CHAPTER SIX

• THE ANALYSIS AND VALUATION

OF BONDS
• A bond or debenture is a debt instrument
issued by the government or a government
agency or a business enterprise which
transfers an obligation to pay the principal and
interest on its maturity according to the
preconditions.
 Bond valuation-Terminology
• Par Value- It is the value stated on the face of
the bond.
• Coupon Rate and Interest- A bond carries a
specific interest rate which is called the
coupon rate.
• Maturity Period- Typically, bonds have a
maturity period of 1-10 years; sometimes they
have a longer maturity.
 FEATURES OF A BOND
• Bond issues are considered fixed-income
securities because they impose fixed financial
obligations on the issuers. Specifically, the issuer
agrees to
1. Pay a fixed amount of interest periodically to
the holder of record
2. Repay a fixed amount of principal at the date of
maturity
• Normally, interest on bonds is paid every six
months, although some bond issues pay in
intervals as short as a month or as long as a year.
 Characteristics of bonds

3. maturity : bond most of time has a single

maturity date called term maturity but
sometimes they can be serial obligation bonds
which has a series of maturity dates,.
4. its indenture provisions
5. the features that affect its cash flows and/or
its maturity.
 Bonds classification

•
1. By form of payment
 Non interesting bearing bonds - bonds issued at a discount
 Regular serial bonds - serial bonds in which all periodic
installments of principal repayment are equal in amount.
 Deferred –interest bonds –bonds paying interest at a later date;
 Income bonds – bonds on which interest is paid when and only
when earned by the issuing firm;
 Indexed bonds - bonds where the values of principal and the
payout rise with inflation or the value of the underlying
commodity;
 Optional payment bonds – bonds that give the holder the choice
to receive payment on interest or principal or both in the currency
of one or more foreign countries, as well as in domestic currency.
• General obligation bonds – bonds, secured by
the pledge of the issuer’s full faith and credit,
usually including unlimited tax-power;
• Guaranteed bonds – bonds which principal or
income or both are guaranteed by another
corporation or parent company in case of default
by the issuing corporation;
• Participating bonds – bonds which, following the
receipt of a fixed rate of periodic interest, also
receive some of the profit generated by issuing
business;
 Type of circulation

• Convertible bonds: give to its owner the privilege of

exchanging them for other securities of the issuing
corporation
• Non convertibility
Recall possibility:
1. Callable (redeemable) bonds – bonds issue, all or
part of which may be redeemed by the issuing
corporation under definite conditions, before the issue
reaches maturity;
2. Non callable (irredeemable) bonds – bonds issued
which contains no provision for being “called” or
redeemed prior to maturity date.
 Type of issuers:
• Treasury (government) bonds – an obligation
of the government.
• Municipal bonds - bonds issued by political
subdivisions in the country
• Corporate bonds – a long-term obligation of
the corporation;
• Industrial bonds – bonds issued by
corporations other than utilities, banks and
railroads.
 Place of circulation:

• Internal bonds - bonds issued by a country

payable in its own currency;
• External bonds - bonds issued by government
or firm for purchase outside the nation,
usually denominated in the currency of the
purchaser.
 2. Coupon payment
• Coupon bonds – bonds with interest coupons
attached;
• Zero-coupon bonds – bonds sold at a deep discount
from its face value and redeemed at maturity for full
face value.
• Full coupon bonds – bonds with a coupon rate near or
above current market interest rate;
• Floating-rate bonds – debt instruments issued by large
corporations and financial organizations on which the
interest rate is pegged to another rate, often the
Treasury-bill rate, and adjusted periodically at a
specified amount over that rate.
 3. Collateral
• Secured bonds – bonds secured by the pledge of assets
• Unsecured bonds – bonds backed up by the faith and
credit of the issuer instead of the pledge of assets.
• Debenture bonds – bonds for which there is no any
specific security set aside or allocated for repayment of
principal;
• Mortgage bonds (or mortgage-backed securities) – bonds
that have as an underlying security a mortgage on all
properties of the issuing corporation;
• Asset-Backed Securities (ABS) – similar to mortgage
bonds, but they are backed by a pool of bank loans, leases
and other asset
 Valuation of Bonds
• Calculating the value of bonds is relatively
easy because the size and time pattern of cash
flows from the bond over its life are known.
• A bond typically promises Interest payments
every six months equal to one-half the coupon
rate times the face value of the bond
• The bond also promises payment of the
principal on the bond’s maturity date.
 Valuation of Bonds
Characteristics of Bonds
• Bonds are debt securities that pay a rate of interest
based upon face amount or par value of the bond.

• The Price changes as market interest changes

• Interest payments are commonly semiannual

• Bond investors receive full face amount when bonds

mature
THE FUNDAMENTALS OF BOND VALUATION

• The value of bonds can be described in terms

of dollar values or the rates of return they
promise under some set of assumptions.
• present value model, which computes a
specific value for the bond using a single
discount value.
• the yield model, which computes the
promised rate of return based on the bond’s
current price
 present value model
• the value of a bond (or any asset) equals the present value of
its expected cash flows.
• The cash flows from a bond are the periodic interest payments
to the bondholder and the repayment of principal at the
maturity of the bond.
• Therefore, the value of a bond is the present value of the
interest payments plus the present value of the principal
payment.
•
• Where :
• Pm = the current market price of the bond
• n = the number of years to maturity
• Ci = the annual coupon payment for bond i
• i = the prevailing yield to maturity for this bond issue
• Pp = the par value of the bond
 Contd.
• The value computed indicates what an investor would be willing to
pay for this bond to realize a rate of return that takes into account
expectations regarding the RFR, the expected rate of inflation, and
the risk of the bond.
• Example:
• an 8 % coupon bond that matures in 20 years with a par value of
$1,000. This calculation implies that an investor who holds this
bond to maturity will receive $40 every 6 months (one half of the
$80 coupon) for 20 years (40 periods) and $1,000 at the maturity of
the bond in 20 years.
• If we assume a prevailing yield to maturity for this bond of 10
percent (the market’s required rate of return on the bond), the
value for the bond would be:

• =
 Contd.

• The first term is the present value of an annuity of

$40 every 6 months for 40 periods at 5 percent,
• While the second term is the present value of $1,000
to be received in 40 periods at 5%. This can be
summarized as follows:
• Present value of interest payments
 $40 × 17.1591 = $686.36
Present value of principal payment
$1,000 × 0.1420 = 142.00
Total value of bond at 10% $828.36
 The Yield Model
• Instead of determining the value of a bond in
dollar terms, investors often price bonds in
terms of yields—the promised rates of return
on bonds under certain assumptions
• In this model it is assumed that we know the
price of the bond and we compute the
discount rate (yield) that will give us the
current market price (Pm )
 COMPUTING BOND YIELDS
• Bond investors traditionally have used five yield measures for the following purposes:
• YIELD MEASURE PURPOSE
1. Nominal yield : Measures the coupon rate.
2. Current yield : Measures the current income rate.
3. Promised yield to maturity: Measures the estimated rate of return for bond held
to maturity.
4. Promised yield to call: Measures the estimated rate of return for bond held to
first call date.
5. Realized (horizon) yield: Measures the estimated rate of return for a bond likely
to be sold prior to maturity. It considers specific reinvestment assumptions and an
estimated sales price. It also can measure the actual rate of return on a bond
during some past period of time.
 Nominal and current yields are mainly descriptive and contribute little to investment
decision making.
 The last three yields are all derived from the present value model as described
previously.
 To measure an estimated realized yield (also referred to as the horizon yield or total
return), a bond investor must estimate a bond’s future selling price.
 Nominal yield
• Nominal yield is the coupon rate of a particular
issue. A bond with an 8 percent coupon has an 8
percent nominal yield. This provides a convenient
way of describing the coupon characteristics of
an issue.
 Current yield
• Current yield is the annual interest divided by the bond’s .
• CY = Ci /Pm
• where:
• CY = the current yield on a bond
• Ci = the annual coupon payment of bond i
• Pm = the current market price of the bond
• Because this yield measures the current income from the bond as a
percentage of its price, it is important to income-oriented investors
who want current cash flow from their investment portfolios.
• Example: The annual interest is Rs 60 on the current investment of
Rs 883.40. Therefore, the current rate of return or the current yield
is: 60/883.40 = 6.8 per cent. Current yield does not account for the
capital gain or loss.
 CALCULATING FUTURE BOND PRICES
• Dollar bond prices need to be calculated in
two instances:
 when computing realized (horizon) yield, you
must determine the future selling price (Pf) of
a bond if it is to be sold before maturity or first
call, and
 when issues are quoted on a promised yield
basis, as with municipals.
 Yield to Maturity
• The yield-to-maturity (YTM) is the measure of a
bond’s rate of return that considers both the
interest income and any capital gain or loss.
• To compute the YTM for a bond, we solve for
the rate i that will equate the current price (Pm)
to all cash flows from the bond to maturity.
• this resembles the computation of the internal
rate of return (IRR) on an investment project.
• A perpetual bond’s yield-to-maturity:
 YTM
Example1: ABC company purchases a bond for $1,000 value at
10% coupon rate. The bond has 4 years maturity period. The
bond makes annual interest payment, the first to be received
one year from today. The company paid $1032.40 for the bond.
What is the bond yield to maturity?
Solution: hence it is going to be determined the IRR of the
bond we have to apply try and error method and lets try at 9%.
 Interest is 100= (0.1*1000) w/h is annuity cash inflow
 Price of the bond when issued is 1,000 w/h we need its PV
1032.40 = (100*3.240) + (1,000* 0.708)
1,032.40= 324 +708
Therefore the YTM of the bond is 9%
 Contd.
• Example 2: a bond with a value of 1,000 and 8 percent interest
rate, 20-year maturity, priced at $900. the bond gives a
semiannual interest yield. Find its annual and semi annual; YTM
of the bond. Givens: P0= 1,000 PM= 900 I=8 %
• Therefore the period will be( payment period 40, 20*2)
• Interest for semi annual = .08*1000/2 = 40 semi annually or
(80= .08*1000 annually). Therefore try and error method will
give:
 Semi annual Interest is 40(0.04*1000) w/h is annuity cash inflow
 Price of the bond when issued is 1,000 w/h we need its PV
 Lets try it at 5% and 4 %
 at 4%: (40*19.7928) + (1,000*0.2083) = 1,000.012
 At 5%: (40*17.1591) + (1,000*0.1420) =828.36
 Contd.

• YTM= LR +
• Whre NPV1= d/ce between PV of lower rate
value and required value
• NPV2 is the d/ce between higher rate vale and
lower rate value.
• NPV1: 1000.012-900= 100.012
• NPV2: 1000- 828.36 = 171.652
• YTM= 4 + = 4.582% semi annually and 9.164%
annually.
 Yield to Call (YTC)
• The rate of return earned on a bond if it is called before its
maturity date.

• N is the number of years until the company can call the

bond;
• call price is the price the company must pay in order to call
the bond (it is often set equal to the par value plus one
year’s interest); and
• kd is the YTC.
• Example: Suppose the 10% 10-year Rs 1,000 bond is
redeemable (callable) in 5 years at a call price of Rs 1,050.
The bond is currently selling for Rs 950.The bond’s yield to
call is 12.17%.
 YTM for a Zero Coupon Bond
• zero coupon bonds refers to bonds that only have the one cash inflow at
maturity.

Where: : present value

: future value (maturity value)
i: interest rate
• Assume a zero coupon bond maturing in 10 years with a
maturity value of $1,000 selling for $311.80 and interest paid
semiannual. Because you are dealing with a zero coupon
bond, there is only the one cash flow from the principal
payment at maturity. Therefore, you simply need to
determine what the discount rate is that will discount $1,000
to equal the current market price of $311.80 in 20 periods (10
years of semiannual payments). The equation is as follows:
 Contd.
• Therefore, you simply need to determine what
the discount rate is that will discount $1,000 to
equal the current market price of $311.80 in 20
periods (10 years of semiannual payments). The
equation is as follows:
• = 311.80 =
• You will see that i = 6 percent, which implies an
annual rate of 12 percent. For future reference,
this yield also is referred to as the 10-year spot
rate, which is the discount rate for a single cash
flow to be received in 10 years.
THANK U VERY MUCH
END OF CHAPTER
END OF COURSE