Valuation of

Bonds

SA

Sem 3
 Bond

 Bond is a generally a long term debt instrument or security.

 Bonds issued by government do not have any risk of default.

 Hence Govt. bond interest rate is taken as risk free rate (Rf)

 Bonds of public sector companies in India are generally secured, but still not
absolutely free from risk of default

 The secured bonds of private sector companies are also called debentures.
 Secured debentures.
 Unsecured debentures.
 More on Bond
 Government Bonds are also called GILT edged securities.
 Tbills are short term securities issued by RBI. Currently 91 & 364 days
are only traded.
 Tbills are issued at a discount.
 Yield of Tbill:
FV 365
Yield = -1 X
Price No. of days

 Coupon rate on central govt. dated securities is higher than discount rate
on Tbills as maturity is longer. Hence investors require liquidity premium.
 Features of Bond or Debentures
 Face value: also called par value. Bonds are generally issued at face
value of Rs 100 or Rs 1000 and interest is paid on face value.

 Interest (Coupon) rate: it is fixed and known to bond holders.

 Interest paid is tax deductible.

 Maturity: A bond is generally issued for a specified period of time. It is

repaid on maturity.

 Redemption (maturity) value: value that bond holder will get on maturity.
 Bond may be redeemed at par, premium (more) or discount (less
than par)
 Features of Bond or Debentures

 Market Value: bond may be traded in a stock exchange. The price

at which it is currently sold or bought.
 It may be different from par value or redemption value.

 Call option: the option entitles the issuer to call back the bond and
redeem them before maturity. (rates coming down)

 Put Option: the investor can put the bonds back to issuer (rates
hiked)
 Types of Bond

 Secured and Unsecured (secured by collateral assets or not)

 Senior and Subordinate (Like, Ordinary share and pref share)

 Registered and unregistered (based on transferability)

 Convertible and Non convertibles (coveted to equity share or

not after specific period of time)

 Floating rate bonds (based on fixed interest rate or floating)

 Indexed Bonds (interest benchmark as index)

 Bond Values
 The present value of a bond (debenture) is the discounted value of its cash flows;
i.e. PV of annual interest payments + PV of terminal or maturity value.

C1 C2 C3 Cn F
V0 = + + + …….. + +
(1 + kd)1 (1 + kd)2 (1 + kd)3 (1 + kd)n (1 + kd)n

C = coupon rate; F = Maturity Value; k d = discount rate; n = no. of years to maturity

 The appropriate discount rate would depend upon the risk of the bond. The risk in
holding a govt. bond is less than the risk associated with a debenture issued by
any company.

 By comparing the present value of a bond with its current market value it can be
determined whether bond is overvalued or undervalued.
 Sum
 The debenture of MIS Ltd is selling at a discount of 5% from its face
value. The face value of the debenture is Rs 100, coupon rate is 8% and
the interest payments are made at the end of every 6 months. The next
interest payment will fall due at the end of 6 months from now.
The debenture will be redeemed in two equal installments; the first
installment will be payable at the end of 5 years and 6 months from now,
and the second installment will be payable at the end of 6 years and 6
months from now.

You are required to determine the yield that you will realize if you invest
in the debenture now and hold it till maturity.
 Sum
Suppose an investor is considering the purchase of a 5 year, Rs 1000 par

value bond, bearing a nominal rate of interest of 7% per annum.

The investor’s required rate of return is 8%. What should he be willing to

pay now to purchase the bond if it matures at par.

 Different rates corresponding to bonds

 Yield to maturity (ytm): it is the measure of a bond’s rate of return that

considers both the interest income and any capital gain or loss.
 It is bond’s internal rate of return.

 Current yield: (not same as ytm); Current yield only considers annual

interest, and does not account for capital gain or loss.

 Yield to call: a number of companies issue bonds with buy back or call

options. Thus a bond can be called or redeemed before maturity.

 Example to illustrate the different yields

 Suppose the market price of a bond is Rs 883.4/-;

Face value being Rs 1000.

The bond will pay interest at 6% per annum for 5 years, after which it is to

be redeemed at par.

The company makes a provision to buy back the bonds after 3 years at par.
 Classification of Bonds
 Bonds with maturity
 Pure discount/ deep – discount/ zero – coupon bonds:

 bonds that don’t carry explicit rate of interest.

 It provides for a payment of lump sum amount at a future date in exchange for a

current price of bond.

Face value or Maturity value , where, n = terms to mature
 Valuation, V0 =
(1 + kd)n kd = ytm

 Perpetual bonds/ consol:

 Has an indefinite life; hence it has no maturity value; only interest payments
Interest
 Valuation, V0 = , where, kd = ytm
kd
 Accrued Interest

Suppose a bond pays interest semi annually on July 1 and Jan 1.

If a person sells the bond on May 1, he gets no interest for holding

the bond for 4 months, whereas the buyer gets the interest for 6
months (Jan 1 – July 1) though he actually holds the bond for 2
months (May 1 – July1).

In India it’s a practice to give the seller the interest for holding the
bond for these 4 months (in Govt. Securities) and this is known as
Accrued interest. It is paid in addition to the market price of bonds.
 Effects of different factors on Bond value
 Bond value is inversely proportional to interest rate.

 Relationship between required rate of return and coupon rate

 If kd = C.rate; V0 = par value
 If kd > C.rate; V0 is available at a discount
 If kd < C.rate; V0 is at a premium

 Intensity of interest rate risk is higher on bonds with longer maturities,

(under normal market conditions).
 This is a normal expectation as short term instrument generally hold less risk
than long term ones; as future is uncertain.
 i.e. investors of bonds are subjected to interest rate risk
 Convertibles – a hybrid security
A convertible debenture is a debenture that can be changed into a specific number
of ordinary shares at the option of the owner.
The most notable feature is that it promises a fixed income associated with
debenture as well as chance of capital gains associated with equity share after the
owner has exercised his conversion option.

Conversion ratio: number of ordinary shares that investor can receive when he
exchanges his debentures. doubt
Conversion Price: Price paid for the ordinary shares at the time of conversion.

Conversion Value (1 debenture’s): Conversion ratio*market price of the share.

Value of Non-Convertible: (w/o feature of conversion): same as bonds

 Sum
 Sozomon Limited issued partly convertible debenture of Rs 1000 face

value carrying 10% interest payable semiannually. 50% of the debenture

will be converted into 10 equity shares of Rs 10 face value. Rest of the

portion will be redeemed at the end of 8th year at par. The expected market

price of the equity share at the end of 4th year is Rs 80. An investor

expects annual rate of return of 14% on debt component and 12% on

equity component.

What is the value of this debenture.

 Why issue Convertible debentures?

 Sweetening debentures to make them attractive

 Avoiding immediate dilution of earnings

 Using low cost capital initially (interest on debt is tax

deductible)
 Warrant
A warrant entitles the purchaser to buy a fixed number of ordinary shares at a
particular price on or before a specified time period.

E.g. Deepak Fertilizers and Petrochemicals Corp Ltd issued 14%, Rs 100 debentures
of Rs 190 crore in Jan 1987. Each debenture had 3 parts:
Part A of Rs 20 which will compulsorily and automatically be converted into one

equity share with face value of Rs 10 at a premium of Rs 10 on 1 st Jan 1990.

Part B of Rs 30 which will compulsorily and automatically be converted into one

equity share with face value of Rs 10 at a premium of Rs 20 on 1 st Jan 1991.

Part C of Rs 50 which will have a detachable warrant attached to it. Warrant will

entitle the holder to apply for 1 equity share of Rs 10 between 1993 and 1995 at a
price to be approved by Controller of Capital Issues but not exceeding Rs 50. The
warrant will be separately listed and traded on stock exchanges.
 Characteristics of Warrants
Exercise Price: Price at which holder can exercise the warrant
and purchase the shares known as the strike price or the
exercise price.
 Here price cannot exceed Rs 50.
Exerciseratio: Number of ordinary shares that can be
purchased at the exercise price per warrant.
 Here 1 equity share in exchange of 1 warrant, i.e. 1:1.

Expirationdate: It is the date when the option to buy shares in

exchange for warrant expires.
 Here it is end of 1995.

 Here it is a detachable warrant since it will be separately listed and

traded.
 Characteristics of Warrants
The exercise price can be fixed below the ordinary share’s
market price prevailing at that time; this will encourage some
holders to exercise the warrant. Others may keep holding and
wait till expiration date with the expectation of ordinary share
price to rise ( as they buy at lower exercise price). If the ordinary
share price is more than the exercise price between 1993 and
1995, then holders will exercise their warrant and buy shares at
the exercise price (lower than ordinary share market price).
Thus company raises additional capital at the time of exercise.
 Valuation of Warrants
Theoretical Value = (Share price – exercise price) * Exercise ratio

Suppose share price of DFPC on Dec 1992 is Rs 65, and exercise price is
fixed at Rs 50,
then theoretical value of each warrant = (65 – 50)*1 = Rs 15/-

If share price is less than exercise price, then theoretical value = zero, instead
of being negative. (% gain will observed by exercising warrant)

Premium = Warrant’s market value – warrant’s theoretical value

warrant’s theoretical value
 Types of Warrants
Detachable warrant: Which can be detached from the debenture and
can be separately traded in the stock market. Here the debenture
holder may sell his warrant in the market when its price increases but
continue holding the debenture.

Non detachable warrant: Which cannot be separately traded

Rights of warrant: warrant entitles purchase of ordinary shares.

Hence the holders are not shareholders until they exercise the warrant.
Thus they do not have rights of voting or dividends till they exercise
the warrant and buy ordinary shares at exercise price.
 Difference between CD & Warrants

If Convertible debentures are exercised company is not

raising any additional capital whereas by the exercise of
warrants company is able to raise additional capital (@ of
exercise price).

In Warrants new shares are issued thereby raising the

capital.
Kavya Alloys Ltd has announced a rights issue of PCD to part finance
its Rs 11 crore vertical integration program. As per the terms of the
issue 14% PCDs of Rs 100 each will be issued at par. The convertible
part of the debenture (Part A) of Rs 40 each will be converted into two
equity shares of Rs 10 each, 12 months from the date of allotment. The
non convertible part (B) of Rs 60 each will be redeemed after 7 years.
Interest is paid semiannually and the required rate of return is 24%
compounded semi annually. doubt

Part A Year end 31.3.98 31.3.99 31.3.2000 31.3.2001

EPS; 4 3.1 3.5 4.1
Bonus ratio 1:3

Part B Month Jan 2001 Feb 2001 Mar 2001 Apr 2001 May 2001

Avg. P/E 13 12.4 11.6 10.5 9.5

ratio
 Bond Theorems

Theorem1: If a bonds market price increases,

then its yield must decrease and vice versa
i.e. yield and price are inversely related.

Bond price Yield

 Bond Theorems
 Theorem2: If a bonds yield does not change over its life then the
size of its discount or premium will decrease as its life gets
shorter. Price of a premium bond
Par value

Premium Price of a discount bond

Discount

Today Maturity date

 Bond Theorems
 Theorem3: If a bonds yield does not change over its life then the
size of its discount or premium will decrease at an increasing rate
as its life gets shorter. Price of a premium bond
Par value

Premium Price of a discount bond

Discount

Today Maturity date

 Bond Theorems

Theorem4: A decrease in a bonds yield will raise the bonds

price by an amount that is greater than the corresponding fall in

the bonds price that would occur if there was an equal sized
increase in bonds yield.

X (5%)
Where X>Y
Bond price Yield

Y (5%)
 Bond Theorems

Theorem5: The percentage change in a bonds price owing

to change in its yield will be smaller if its coupon rate is higher.

Assumption: There is at least one coupon payment left besides

the one at maturity.

This theorem does not apply for 1 year bond or perpetual bonds.
 Risks associated with bonds

 Interest rate risk

Default risk
 Interest rate risk

 Investors are subject to interest rate risk: reinvestment of annual

interest and the capital gain or loss on sale of the bond at the end
of holding period.

 When interest rate rises – there is a gain on reinvestment and a

loss on liquidation and vice versa.
 Duration
 For any bond there is a holding period for which these two effects
exactly balance each other. What is lost on reinvestment is exactly
compensated by a capital gain on liquidation and vice versa. For this
holding period there is no interest rate risk. This is called Duration.

 Duration is the time (in years) taken for the price of a bond to
be repaid by the bonds internal cash flows.

 Duration is used to immunize a bond portfolio from interest rate

risk by setting the investment horizon equal to bond’s duration.

 Duration
 Macaulay Duration: created by Fredrick Macaulay

C1t1 C2t 2 Cn t n RVt n

  ...  
(1  y ) t1
(1  y ) t2
(1  y ) tn
(1  y ) tn
D
P0
C = coupon payments

y = ytm

t1 – n = years to maturity

RV= redemption value

 Duration
 Macaulay Duration is a measure of the effective maturity of a bond
defined as: the weighted average of the times until each payment,
with weights proportional to the present value of the payment.

 The Short cut formula for duration of a bond:

rc rc
D= X PVIFA rd, n X (1 + rd) + 1 – Xn
rd rd

rc = Current yield

rd = ytm

n = terms to maturity

Note: Short cut formula is used only when the bond is redeemable at maturity.
 Duration
 Modified Duration: It is the modified Macaulay duration which accounts for changing interest
rates.

D
Dmod 
y D = Macaulay Duration
1
f y = ytm

f = frequency of compounding
 Duration of a cash flow
e.g. Duration of a liability
 Immunization Use of Duration
Duration is used in immunization, where a portfolio of bonds
is constructed to fund a known liability.

Suppose a pension fund has a liability of 100mn at the

end of 5 years. The fund manager can immunize this liability by
buying a 5 year Zero coupon bond (as Duration = 5years)*.

[* Duration of zero coupon bond = maturity period.]

If the fund manager has to cater to a series of payments, then

he needs to match the liability duration with the duration of the
bonds.
 duration
Bond price

Actual bond price

Duration

y
 Duration Wandering

Duration changes or wanders with passage of time.

Thus it becomes necessary for the investor to monitor and
adjust the duration annually or at intervals by rebalancing the
portfolio.

Rebalancing means that the investor has to sell a part of the

portfolio and buy other securities so that the duration of the new
portfolio matches the new duration of the liability.
 Convexity
 The theorem 1 and 4 have led to convexity.

 It implies that bonds price and yield are inversely related but the fall in
price with an equivalent increase in yield is not equal to the rise in price
for an equivalent decrease in yield i.e. the relation is not linear but

convex in nature.

 The degree of convexity shows how much a bond’s yield changes in

response to a change in price. Thus convexity is the measure of risk.

 Convexity

P+

P-

y- y y+
 Convexity
Convexity is used to compare bonds.
A bond with greater convexity is lesser affected by
interest rates than the bond with lower convexity.
i.e. bonds with lesser convexity will have higher
price regardless of rise or fall in interest rate.
I.e. bonds with higher convexity have lesser
volatility when there is interest rate change.
 Convexity
Bond 1 and 2 has same price and convexity
when yield is y.
For a large increase in y, price of both bonds
will fall
But price of Bond 2 will decrease more than
bond 1 because of lesser convexity.

P
P1
Bond 1 (higher convexity)
P2
Bond 2 (lower convexity)
duration

y y+
 Sum
Sharma is required to make payments at the end of each year for next 6 yrs.
Year Payments (lakh)
1 25.50 He is planning to immunize his liability by
2 19.25 investing in following bonds:
3 18.25
4 17.50
5 19.50
6 17.50

Bond X: 11% coupon bond of FV Rs 1000 maturing after 5 years, redeemable

at 5% premium and currently traded at Rs 966.38.

Bond Y: 13% coupon bond of FV Rs 1000 maturing after 3 years, redeemable

at 5% discount and currently traded at Rs 988.66.

Calculate proportion of funds invested in each bond so that his payments are
Immunized. (interest rate is 12%.)
 Interest rate elasticity
P0
P0 P0 Ytm
IE = Or, = IE X
Ytm P0 Ytm
Ytm

Interest rate elasticity is always negative, due to the inverse

relation between yield and price of bonds.

It indicates that if there is 1% change in ytm, what will be the

% change in price of bond.

 Interest rate elasticity

Interest rate elasticity in terms of Duration and ytm.

Ytm
IE = -D X
1 + Ytm
 Sum

A bond with FV Rs 500 and a coupon rate of 12% is currently quoting

in the market at Rs 420. Term = 4 yrs. The holder of this bond has an

applicable tax rate of 30% and a capital gains tax of 15%. Interest is

payable annually.

Calculate interest rate risk when market interest rate falls by 200bp.

Calculate interest rate risk when market interest rate rises by 100bp.
 BOND RATINGS

 Bonds are rated as to their riskiness by several firms (CRISIL, ICRA )

 Bonds with the highest rating are rated AAA or P1 (short term).

 As bonds become riskier their ratings drop. Riskiness is the chance

of default.

 Investment grade bonds must be rated at least BBB.

 Bonds rated lower than BBB are vulnerable to default risk.