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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.
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.
Putable bond: This can be redeemed prior to maturity at the
initiative of the bondholder.

Comparison of Tata Motor FD & Tata Capital NCD


Tata Motor

Tata Capital

Maturity

1-3 Years

5 Years

Rate of Interest

10%-11% (A)

12% (A)

Minimum
Application
TDS Applicable

Rs.20,000

Rs.10,000

Yes

No

Mode of Issuance

Physical

Demat

Premature
withdrawal

At the discretion of
the company

Secondary market
selling.

Optionable

No

Attached Call/Put
option 36 months/42
months.

Security

Unsecured

Secured

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.

Example
Suppose an Investor is considering the
purchase of a 5 years Rs.1000 per value bond
bearing a coupon rate of 7% p.a. The
investors required rate of return is 8% p.a.
How much he will be willing to pay now to
purchase the bond if the bond redeemed at
par?

Bond Values and Annual Interest


Payments

Bond Values and Semi-annual Interest Payments

Example
A 10-years bond of Rs.1000 carrying a coupon
rate of 12% p.a. The interest is paid semiannually. What is the value of the bond if the
required rate of return is 12%?

Calculation of Bond Return


Current yield: This is the interest received calculated as a
percentage of bonds 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: 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.
It is also less meaningful in the absence of secondary bond
market.

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.

Example
Mr. Ramnath bought some debenture from
Y2K Ltd. The debentures is having a face value
of Rs.500 and carry a coupon of 14 percent.
Interest is payable annually. The debenture
will mature after 5 years. The current market
price of the debenture is Rs.455.
Calculate the YTM.

YTM with Semi-Annual Coupon


Mr. Rakesh bought some bond from Oil India
Ltd. The bond is having a face value of Rs.1000
and carry a coupon of 8 percent. Interest is
payable semi-annually. The bond will mature
after 10 years. The current market price of the
bond is Rs.930.
Calculate the YTM.

Assumptions (YTM):
1. All coupon and interest payment are made on
schedule.
2. The bond held to 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.

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.

Valuation Zero Coupon Bond


A zero coupon bond having a face value of
Rs.2,00,000. The bond will mature after 20
years. If the required rate of return from the
bond is 15%.
Calculate the issue price.