Valuation of Bonds

Bonds - Meaning
A debt security by a borrower and subscribed by the investor in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals

Bond Indenture
A contract that specifies all rights and obligations of the issuer and the owner of a fixed income security. It defines the obligations and restrictions on borrower and forms the basis of transaction. The contracts are known as Covenants. A Negative Covenant means prohibitions on the borrower and Positive Covenant means promises of the borrower.

Basic Features
Straight (Option Free Bond) : With treasury bonds and almost all US corporate bonds the annual interest is paid in two semiannual installments. Zero Coupon Bonds: Sold below par value. Floating rate securities Inflation Indexed Bonds Embedded Options

Bond Valuation
Determination of the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.

Basic Terminology
Book Value : Value of an asset based on historical data Market Value: the price for which an asset can be sold Going Concern Value: value as per the operating, performing & running business unit Liquidating Value: Net realizable value Capitalized value: the sum of present value of future cash flows from an asset.

Par Value: (Also known as face value or Nominal value)

Coupon rate: rate at which the interest on the par value is payable
Maturity RRR: It is the minimum rate of return needed to induce investors or companies to invest in something. This consist of two parts i.e. risk free rate and risk premium.

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The value of a bond may be defined as the sum of the present value of the future interest payments plus the present value of the redemption repayment. The appropriate discount rate to find out the resent value would be the RRR.

Yield to Maturity
The cash flows in relation to a bond are consisting of regular interest payments and the redemption repayment.

The rate of return which makes the discounted value of cash flows equal to the bonds market value.

Bond Value Theorems

The market value of the bond increases, the yield would decline and vice versa. The discount or the premium depends upon the maturity and yield remains the same. The discount or premium amount will decrease at an increasing rate. Raise in the bonds price for a decline in the bonds yield is greater than fall in bonds price for a raise in yield. Change in the price will be lesser for a % change in bonds yield if the coupon rate is higher.

Convexity
The Bonds price and yield are inversely related. The rise in the bond price would cause a fall in the yield and vice-versa. In general, the higher the convexity, the more sensitive the bond price is to decreasing interest rates and the less sensitive the bond price is to increasing rates.

Duration
The term duration refers to the time structure of the bond and the bonds interest rate risk. Generally time structure refers to the asset time to maturity. Duration is measure of the weighted average life of bond. Weights being present value of cash flows. Duration is a measure of price sensitivity of a security to change in yield. Average time until all interest coupons and the principle amount is recovered. This is called Macaulays Duration

Immunisation
It is a technique that makes the bond portfolio holder to be relatively certain about the cash flows. The strategy ensures that a change in interest rates will not affect the value of a portfolio. Whenever there is an increase in the market interest rate, the price of the bonds fall.

Risk Associated in Bonds Investment

Interest Rate Risk Call/ Prepayment Reinvestment Yield Curve Risk Credit Risk Volatility Risk Exchange Rate Risk Inflation Risk Sovereign Risk