Bond Return and Valuation

Chapter Objectives

To understand the basics of bond To know the concept of bond return and valuation

To learn about the types of bond risk

To understand the bond value theorems To understand the concept of duration and immunisation

Concept of Bond

It is a contract between a borrower and a lender in which the borrower is required to pay a certain amount of interest income to the lender. In general, bonds carry a fixed payment of interest till the maturity date.

The rate of interest is also known as coupon rate.

Types of bond

Treasury notes and bonds are debt securities issued by the Central Government of a country. Treasury notes maturity range up to 10 years, whereas treasury bonds are issued for maturity ranging from 10 years to 30 years. Apart from the central Government, various State Governments and sometimes municipal bodies are also empowered to borrow by issuing bonds. They usually are also backed by guarantees from the respective Government. These bonds may also be issued to finance specific projects (like road, bridge, airports etc.)

Types of bond

Bonds are also issued by large corporate houses for borrowing money from the public for a certain period. These bonds are not exempt from taxes. Zero coupon bonds (also called as deep-discount bonds or discount bonds) refer to bonds which do not pay any interest (or coupons) during the life of the bonds. The bonds are issued at a discount to the face value and the face value is repaid at the maturity. The return to the bondholder is the discount at which the bond is issued, which is the difference between the issue price and the face

Types of bond

Convertible bonds offer a right (but not the obligation) to the bondholder to get the bond converted into predetermined number of equity stock of the issuing company, at certain, pre specified times during its life. In case of callable bonds, the bond issuer holds a call option, which can be exercised after some prespecified period from the date of the issue. The right is exercised if the coupon rate is higher than the prevailing interest rate in the market

Bond Risk

Bonds are considered to be quite safe but they also carry a certain amount of risk. Types of bond risk:

Interest rate risk: The value of bonds changes due to variability of the market interest rates. Default risk: The borrower fails to pay the agreed value of debt instrument on time. Marketability risk: There is difficulty in liquidating the bonds in the market. Callability risk: There is an uncertainty created in the returns of the investor by the issuers right to call the bond any time.

Bond Pricing

The cash inflow for an investor in a bond includes the coupon payments and the payment on maturity (which is the face value) of the bond. Thus the price of the bond should represent the sum total of the discounted value of each of these cash flows (such a total is called the present value of the bond). The discount rate used for valuing the bond is generally higher than the risk-free rate to cover additional risks such as default risk, liquidity risks, etc. Bond Price = PV (Coupons and Face Value)

Bond Pricing

Basic bond valuation model n coupon face value P = ------------ + --------------------t=1 (1+y)t (1+y)n Bond values with semi annual interest As half yearly interest can be reinvested the value of such bonds would be more. 2n (coupon/2) face value P = ------------ + --------------------t=1 (1+y/2)t (1+y/2)2n

Bond Yield Measures

There are several ways of describing a rate of return on bond. Some of them are:

Holding period return The current yield Yield to maturity

Holding Period Return

It is a return in which an investor buys a bond and liquidates it in the market after holding it for a definite period of time. The formula for calculating holding period of return is as follows:
Price gain + Coupon payment Purchase price It can be calculated on a daily, monthly or annual basis.

The Current Yield

It is a measure through which the investors can easily figure out the rate of cash flow on the investments made by them every year. It is calculated as:
Annual Coupon Payment Purchase Price

Yield to Maturity

It is the rate of return earned by an investor who purchases a bond & holds till maturity. The YTM is the discount rate which equals the present value of promised cash flows to current market price/purchase price. The following assumptions are used to calculate yield to maturity:
There should not be any default. The interest payments are reinvested at yield to maturity. The investor has to hold the bond till its maturity. It is calculated as: I + (F-P)/n YTM = ------------------(F + P )/2

Duration of a bond

Duration measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future. The duration of a bond is expressed as a number of years from its purchase date. Thus, the higher the coupon rate of a particular bond, the shorter its duration will be. In other words, the more money coming in now (because of a higher rate), the faster the cost of the bond will be recovered.

Duration of a bond

Duration = t * wt The weights (Wt) associated for each period are the present value of the cash flow at each period as a proportion to the bond price, i.e. PV of cash flow Wt =----------------------------Bond price

Bond Value Theorems

These are evolved on the basis of three factors:

(i) coupon rate (ii) years to maturity (iii) expected rate of return.

The five bond value theorems are as follows:

Theorem 1: If the bonds market price increases then its yield declines and vice versa. Theorem 2: If the bonds yield remains constant over its life, then the discount or premium depends on the maturity period. Theorem 3: If the yield remains constant over its life, the discount and premium on bonds will decline at an increasing rate as its life gets shorter. Theorem 4: A raise in the bonds price for a decline in the bonds yield is greater than the fall in the bonds price for a raise in the yield. Theorem 5: The percentage change in the bonds price owing to change in its yield will be small if the coupon rate is high.

Duration

It measures the time structure and interest rate risk of the bond. The formula for calculating the duration is as follows:
D=
where D

t =1

Pv (C t ) t P0

= Duration

C = Cashflow R = Current yield to maturity T = Number of years Pv(ct) = Present value of the cashflow P0 = Sum of the present value of cashflow

Immunisation

It is a technique that makes a bondholder relatively certain about the promised cash stream. An immunisation can be achieved by reinvesting the coupons in the bonds that offer higher interest rate.

Chapter Summary
By now, you should have:

Understood the basics of bond

Understood the concept of bond return and valuation

Learnt about the types of bond risks

Understood the various bond value theorems

Learnt the concept of immunisation