Summary. Chapter 6. Bond Valuation

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Egbert Pierce
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1 Summary Chapter 6 Bond Valuation Learning objectives: This chapter will help you understand the important concepts relating to bonds and bond investing including bonds valuation. It will also take you through the basic concepts of valuation of securities. 6.1 Introduction A bond is a debt security, in which the issuer is obliged to pay interest (the coupon) to use and / or to repay the principal at a later date, termed maturity depending on the terms of the bond. A bond or fixed income is like a loan given by the holder of the bond i.e. lender (creditor) to the issuer of the bond i.e. borrower (debtor) who owes the holders a debt. Bonds provide the borrower with external funds to finance long-term investments. Investors are willing to invest in bonds at lower rates as they are backed by assets and a contract.. Issuers of bond earn profits on issuing bonds as it incurs lesser costs in the form of coupon rate in comparison with interest rates on commercial loans.the ratings issued by leading credit rating companies like Crisil, CARE etc involves looking into various sectors that can help the investor understand the risk involved in investing in bonds like the ability of the company to pay back the loan, kind of collateral offered by the company to cover the loan etc.the risks in bond investing include interest rate risk(greater for bonds with longer maturity period), reinvestment risk, default risk, downgrade risk, inflation risk etcbonds can be offered for different rates and maturity periods. Hence it is essential to measure the yields before taking a decision to invest in bonds. Various types of bonds are issued in the bond market and hence it's important to know the differences in each type of bond issuer and what it can do for your portfolio. Bonds issued by governments have the lowest default risk and are backed by the topmost security of the issuer. Corporate bonds are the cheapest source of raising long term funds through debt for Corporates. Bonds are brought through brokers who make their money on the markup on the price unlike stock where commission is paid to the broker. 6.2 Bond Market The bond market is also called the debt market or credit market. It is a financial market in which the participants can issue and trade debt securities. The primary goal of a bond market is to provide a mechanism for a long term funding of public and private expenditures. The issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity date.

2 Indian bond market, consisting of Government and Corporate Bonds is a very liquid market. It has provided healthy and stable returns for year. Primary market: the initial sale of bonds by issuers to large investors or syndicates. Trades in the primary market raise capital for issuing firms. Secondary market: the market in which investors trade with each other after the bonds are issued in the primary market. Trades in the secondary market do not raise any capital for issuing firms. Corporate bonds are traded over the counter markets by large financial institutions like Life Insurance Companies, Mutual Funds, Pension Funds etc. However a representative group of bonds are listed on stock exchange and traded even by individuals and small and medium business enterprises.the bond market has been a huge contributor to the stable growth of the economy by raising funds to support the infrastructural development undertaken by the government and expansion plans of the companies. The different types of bond market in India are as follows: Corporate Bond Market Municipal Bond Market Government and Agency Bond Market Funding Bond Market Mortgage Backed and Collateral Debt Obligation Bond Market 6.3 Bonds Terminology Par Value : Par value for a bond or fixed-income instrument determines its maturity value. Par value is also called the face value of a bond.. The par value represents the amount of money the firm borrows and promises to repay on the maturity date. Maturity Date : Maturity date is the date on which the face value of a bond becomes due and is repaid to the investor and interest payments stop. Bonds can be issue for any maturity date. However most bonds are issued for maturities ranging from 10 to 30 years. The effective maturity of a bond declines each year after it has been issued. Coupon rate: The Coupon rate is the annual interest rate paid on a bond, expressed as a percentage of the face value. A coupon rate is the yield paid by a fixed-income security. The coupon rate is calculated on the bond's face value (or par value), not on the issue price or market value. For example, if you have a 30-year- Rs 3,000 bond with a coupon rate of 10 per cent, you will get Rs 300 every year for 30 years, in spite of a fluctuating bond price in the market. Credit/Default Risk : Credit or default risk is the risk that interest and principal payments due on the bond will not be made on maturity date or as required. 6.4 Types of Bonds Bonds come in many different varieties. While classifying bonds, various factors like issuer, priority, redemption features and coupon rates are considered. Bonds can remain as fixed income instruments or acquire characteristics of floating income instruments.

3 A normal bond instrument has a fixed claim in the form of fixed percentage of interest payment specified at the time of issue. A flexi bond has the characteristics of variable interest which changes as per prevailing economic conditions. LIBOR (London Inter-bank Offer rate) is a popular base rate for flexi debt instruments. In India the Mumbai Inter-bank Offer rate is the most common reference rate for flexi debt instrument. A zero-coupon bond also known as discount bond issues a document at offer prices and does not pay regular interest but repays certain value additions that compensates for the regular income through the duration of debt. A Treasury bond (T-Bond) is a marketable, fixed-interest government debt security with a long term maturity. A government bond is a bond issued by a national government, generally with a promise to pay periodic interest payments and to repay the face value on the maturity date. Government bonds are referred to as sovereign bonds. Many governments issue inflation-indexed bonds, which protect investors against inflation risk by linking both interest payments and maturity payments to a consumer prices index. A junk bond refers to high-yield or noninvestment-grade bonds and have a higher default risk in relation to investment-grade bonds. Exchange-traded funds (ETFs) have gained a wider acceptance as financial instruments. Bond ETF is a type of exchange-traded fund (ETF) that exclusively invests in bonds. Tax-saving bonds enables investors to receive exemption from paying taxes on the interest income as long as you hold the bond or until its period of maturity. Municipal Bonds are issued by local and state governments. Agency Bonds are issued by Government agencies Convertible bonds can be converted into a pre-defined number of stocks as and when required by the investor. A warrant is a call option to buy a stated number of shares but expire at a certain date. Perpetual warrants will never expire. Non-Convertible bonds are just plain bonds having basic features such as coupon rate and redemption on maturity. Protection from default risk bonds contains Sinking fund provisions which compel the issuer to gradually repurchase outstanding bonds. A debentureis like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest 6.5 Bond Ratings Credit ratings, debt ratings or bond ratings are issued to individual companies and to specific classes of individual securities such as preferred stock, corporate bonds and various classes of government

4 bonds.. Bond ratings were assigned since the early 1900 to reflect their possibility of going into default. Bond ratings are based on both qualitative and quantitative factors like ratios, security, subordination, guarantee provisions, systematic repayment through sinking fund, maturity, regulation, stability, antitrust actions, overseas operations, environmental factors, product liability, pension liabilities, accounting policies etc. Bond ratings are important to both companies and investors. Bond rating enables investor to make an investment decision based on default risk where as a good reputation of the company may help it issue bonds at a competitive rate and keep its cost of debt at an lower end. Changes in bond rating affects the ability of the company to borrow long term capital and cost of capital. Credit rating agency provides an opinion relating to future debt repayments by borrowers, help investors facilitate comparative assessment of investment options,provides inputs to the investors to make an investment decision, speaks more about risk of non-payment and is simply mentions the risk associated with such repayment. Securities and Exchange Board of India (SEBI), regulates the rating agencies in the country. Indian credit rating industry mainly comprises of CRISIL, ICRA, CARE, ONICRA, FITCH India, Brickwork Ratings & SMERA. CRISIL is the largest credit rating agency in India, with a market share of greater than 60%. CRISIL's long-term ratings reflect CRISIL's current opinion on the relative safety of timely payment of interest and principal on the rated financial obligations which have an originally contracted maturity of more than one year. A simple alphanumeric symbol is normally used to convey a credit rating. CRISIL assigns credit ratings to debt obligations on three basic scales: the long-term scale, the shortterm scale, and the fixed deposit scale. 6.6 Bond Valuation Valuation of bond is simpler than equity because the expected cash flows are certain. Investopedia defines Bond valuation as a technique for determining the fair value of a particular bond. It further states that Bond valuation includes calculating the present value of the bond's future interest payments, also known as its cash flow, and the bond's value upon maturity, also known as its face value or par value. Wikipedia defines Bond valuation as the determination of the fair price of a bond. It further states that as with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. If the bond includes embedded options, the valuation is more difficult and combines option pricing with discounting. Various approached of Bond valuation: As per basic present value (PV) approach bond's value is equal to the present value of its expected (future) cash flows. The valuation process involves estimating the expected cash flows, determine

5 the interest rates that should be used to discount the cash flows and calculating the present value of the expected cash flows Under Relative Price Approach the bond will be priced relative to a benchmark, usually a government security. Under Arbitrage-free pricing approach a bond is considered to provide multiple cash flows coupon or face and each cash flow is viewed as a zero-coupon instrument maturing on the date it will be received. If the coupons for each individual coupon is not adequately represented by a fixed (deterministic) number then the stochastic calculus approach is employed. 6.7 Bond Yields Yield is referred to the return obtained by the investor on a bond. When the investor buys a bond at par, yield is equal to the interest rate. Yield changes with the price change. When price goes up, yield goes down and vice versa. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. Similarly When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons. Bond Yields can be measured by using the following : (a)coupon yield (b)current Yield (c)yield to maturity (d)yield to call Coupon Yield = Coupon Payment / Face Value Current Yield = Coupon payment / Current Market Price of the Bond The YTM is the discount rate which equals the present value of promised cash flows to the current market price. Yield to call is the yield of a bond or note if you were to buy and hold the security until the call date. The term structure of interest rates, popularly known as Yield Curve, shows how yield to maturity is related to term to maturity for bonds that are similar in all respects, except maturity. Yield curves normally upwards-sloping. Yiled Curve defines the array of discount factors on a collection of default-free pure discount bonds. Liquidity Preference Theory states that the slope of the yield curve is influenced not only by expected interest rate changes, but also by the liquidity premium that investors require on longterm bonds. The Preferred Habitat Theory states that the shape of the yield curve may be

6 influenced by investors who prefer to purchase bonds having a particular maturity regardless of the returns those bonds offer compared to returns available at other maturities. Market Expectation Hypothesis Assumes that various maturities are perfect substitutes of each other. and suggests that the shape of the yield curve depends on market participants' expectations of future interest rates. Macaulay duration is calculated by adding the results of multiplying the present value of each cash flow by the time it is received and dividing by the total price of the security. 6.8 Bond Value Theorems 1.Bond prices move inversely to the change in interest rates. When the required rate of return is greater than the coupon rate the value of the bond is less than its par value. When the required rate of return is less than the coupon rate, the value of the bond is greater than its par price. 2.The sensitivity to changes in the market rates increases at a diminishing rate as the time remaining until the bonds maturity increases. For a given change in interest rates, changes in the bond prices are greater for long term maturities. 3. Bond price volatility is related to its coupon rate. The percentage of change in a bonds price due to change in market interest rate will be smaller of the coupon rate is higher. 4.The bonds price moves inversely proportional to its yield to maturity. 5.The longer the term to maturity, the greater will be the change in price with change in YTM.

The following pages explain some commonly used bond terminology, and provide information on how bond returns are generated.

The following pages explain some commonly used bond terminology, and provide information on how bond returns are generated. 1 2 3 Corporate bonds play an important role in a diversified portfolio. The opportunity to receive regular income streams from corporate bonds can be appealing to investors, and the focus on capital preservation