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Bonds Valuation

Bonds Valuation

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A certificate of debt that is issued by a government or corporate in order to raise money with a promise to pay a specified sum of money at a fixed time in the future and carrying interest at a fixed rate. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity).

To reduce cost of capital To gain the benefit of leverage To effect tax saving To widen the sources of finance To preserve control

Assumptions The bond is held till maturity rather than selling it at a price different from the face value before its maturity expires. All the cash flows, received from coupon payments are reinvested at the same YTM, promised.

The coupon payments are made regularly and the principal in full in scheduled times

Contd.

Po = [C /(1+k)t] + M/(1+k)n

t=1

= C * PVIFA k,n

Where P = value in Rupees N = number of years

+ M * PVIF k,n

M= maturity value t=time period when the payment is received

The current Yield relates to the annual coupon interest to the market price. Annual Interest Price Illustration: Calculate the current yield on the Rs 1000 par value bond whose coupon rate is 10 percent. The current market price of the bond is Rs 1052.1

Current Yield =

The promised compounded rate of return on a bond purchased at the current market price and held till maturity. Or The yield to maturity is the periodic interest rate that equates the present value of the expected future cash flows (both coupons and maturity value) to be received on the bond to the initial investment in the bond, which is its current price.

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.

YTM

Where YTM = yield to maturity C = annual interest payment M = maturity value of the bond P = present price of the bond n= years to maturity

Calculate the YTM of a bond having a face value of $100 and market price of $80 for a period of 8 years. The bond pays a

The promised return on a bond from the present to the date that the bond is likely to be called.

Po = [C /(1+k)t] + M*/(1+k)n

t=1 Where M* = call price (in rupees) n*= number of years until assumed call date.

n*

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.

Valuation of Zero coupon bonds.

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.

Where r* = realized YTM

Consider a bond of Rs 1000/- carrying an interest rate of 15 pa and maturing after five years and the reinvestment rate applicable for the future cash flow is 16 %. Calculate realised yield to maturity .The present market price of the bond is Rs 850

Illustration

A bond having a par value of $10,000 pays interest at a rate of 8 percent. If the reinvestment rate works out to be 10 percent

(1)

(2)

(3) (4)

The market price of a bond will be equal to the par value of the bond, if YTM is equal to coupon rate. If YTM increases above the coupon rate, the market value drops below the face value. Inverse of theorem 2. 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.

Default risk: Arises when company default in paying interest or principal. Interest rate risk: The change in interest rate in the general level of economy. 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.

Duration measures the weighted average maturity of a bonds cash flows on a present value basis. That is, the present values of the cash flows are used as the weights in calculating the weighted average maturity Duration can be defined as number of years needed to fully recover purchase price of a bond, given the present value of its cash flows.

The holding period for which interest rate risk disappears is known as the duration of the bond. 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 will be mentioned regarding YTM or required rate of return; Coupon rate will be taken as the proxy of YTM or RRR for discounting.

Period (1) 1 2 3 4 5

6

1110

0.535

PF of CF PVCF * T (4) 5= 4*1 99.11 99.11 89.32 178.64 80.41 241.23 72.49 289.96 65.23 326.15

593.85 3563.10

The stated YTM is the maximum Possible YTM without considering the default risk. In expected YTM we consider the default risk. Expected YTM Rs.1000 9% Semi annual 10 750 700 11.6% Stated YTM Rs.1000 9% Semi annual 10 750 1000 13.7%

Face Value Coupon Years left for maturity Current Price Redemption YTM

For periodic coupon bonds the duration is less than the term to maturity. The longer the term to maturity of a coupon paying bond, the greater the difference between its duration and term to maturity. For Zero coupon bonds the duration is equal to its term to maturity. For perpetual bonds (1+YTM)/YTM.

The market price of a Rs 1000 par value bond carrying a coupon rate of 14% and maturing after five years is Rs 1050.What is the YTM on this bond. What would be realised yield to maturity if the reinvestment rate is 12%.

A Rs 100 par value bond bears a coupon rate of 14% and matures after five years. Interest is payable semi- annually. Compute the value of the bond if the required rate of return is 16%. PVIFA 16%, 5years=3.274 PVIFA 8%,10years=6.710 PVIF 8%,10years=0.463 PVIF 16%,5 years= 0.476

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

Maturity (yrs) 1 2

100000

100000 100000

13.50

13.50 13.75

3

4 5

100352

99706 99484

13.35

13.60 13.90

Another perspective on the term structure of interest rate is provided by the forward rate i.e. interest rate applicable to bonds in future. From one year treasury bill One year spot rate can be found out as below 88968=100000/1+r1 so r1=0.124

Now consider the two year Govt Security It has two parts Interest of Rs 12750 at the end of year 1 and Rs 112750 receivable at the end of year2. Present value of the first part is 12750/(1+r1)=11343.40 For Present value of the second part we have to discount twice with r1and r2

So the equation will be 99367=12750/1.124+112750/1.124(1+r2) Solving the equation we get r2=0.1289 To get the forward rate for year3 we can set up the equation for value of three year bond.

Identify the bond with desired characteristics and hold it till maturity. These investors do not actively traded with the objective of enhancing return. When a bond is hold till maturity price risk is eliminated. To eliminate the price risk the investor has to choose carefully the quality bond. Therefore this strategy will suits the investors with the objective of minimization of risk with moderate income.

Invest in bonds with several maturity dates instead of a single time horizon. Rating A BBB AA AAA AAA Par Value 10,00,000 10,00,000 10,00,000 10,00,000 10,00,000 Current Semiannual YTM 8% 8.5% 9% 9.5% 9.75% Maturity 2013 2014 2015 2016 2017

Company A B C D E

When interest rates decline, the investor losses on short term securities since the entire redemption amount has to be reinvested at lower rate where as he gains from the long term investment since they remain locked at higher rate. When interest rates increase: vice versa. Thus an evenly distributed portfolio across as maturity ladder offsetting the reinvestment risk. Laddering also ensure better diversification. The downside: More transaction cost & administrative cost comparing to buy-&-hold strategy.

A bond portfolio is formed with the objective of replicating the performance of a selected index. If the investors risk tolerance is low then select an index which includes more Govt. bonds than corporate.

Objective is to build wealth through investment so as to provide money for retirement, higher education of children etc. a. Dedication: Create and maintain bond portfolio that has a cash inflow structure closely matches the cash outflow structure of future liabilities. (i) Pure cash Matching: The cash inflows (coupon & principal) exactly match the required payments for a stream of liabilities. The easiest way to implement this is to purchase zero coupon bonds whose maturity coincide with the time when money would be needed.

Year

1

2 3 4 5

8.50%

11,58,278 9.00%

Year

Liabilities

Bonds

Maturity

Coupon rate

1 2 3 4 5 6 7 8 9 10

10,00,000 10,00,000 15,00,00 20,00,000 25,00,000 30,00,000 35,00,000 40,00,000 45,00,000 50,00,000

A B C D E F G H I J

1 2 3 4 5 6 7 8 9 10

8.00% 8.50% 9.00% 9.50% 10.00% 10.50% 10.75% 11.00% 11.25% 11.50%

10,00,000 10,00,000 15,00,00 20,00,000 25,00,000 30,00,000 35,00,000 40,00,000 45,00,000 50,00,000 0 5,96,000

0 29,800

15,96,000 15,96,000 15,96,000 15,51,000 14,84,500 13,74,500 12,17,000 9,80,500 7,05,500 3,68,000 0 0 5,00,000 7,00,000 11,00,000 15,00,000 22,00,000 25,00,000 30,00,000 32,00,000 15,96,000 5,96,000 22,21,800 12,21,800 33,78,890 18,78,890 42,23,835 22,23,835 49,19,526 24,19,526 54,15,003 24,15,003 59,52,753 24,52,753 60,55,890 20,55,890 58,64,185 13,64,185 50,00,394 394

2

3 4 5 6 7 8 9 10

12,21,800 61,090 18,78,890 93,945 22,23,835 1,11,192 24,19,526 1,20,976 24,15,003 1,20,750 24,52,753 1,22,638 20,55,890 1,02,795 13,64,185 68,209

(i) (ii)

In maturity matching price risk is eliminated but not the reinvestment risk. Using the concept of duration we can immunization the portfolio from changing interest rate. The zero coupon bond is the simple solution to immunization but the difficult part is to find out zero coupon bond whose maturity exactly matches with the duration time. e.g.: Pension plan of ICICI Pru. States that a client Mr. X will receive Rs.10,000 for 15 years. The first payment is likely to be received by him at the end of 6th year. Mr. Y who is managing the fund, wants to immunize this liability by investing in 10 years & 15 years zero coupon bonds whose maturity value is Rs.1000 per bond. If the current interest rate is 8% p.a. you are required to calculate How much money should he invest in each zero coupon bond? How many bonds in each type he should purchase?

Year

PV of CF

N*PVCF

1

2 3 4

5 6

7 8 9

10,000

10,000 10,000 10,000

0.630

0.583 0.54 0.50

6300

5830 5400 5000

37800

40810 43240 45000

10

10,000

0.463

4630

46300

11

10,000

0.429

4290

47190

12 13

14 15

10,000 10,000

10,000 10,000

0.397 0.368

0.340 0.315

3970 3680

3400 3150

4764 47840

47600 47250

16 17

18 19

10,000 10,000

10,000 10,000

0.292 0.270

0.250 0.232

2920 2700

2500 2320

46720 45900

45000 44080

20 Total

10,000

0.215

2150 58,240

43000 6,75,300

Duration= 6,75,300/58,240 = 11.60 years. Present value of deferred payments = Rs.58,240 If W is the weight of 10 years coupon bond in the portfolio 10W +15(1-W) = 11.60 W = 68% So investment in 10years bond is 68% i.e. 0.68 *Rs.58,240 = Rs.39,603 So investment in 15years bond is 32% i.e. 0.32 *Rs.58,240 = Rs.18,637. (ii) Number of bonds: Redemption value of 10 years bond = 39,603*(1.08)10 = Rs.85,500 i.e. 86 bonds. Redemption value of 15 years bond = 18,637*(1.08)15 = Rs.59,119 i.e. 59 bonds

Where t = the time period at which the cash flow is expected to be received n = number of years to maturity Market price = the present value of all the cash inflows Illustration: calculate the duration of a bond using coupon -10 percent, maturity -5 yrs, ytm-10%, par value -Rs1000

I t 1 2 3 4

1100 0.621

When a bond has coupon the duration is less than the term to maturity A bond with a larger coupon will have a shorter duration A bond with no coupon payments will have a duration equal to the term to maturity There is a positive relationship between term to maturity and duration Higher the market yield lower is the duration

The duration concept is used in certain bond management strategies, particularly immunisation.

The strategy of immunising (protecting) a portfolio against interest rate risk is called immunisation. The strategy of immunising a portfolio against interest rate risk by canceling out its two components, price risk and reinvestment risk.

while

If Interest rates go down Reinvestment rates

while

Interest rate risk is broadly composed of two types of risk. Price risk: Price risk arises due to inverse relationship between bond prices and yields. Reinvestment risk: It results from uncertainty about the rate at which future coupon and principal can be reinvested.

Bond A: Purchased for $1000, five year maturity, 7.9% coupon, 7.9% yield to maturity.

Bond B: Purchased for $ 1000, six year maturity, 7.9% coupon, 7.9% yield to maturity, duration 5 years

Calculate the ending wealth for Bond A if the market yields constant return at 7.9%, ending wealth for bond B when market yield declines to 6% in year 3 and ending wealth for Bond B if the market yield decline to 6 % in year 3 for period of 5 years

Theorem I

Bond prices (or the present value of the bond) move inversely to the YTM (i.e. the discount rate used). In other words, if a bonds market price increases, then its yield decreases; and conversely, if a bonds market price decreases then its yield increases.

Illustration: A rupees 1000 par value bond has a life period of 5 yrs. The coupon on the bond is Rs 80. If the required rate of return in 8 percent calculate the present value of the bond. If the required rate of return declines to 7 percent calculate the bond price. If the YTM increases to 10 percent calculate the bond price.

Theorem II

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.

Illustration: A rupees 1000 par value bond has a life period of 5 yrs. The coupon on the bond is Rs 60. If the required rate of return in 9 percent calculate the present value of the bond. Calculate the premium or discount for each of the years till maturity.

Theorem III

A decrease in a bonds yield will raise the bonds price by the amount that is greater in size than the corresponding fall in bonds price that would occur if there were an equal sized increase in the bonds yield.

Illustration: A Rs 1000 par value bond is currently selling at Rs 1000. The coupon rate is 7 percent. Check the validity of the theorem.

Theorem IV

The percentage change in a bonds price owing to a change in its yield will be smaller if its coupon rate is higher.

Illustration: Bond D (Coupon Rate- 9%, life -5 yrs, yield 7%)

Calculate the bond prices of both these bonds if the par value if the par value is 1000 . Check the validity of the theorem by increasing the yield to 8 percent.

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