates the issuer to make interest and principal payments to the holder on specified date.

Maturity (or term) Face value (or par) Coupon rate

Types of Bond

Convertible and Non-Convertible Bond Sinking Fund Bond Serial Bond Mortgage Bond Collateral Bond Redeemable Bond

Bond Features

Indenture Maturities Interest Payments Call/ Put Feature

Reasons for Issuing Bonds

To To To To To

reduce the cost of capital gain the benefit of leverage effect tax saving widen the sources of funds preserve control

Repayment Schemes

Bonds with a balloon payment

Pure discount or zero-coupon bonds

Pay no coupons prior to maturity.

Coupon bonds

Pay a stated coupon at periodic intervals prior to maturity.

Pay a variable coupon, reset periodically to a reference rate.

Floating-rate bonds

Repayment Schemes

Bonds without a balloon payment

Perpetual bonds Pay a stated coupon at periodic intervals. Annuity or self-amortizing bonds

Pay a regular fixed amount each payment period.

Principal repaid over time rather than at maturity.

Bond Valuation

Bond valuation is the process of determining the fair price of a bond The fair value of a bond is the present value of the stream of cash flows it is expected to generate The price or value of a bond is determined by discounting the bond's expected cash flows to the present using the appropriate discount rate

Bond Valuation Contd..

Cash flows:

the periodic coupon payments C, each of which is made once every period; the par or face value F, which is payable at maturity of the bond after T periods.(NB final year payment will include the par value plus the coupon payment for the year)

Discount rate: the required

(annually compounded) yield or rate of return r.

r is the market interest rate for new bond issues with similar risk ratings

Bond Valuation Contd..

Coupon yield-The coupon yield is simply the coupon payment (C) as a percentage of the face value (F). Coupon yield = C / F Coupon yield is also called nominal yield Current yield- The current yield is simply the coupon payment (C) as a percentage of the bond price (P).

Current yield = C / P0.

Bond Valuation Contd..

The yield to maturity (YTM) is the discount rate which returns the market price of the bond. It is the internal rate of return of an investment in the bond made at the observed price

Yield to Maturity

To achieve a return equal to YTM, the bond owner must:

reinvest each coupon received at this rate, hold the bond until maturity, and redeem the bond at par.

Yield to Maturity

When a bond sells at a discount, YTM > current yield > coupon yield. When a bond sells at a premium, coupon yield > current yield > YTM. When a bond sells at par, YTM = current yield = coupon yield.

Duration

It is the weighted average maturity of a bond's cash flows or of any series of linked cash flows In laymans term, 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

Duration Contd..

Duration is useful as a measure of the sensitivity of a bond's price to interest rate movements It is inversely proportional to the percentage change in price for a given change in yield

Duration Contd..

P (i) is the present value of coupon i, t (i) is the future payment date, V is

the bond Price and D is the duration.

Duration Contd..

The duration of a bond is less than its time to maturity (except for zero coupon bonds). The duration of the bond decreases the greater the coupon rate. This is because more weight (present value weight) is being given to the coupon payments. As market interest rate increases, the duration of the bond decreases. This is a direct result of discounting. Discounting at a higher rate means lower weight on payments in the far future. Hence, the weighting of the cash flows will be more heavily placed on the early cash flows -- decreasing the duration.

Duration Contd..

Duration is a weighted average term to maturity where the weights are relative size of the contemporaneous cash flow. Modified Duration = Duration / (1+i) = percent change in price from a 1% change in yield.

What impact will higher expected inflation have on the prices and yields of existing bonds? Higher inflation will cause bond investors to require higher coupon payments on new bonds. Since the coupon rate on existing bonds will not change, the prices of existing bonds will fall since new bonds are offering higher cash payments. The yield to maturity would increase and not decrease. The required return is a function of return for time value, risk and also for the impact of inflation. Higher inflation would lead to higher yields. Bondholders would have to earn a higher return before inflation to end up with the same return after inflation.

Bonds of Alpha Corp. are quoted at $96.50. The bonds carry a coupon rate of 6.25% and will mature in 10 years. The bonds have a par value of $1,000. What would be the annualized yield on the bonds? 6.7367%

You contact your broker to price the Nokia Entertainment bonds, which will mature in 20 years and have a coupon rate of 5.50%. Your broker indicates that since these bonds were issued, interest rates on bond in this risk class have fallen to an APR or bond equivalent yield of 4.70%. What would you have to pay for these bonds that have a par value of $1,000? 1103

You are analyzing an opportunity to buy some new bonds that will offer a coupon rate of 5.50% and will sell at their par value of $1,000. The bonds have a seven-year maturity. You decide to purchase the bonds and right after you purchase the bonds, Mr. Greenspan and the Federal Reserve Open Market Committee (FOMC) meets and decides to raise interest rates. The yield on your bond increases by % to an annual yield of 6%. You hold the bonds for six months and decide to sell your bond right after you receive the first coupon payment. The rates have remained at the new levels and the bond is sold at an annualized yield of 6%. 973.41

Market Committee (FOMC) meets and decides to raise interest rates. The yield on your bond increases by % to an annual yield of 6%. You hold the bonds for six months and decide to sell your bond right after you receive the first coupon payment. The rates have remained at the new levels and the bond is sold at an annualized yield of 6%. What will be the HPR that you would have earned on the bond? 0.09%

Bond values are determined by using the discounted cash flow method. The bond value is the present value of the cash flows that you receive over the life of the bond. The calculation of the present value of cash flows assumes that intermediate cash flows are invested at the rate that is used to discount the cash flows. Since most investors reinvest intermediate payments, the return that will actually be earned on the bond will be influenced by changes in interest rates over the bond's maturity. Suppose that you buy a 4-year bond that has a coupon rate of 4% with a selling to yield (yield to maturity) of 5%. Right after you purchase the bond, the Federal Reserve enacts monetary policy that reduces the yield to maturity on the bond to 4%. If you hold the bond until maturity and reinvest the semiannual interest payments at 4% and not the initial yield to maturity of 5%, what will be the actual rate that you would have earned on your investment? To solve this problem, you will need to use both present value and future value.

The return will be higher than 4% since you originally purchased the bond at a yield to maturity of 5%. You paid less than par and so your return will be greater than 4% but less than 5%. The purchase price for the bond would equal $964.15. Calculations: N=8 Int. = 5 Pmt. = $20.00 FV = $1,000 Solve for PV PV = $964.15 If you reinvested the interest payment that you received at 4%, the future value of the bond investment would equal the future value of the semiannual interest payments plus the principal payment at maturity. That value would equal $171.66 plus the return of principal of $1,000, or $1,172.66. You invested $964.15 and 4 years later you have amassed a sum of $1,171.66. To calculate the return youwould need to solve for the interest rate that would equate the two lump sums. N=8 PV = $954.13 FV = $1,171.66 Solve for Int. Int. = 2.4666% (Semiannual) or 4.9331% annual