Valuation of Debt

Securities

Dr Ajay Kumar Chauhan

What are Debt or Fixed Income securities ?

Are those private and public sector issues that meet any
one of 3 criteria

 Pay a fixed sum each period (fixed rate debt,

preferred stock)

 Pay a sum to be determined by the formula (floating

rate debt)

 Guarantee a fixed sum upon maturity (zero coupon

bonds)
 DEBT/BOND Valuation

promise to pay a stipulated stream of cash flows.

 Periodic interest payments over the life of instrument,

 Principal payment at the time of maturity.

• Classified into 2 groups according to maturity.

Money market instruments: maturity of one year or

less.
Bonds (or debentures): maturity of more than one year.

• Debt market in India has registered an impressive growth

particularly since 1993.
Bond: When a Co. (or Govt) borrows money from the public
(bondholders) and agrees to pay it back later

Par Value : Amount of money that the Co borrows (Usually Rs

1,000)

Coupon Payments : are like interests. The Co makes

regular payments to the bondholders, like every 6 months or
every year.

Indenture The legal stuff. A written agreement between the Co &

Bond holder. They talk about how much the coupon payments will be, and
when the money (par value) will be paid back to the bondholder.

Maturity Date Date when the Co. pays the par value back to
the bondholder.

Market Interest Rate which changes everyday.

 Types of Debt Instruments

The variety of debt instruments may be

classified as follows :

 Money Market instruments

 Govt securities and Govt-guaranteed bonds

 Corporate debentures
 Money Market Instruments

• maturity < 1 year at the time of issue.

• Includes T-bills, CODs, CPs

T-Bills represent short-term obligations of Govt which have

maturities like 91 days, 182 days & 364 days
 do not carry an explicit interest rate
 sold at a discount and redeemed at par value.
 Though the yield on T-bills is somewhat low, they have appeal
for the following reasons :
(i) Transacted readily as they are issued in bearer form.
(ii) Very active secondary market and DFHI is a major market
maker.
(iii) Virtually risk free.
Certificates of Deposit : represents a
negotiable receipt of funds deposited in a bank for a
fixed period. It may be in a registered form or a
bearer form. The latter is more popular as it can be
transacted more readily in secondary market.

 sold at a discount and redeemed at par value

 popular form of short-term investment for co’s for
the following reasons : (i) Banks are normally willing
to tailor the denominations and maturities to suit the
needs of the investors. (ii) fairly liquid. (iii) generally
risk-free. (iv) Offer a higher rate of interest than T-
bills or term deposits.
Commercial Paper : represents short-term
unsecured promissory notes issued by
firms that are generally considered to be financially
strong
usually has a maturity period of 90 days-180 days
sold at a discount and redeemed at par.
CP is either directly placed with investor of sold
through dealers.
Does not have a well developed secondary
market in India.
Main attraction is that it offers an interest rate that
is typically higher than offered by T-bills or CODs.
Disadvantages  does not have an active
secondary market. Hence, it makes sense for firms
that plan to hold till maturity.
 Govt Securities & Govt-Guaranteed Bonds

Largest borrowers in India are the Central & State govts.

GOI periodically sells central govt securities. These are
essentially medium to long-term bonds issued by the RBI on
behalf of the Govt of India. Interest payments on these bonds
are typically semi-annual.

State govts also sell bonds. These are also essentially

medium to long-term bonds issued by the RBI on behalf of
state govts. Interest payments on these bonds are typically
semi-annual.

Apart from the central and state Govts, a no. of govt

agencies issue bonds that are guaranteed by the central govt
or some state govt. Interest payments on these bonds are
typically semi-annual.
 Corporate Debt
Bonds (or debentures) are issued frequently by PSU’s, FIs, and
private sector Co’s.

Various types of corporate bonds are:

Straight Bonds : (or plain vanilla bond) pays a fixed periodic (usually semi
annual) coupon over its life and returns the principal on maturity date.

Zero Coupon Bonds: issued at a steep discount over its face value and
redeemed at face value on maturity. For e.g., In 1996, IDBI issued deep
discount bonds at Rs 5,300 of a face value of Rs. 200,000 with maturity
period of 25 yrs.

Floating Rate Bonds : pay an interest rate that is linked to a benchmark

rate such as the T-bill interest rate. For e.g., in 1993 the SBI came out with
the first ever issue of floating interest rare bonds in India. It issued 5 million
(Rs 1000) face value) unsecured, redeemable, subordinated floating
interest rate bonds carrying interest at 3 % per annum over the bank’s max
term deposit rate.
Bonds with Embedded Options : These options
give certain rights to investors and/or issuers.

Convertible Bonds give the bond holder the right (option)

to convert them into equity shares on certain terms.

Callable Bonds give the issuer the right (option) to redeem

them prematurely on certain terms.

Puttable Bonds give the investor the right to prematurely

sell them back to the issuer on certain terms.

Junk Bonds - speculative or below-investment

grade bonds; rated BB and below.
 Commodity-Linked Bonds :

• Payoff depends to a certain extent on the price of a certain

commodity.

• Principal is paid in either the physical units of a reference

commodity or its equivalent monetary value. Similarly, Coupon
payments may or may not be in units of the commodity to which
the bond is indexed.

• Nominal return of conventional bond held to maturity is known

with certainty, although the real return is unknown due to
inflation uncertainty, whereas both the nominal and real returns
of the commodity-linked bond are not known.

• Weather-linked Bonds :
 CDO Structure
Tranche 1
Bond 1
1st 5% of loss
Bond 2
Yield = 35%
Bond 3
Tranche 2
2nd 10% of loss
Yield = 15%
 Trust
Tranche 3
3rd 10% of loss
Bond n Yield = 7.5%
Tranche 4
Average Yield
Residual loss
8.5%
Yield = 6%
 Bond Features
Bonds tend to be confusing because of complex provisions attached to
them. The financial contract between the issuer and the holder of bonds is
called the bond indenture which spells out the features of the bond in
terms of collateral, sinking fund, call provision, protective covenants, and so
on.

 Collateral : represents a pledge of assets in favour of the bond

holders. If serves as an insurance against any possible default by the
borrower.

Sinking Fund : provision requires the issuing firm to retire a certain

percentage of bond issue at stipulated points of time.

Protective Covenants : The bond indenture often contains

several covenants to protect the interest of lenders. These
convenants impose restrictions on management and give bondholders
greater confidence that the firm will honour its commitments. For eg,
convenants may put limits on dividend payment, managerial compensation,
and total borrowings.
 Bond Pricing

Value of a bond is equal to PV of the cash flows expected from it.

Determining the value of a bond requires:

An estimate of expected cash flows.
An estimate of the required return.

Assumptions:
• Coupon interest rate is fixed for the term of the bond.
• Coupon payments are made every year and the next coupon payment is receivable
exactly a year from now.
• Bond will be redeemed at par on maturity.

Given these assumptions, the cash flow for a non-callable bond comprises an annuity
of a fixed coupon interest payable annually and the principal amount payable at
maturity. Hence the value of bond is :-

Present Value PV of Coupon Payments PV of Par Value

Of a Bond = ( an annuity) + ( time value of money)
Present Value Eq.
n
rc M M
VB  
t 1 (1  rD ) (1  rD ) n

Where, VB =Market Value, M = Maturity Value rc=Coupon Rate, rd= Required Rate
of Return, n= no. of periods to maturity

Example : XYZ Co has decided to issue bonds to raise additional financing for future growth.
How much capital will it raise if it issues 1,000 ten year bonds with a maturity of Rs 1000 and
an annual coupon rate of 10% that is paid semiannually. Co has also determined that
investors require an annual return rate of 12%.
5% *1000 1% *1000 5% *1000 5% *1000 5% *1000 5% *1000 5% *1000 5% *1000
VB        
(1  6%)1 (1  6%) 2 (1  6%)3 (1  6%) 4 (1  6%)5 (1  6%) 6 (1  6%) 7 (1  6%)8
5% *1000 5% *1000 5% *1000 5% *1000 5% *1000 5% *1000 5% *1000 5% *1000 5% *1000
        
(1  6%)9 (1  6%)10 (1  6%)11 (1  6%)12 (1  6%)13 (1  6%)14 (1  6%)15 (1  6%)16 (1  6%)17
5% *1000 5% *1000 5% *1000 1000
   
(1  6%)18 (1  6%)19 (1  6%) 20 (1  6%) 20
 47.16  44.49  41.98  39.60  37.36  35.24  33.25  31.37  29.59  27.91  26.33  24.84  23.44  22.11 
20.86  19.68  18.56  17.51  16.52  15.59  311.80
 885.30

The market value for the bond is 885.30 or in other words the present value of the future cash
flows is 885.30. If Co issues 1,000 of these bonds they will raise approximately Rs 885,300
 Bond Values with Semi-annual Interest

• Most of the bonds pay interest semi-annually. To value such bonds, we have
to work with a unit period of six months, and not one year. This means that
the bond valuation equation has to be modified along the following lines :

 Annual interest payment, C, must be divided by 2 to obtain the semi-annual

interest payment.
 No. of years to maturity must be multiplied by 2 to get the no. of half-yearly
periods.
 Discount rate has to be divided by 2 to get the discount rate applicable to half-
yearly periods.

• With the above modifications, the basic bond valuation becomes :

Where p = value of bond, C/2 = semi-annual interest payment, r/2 = discount

rate applicable to a half-year period, M = maturity value, 2n = maturity period
expressed in terms of half-yearly periods.

• As an illustration, consider a 8-year, 12% coupon bond with a par value of Rs.
1,000 on which interest is payable semiannually. The required return on this
bond is 12 percent. Applying Eq(10.3), the value of the bond is :
 Price-Yield Relationship

• Bond price varies inversely with yield.

• As required yield increase, PV of the cash flow decreases ;

hence the price decreases. Conversely, when the required
yield decreases, the PV of the cash flow increase; hence the
price increases (convex shape):

Price

Yield to Maturity
 Relationship between Bond Price and
Time

• Price of a bond must equal its par value at maturity.

• When interest rates rise, market prices of bonds fall (and vice
versa) (the longer the time until maturity, the more sensitive the
bond price is to changes in interest rates).

• if price < par value, a bond is said to sell at a discount

• if price > par value, a bond is said to sell at a premium
• if price = par value, a bond is said to sell at par
 Various yield measures

Commonly employed yield measures are:

current yield,
yield to maturity,
yield to call, and
realized yield to maturity.
Current Yield : relates the annual coupon interest to
the market price.

For eg, the current yield of a 10 year, 12 % coupon

bond with a par value of Rs. 1000 and selling of Rs.
950 is 12.63 %.

=> does not consider the capital gain (or loss) that
an investor will realize if the bond is purchased at a
discount (or premium) and held till maturity.

=> ignores the time value of money.

=> an incomplete and simplistic measure of yield.

Yield to Maturity
discount rate that makes the PV of future cash
flows from a bond equal to the current price of the
bond. Intuitively YTM is the rate of return which an
investor can expect to earn if the bond is held till
maturity.

Mathematically, it is the interest rate which satisfies the eq.:

Where p = price of bond , C = annual interest (in Rs.), M =

maturity value (in Rs.), n = no. of years left to maturity

Computation of YTM requires a trial and error procedure.

Consider a Rs. 1,000 par value bond, carrying a coupon rate of
9 %, maturing after 8 years. The bond is currently selling of
Rs. 800. What is the YTM on this bond ?

YTM is the value of r in the following equation :

• If r=12 %. P= Rs 90 (PVIFA 12%,8yrs) + Rs 1,000 (PVIF12%,8yrs) = Rs.

851.0

• Since the value is greater than Rs 800, we have to try a higher value of r.
Let us try r= 14 %
• Then, P = Rs. 90 (PVIFA 14%,8yrs) + Rs 1,000 (PVIF14%,8yrs) =
Rs.768.1
• Since this value is less than Rs 800, we try a lower value for r. Let us try
r = 13 %. Here, P = Rs 90 (PVIFA 13%,8yrs) + Rs. 1,000 (PVIF13%,8yrs)
= Rs 808
• Thus r lies between 13 % and 14 %.
• Using a linear interpolation1 in the range 13 % to 14 %, we find that r =
13.2 %.
 Yield to Call

If issuer buy back the bond prior to stated

maturity date in accordance with a call
schedule. For such bonds, it is a practice to
calculate the yield to call (YTC) as well as YTM.

The procedure for calculating the YTC is the

same as for YTM.
Realised Yield to Maturity
• RYTM calculation assumes that the cash flows received through the life of
a bond are re-invest at a rate equal to YTM. This assumption may not be
valid as reinvestment rate/s applicable to future cash flows may be
different. It is necessary to define the future reinvestment rates and figure
out the RYTM.

• Consider a Rs 1000 par value bond, carrying an interest rate of 15 %

(Payable annually) and maturing after 5 years. The present market price
of this bond is Rs 850. The re-investment rate applicable to the future
cash flows of this bond is 16 %. The future value of the benefits receivable
from this bond, calculated works out to 2032. The RYTM is the value of r *
in the following eq.

• Present market price (1+ r*) 5 = Future value

• 850 (1+ r*) 5 = 2032
• (1+ r*) 5 = 2032/850 = 2.391
• r* = 0.19 for 19 %
 Risk In Debt
Interest Rate Risk : Interest rates tend to vary over time, causing fluctuations in
bond prices. A rise in interest rates will depress the market prices of outstanding
bonds whereas a fall in interest rates will push the market prices up. Interest rate
risk, also referred to as market risk, a measured by the percentage change in the
value of a bond in response to a given interest rate change. It is a function of the
maturity period of the bond and its coupon interest rate.
• Current price of bond = PV of principal Interest payments repayment
• Longer maturity period — Greater sensitivity of price to changes in interest rates.
• Larger coupon (interest) payment -- Lesser sensitivity of price to changes in interest
rates.

Inflation Risk : nominal vs real rate of interest.

Default Risk (Credit Risk)

Call Risk

Liquidity Risk
 Interest Rate Sensitivity

1. An increase in yield causes a proportionately smaller price

change than a decrease in yield of the same magnitude.

2. Prices of long-term bonds are more sensitive to interest rate

changes than prices of short-term bonds.

3. As maturity increases, interest rate risk increases but a

decreasing rate.

4. Prices of low-coupon bonds are more sensitive to interest rate

changes than prices of high-coupon bonds.

5. Bond prices are more sensitive to yield changes when the bond
is initially selling at a lower yield.
 Bond Value: 3 Imp Relationships

1. A decrease in interest rates (required rates of return) will

cause the value of a bond to increase; an interest rate
increase will cause a decrease in value. The change in value
caused by changing interest rates is called interest rate risk.

2. 1. If the bondholder's required rate of return equals the

coupon interest rate, the bond will sell at par or maturity value.
2. If r exceeds the bond's coupon rate, the bond will sell at a
"discount."
3. If r is less than the bond's coupon rate, the bond will sell at
a "premium."

3. A bondholder owning a long-term bond is exposed to greater

interest rate risk than when owning a short-term bonds.
 CRISIL Debenture Rating Symbols

CRISIL is the largest credit agency in India. It rates instruments like debentures,
preference shares, fixed deposits, and commercial paper. The rating symbols
employed by CRISIL for debentures are:

1. High Investment Grades ‘AAA’ highest safety, High Safety ‘AA’

2. Adequate safety “A”; however, changes in circumstances can adversely affect

such issues more than those in the higher rated categories

3. Sufficient Safety ‘BBB’; however, changing circumstances are more likely to lead
to a weakened capacity to pay interest and repay principal.

4. Speculative Grades ‘BB’ inadequate safety, Greater susceptibility to

default ‘B’, Vulnerable to default ‘C’, ‘D’.

Note
1. CRISIL may apply ‘+’ or ‘-‘ signs for ratings from AA to D to reflect comparative
standing within the category.
2. Preference share rating symbols are identical to debenture rating symbols except
that the letters are prefixed to the debenture rating symbols, eg. Pf AAA (“pf
Triple A”)