Bond Valuation

Bond : It is an instrument of loan raised by the Govt. or a company against a specific interest rate and a promised date of repayment. Bonds are secured with specific collateral behind them as distinguished from debentures which are unsecured. Interest of the bond is generally lower than the debenture and is paid semi-annually.

Bond Terminology
Face value/Nominal value: This can be thought of as the principal amount on which interest is paid by the issuer. Issue price: The price at which the bond is issued to the lender. It may be at face value, may be at discount or may be at premium. Redemption value: Generally bonds are redeemed at face value on the maturity date, but some time it is also on premium. Coupon: Bond typically pay interest periodically at a prescribed rate of interest. The annual rate at which this interest is paid is known as coupon rate. Maturity: This is the future date of a bond on which the bond is repaid and extinguished. Some bonds do not repay the principal in one installment but spread it out over several years. In this case the date of last installment is taken as maturity date. Basis points: A basis point is simply one-hundredth of one percent change in interest rates and the difference between the two interest rate are usually stated in basis points.

Different Types of bonds

Straight/Plain-vanilla bond: It pays fixed periodic (usually semiannually) coupon over its life and return the principal on the maturity date. Zero coupon bond: It does not carry any regular interest. It is issued at a very high discount over the face value and redeemed at face value. Convertible bonds: The issuer offers bonds with an option for the investor to convert these bonds into equity shares at a pre-fixed ratio. (Detachable Warrant Trading). Floating rate bond: It has the maturity of either 3 years or 5 years and give an interest with reference to 364 days T-bill as a benchmark, i.e. the coupon rate is linked to some well-known rate of interest. Callable bond: It gives the right to the issuer to redeemed the bond prior to its maturity at a specific call price. These bonds are beneficial to the issuer when the coupon interest paid by the bond is higher than the prevailing interest rate. Puttable bond: This can be redeemed prior to maturity at the initiative of the bondholder.

Comparison of Tata Motor FD & Tata Capital NCD

ata Motor Maturity Rate of Interest Minimum Application TDS Applicable Mode of Issuance Premature withdrawal Optionable 1-3 Years 10%-11% (A) Rs.20,000 Yes Physical At the discretion of the company No Tata Capital 5 Years 12% (A) Rs.10,000 No Demat Secondary market selling. Attached Call/Put option 36 months/42 months. Secured

Security

Unsecured

Value of Bond
The value of bond or any financial assets is equal to the sum of the present value of the cash flows expected from it. The value of bond is the total present value of the expected future cash flows, the cash flow from bond is consist of coupon payment till maturity plus the final payment of redemption value at the time of maturity.

Value of Bond Calculation of Bond Return Current yield: This is the interest received calculated as a percentage of bond s current price. Findings: (i) If the bond is selling at par then current yield would be equal to coupon rate. (ii) If the bond is selling at premium (discount) the current yield would be less (more) than coupon interest rate. Drawback: An important drawback is that it consider only coupon income as a source return to the investors, it ignores the capital gains or losses that would also accrue to them.

Yield to Maturity
In practice an investor considering the purchase of a bond not quoted promised rate of return. Instead the investor must use the bond price, maturity date and coupon payment to infer the return offered by the bond over its life. The YTM is defined as the interest rate that makes the present value of a bond payments equal to its price. This interest rate is often viewed as a measure of the average rate of return that will be earned on a bond if it is bought now and held until maturity. It is also viewed as effective rate of return expected by an investor of a bond if the bond is held to maturity.

Assumptions (YTM): 1. All coupon and interest payment are made on schedule. 2. The bond held till maturity. 3. The coupon payments are fully and immediately reinvested at precisely the same interest rate as the promised YTM. Yield to Call: Some bond carry a call feature that entitle the issuer to call/buyback the bond prior to the stated maturity. For such bonds it is a practice to calculate the YTC as well as YTM.

Approximation formula of YTM.

Decision Criteria: Higher the YTM better the bond, from the view point of the investors. Major drawbacks of YTM:

It is assumed that the cash flows are reinvested at the rate equal to YTM. This may not be true always. Valuation of Zero coupon bonds.

Expected YTM Vs. Stated YTM

The stated YTM is the maximum Possible YTM without considering the default risk. In expected YTM we consider the default risk. Expected YTM Stated YTM Face Value Rs.1000 Rs.1000 Coupon 9% Semi annual 9% Semi annual Years left for maturity 10 10 Current Price Redemption YTM Case: Enron. 750 700 11.6% 750 1000 13.7%

Bond Price Theorem

(1) The market price of a bond will be equal to the par value of the bond, if YTM is equal to coupon rate. (2) If YTM increases above the coupon rate, the market value drops below the face value. (3) Inverse of theorem 2. (4) For a given difference between YTM & coupon rate the longer the term to maturity the greater will be the change in the price with change in YTM.

Interest Rate Sensitivity

1. Bond prices and yields are inversely related: as yield increase, bond price fall; as yield fall, bond price rise. 2. An increase in a bond s yield to maturity result in a smaller price change than a decrease in yield of equal magnitude. 3. Prices of long term bond tend to be more sensitive to the interest rate changes than price of short term bonds. 4. Interest rate risk is inversely related to the bond s coupon rate. Prices of low coupon bonds are more sensitive to changes in interest rates than prices of highcoupon bonds. 5. The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases.

Effect of Maturity on Bond Price Volatility

Present Value of an 8% Bond (Par Value = 1000)
Term to Maturity YTM 7% 1 Year 10% 73 907 980 -2.9 7% 569 505 1074 10 Years 10% 498 377 875 -18.5 7% 858 257 1115 20 Years 10% 686 142 828 -25.7 7% 1005 132 1137 30 Years 10% 757 54 811 -28.7

PV of Int. 75 PV of Prl. 934 Total Val % Change in TV 1009

Effect of Coupon on Bond Price Volatility

Present Value of 20 years Bond (Par Value = 1000)
Coupon YTM 7% 0% 10% 0 142 142 -44.7 7% 322 257 579 3% 10% 257 142 399 -31.1 7% 858 257 1115 8% 10% 686 142 828 -25.7 7% 1287 257 1544 12% 10% 1030 142 1172 -24.1

PV of Int. 0 PV of Prl. 257 Total Val % Change in TV 257

Effect of YTM on Bond Price Volatility

Present Value of 20 years 4% Bond (Par Value = 1000)
Low YTM YTM 3% 4% 547 453 1000 -14.1% Medium YTM 6% 462 307 769 8% 396 208 604 -21.5% 9% 370 175 545 High YTM 12% 301 97 398 -27% 100 BP Change at High YTM 9% 370 175 545 10% 343 142 485 -11%

PV of Int. 602 PV of Prl. 562 Total Val % Change in TV 1164

Trading Strategies
I want to maximize rates of return when interest rate change. If you expect a major decline in interest rate Your bond portfolio would be ..

Term Structure Interest Rate

The difference in yields observed for bonds which are similar in all respect except in term to maturity is called term structure of interest rate. The graphical representation between interest rate and term to maturity is called yield curve. Rising yield curve Declining yield curve Flat yield curve. Humped Yield curve

Risk of Bonds
Default risk:: Arises when company default in paying interest or principal. Other things being equal, bonds which carries higher default risk traded at higher stated YTM. Interest rate risk: The change in interest rate in the general level of economy leads to increase in RRR & decrease in price. Inflation risk: Call risk: Issuer redeemed the bond before maturity. Liquidity risk: Barring some popular GoI Bonds the others are not actively traded in the secondary Market.

Determinants of Bond Safety

Coverage Ratio Leverage ratio Liquidity ratio Profitability ratio Cash flow to debt ratio

Altman s Z score Model

Duration
The duration of financial asset measures the sensitivity of the asset s price to interest rate movement. Summary statistic of the effective average maturity of a bond. Duration of bond is useful measure of the sensitivity of a bond s market price to interest rate (yield) movement. It is approximately equal to the percentage change in price for a given change in yield. Eg. A 10 years bond with a duration of 7 years means that it would fall approximately 7% in value if the interest rate increased by 1%.

The Duration Measure

C t (t ) (1  i) t t !1 ! D! n Ct (1  i) t t !1
n n

t v PV (C )
t t !1

price

Developed by Frederick R. Macaulay, 1938 Where: t = time period in which the coupon or principal payment occurs Ct = interest or principal payment that occurs in period t i = yield to maturity on the bond

 Fredrick Macaulay introduced the concept of Duration by taking weighted average maturity of the bond. Each weight factor shows the relative importance of each cash flow to the bonds value or market price. e.g. A company issues Rs.1000 bond with a coupon of 11% payable annually with a maturity of 6 years . Calculate the duration. Note If nothing is mentioned regarding YTM or required rate of return; Coupon rate will be taken as the proxy of YTM or RRR for discounting.

Properties of Duration
1. The duration of zero coupon bond is equals its time to maturity. 2. Holding maturity & YTM constant, a bond s duration is lower when a coupon rate is higher. 3. Holding coupon rate constant, a bond s duration generally increase with its time to maturity. 4. Holding other factor constant, the duration of a coupon bond is higher when the bond s yield to maturity is lower. 5. The longer the term to maturity of a coupon paying bond, the greater the difference between its duration and term to maturity. 6. The duration of perpetual bond is (1+YTM)/YTM.

Bond Duration in Years for Bonds Yielding 6 Percent Under Different Terms
COUPON RATES
Years to
Maturity 1 5 10 20 50 100 8 0.02 0.995 4.756 8.891 14.981 19.452 17.567 17.167 0.04 0.990 4.558 8.169 12.980 17.129 17.232 17.167 0.06 0.985 4.393 7.662 11.904 16.273 17.120 17.167 0.08 0.981 4.254 7.286 11.232 15.829 17.064 17.167

Source: L. Fisher and R. L. Weil, "Coping with the Risk of Interest Rate Fluctuations: Returns to Bondholders from Nave and Optimal Strategies," Journal of Business 44, n (October 1971): 418. Copyright 1971, University of Chicago Press.

Modified Duration and Bond Price Volatility

Bond price movements will vary proportionally with modified duration for small changes in yields An estimate of the percentage change in bond prices equals the change in yield time modified duration

Where: (P = change in price for the bond P = beginning price for the bond Dmod = the modified duration of the bond (i = yield change in basis points divided by 100

(P v100 !  Dmod v (i P

Modified Duration
Modified duration is a modified version of the Macaulay model. It shows how much the duration changes for each percentage change in yield. The formula is used to determine the effect that 1% change in interest rates will have on the price of the bond. A bond having a face value of Rs.500 maturity in 6 years pays a coupon of 12% paid annually. The market price of the bond is Rs.470. The YTM is 13.53%. Calculate Modified duration. Also calculate the % change in price of the bond if the YTM expected to increases by 1.5%.

Trading Strategies Using Modified Duration

Longest-duration security provides the maximum price variation. If you expect a decline in interest rates, increase the average modified duration of your bond portfolio to experience maximum price volatility. If you expect an increase in interest rates, reduce the average modified duration to minimize your price decline. Note that the modified duration of your portfolio is the market-value-weighted average of the modified durations of the individual bonds in the portfolio.

Limitations of Macaulay and Modified Duration

Percentage change estimates using modified duration only are good for small-yield changes Difficult to determine the interest-rate sensitivity of a portfolio of bonds when there is a change in interest rates and the yield curve experiences a non-parallel shift.

Price-Yield Relationship for Bonds

The graph of prices relative to yields is not a straight line, but a curvilinear relationship. This can be applied to a single bond, a portfolio of bonds, or any stream of future cash flows. The convex price-yield relationship will differ among bonds or other cash flow streams depending on the coupon and maturity. The convexity of the price-yield relationship declines slower as the yield increases. Modified duration is the percentage change in price for a nominal change in yield.

Bond Convexity
Modified duration is a linear approximation of bond price change for small changes in market yields

(P v100 !  Dmod v (i P
However, price changes are not linear, but a curvilinear (convex) function

Modified Duration
Dmod dP di ! P

For small changes this will give a good estimate, but this is a linear estimate on the tangent line. MD is the slope of the curve at a given yield, mathematically is the first derivative of price with respect to yield divided by price.

Convexity
Convexity is a measure of how much a bond s price-yield curve deviates from the linear approximation of that curve. Convexity always is positive number, implying that the price-yield curve lies above the modified duration (tangent) line.

Determinants of Convexity
The convexity is the measure of the curvature and is the second derivative of price with resect to yield (d2P/di2) divided by price Convexity is the percentage change in dP/di for a given change in yield

d P 2 di Convexity ! P

Determinants of Convexity
Inverse relationship between coupon and convexity Direct relationship between maturity and convexity Inverse relationship between yield and convexity

Modified Duration-Convexity Effects

Changes in a bond s price resulting from a change in yield are due to:
Bond s modified duration Bond s convexity

Relative effect of these two factors depends on the characteristics of the bond (its convexity) and the size of the yield change Convexity is desirable???