Sri Krishnadevaraya Educational Trust
SIR M. VISVESVARAYA INSTITUTE OF TECHNOLOGY
Bengaluru
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Module-3
Valuation of Securities: Bond – Meaning, features, types,
determinants of interest rates, Bond Valuation, Bond Duration, Bond
Management Strategies.
Preference Shares- Concept, Valuation.
Equity Shares- Concept, Valuation, Dividend Valuation Models, P/E
Ratio valuation model. (Theory & Problems).
Subject Faculty Name & Designation :
Mrs. Ashwini A , Mrs.Vidhyashree M
Assistant Professor
Meaning of Bond
Meaning: Bond is a high security debt instrument issued by large corporates,
government or municipal authorities for funding their project. It is a fixed income
instrument that represents loan made by the borrower from the investor for
specific time period. It represents contract between borrower and investor, where
borrower has to pay fixed rate of interest to the lender at regular time interval for
a pre-determined period of time for the fund raised by him.
The par value of the bond indicates face value of the bond and the
specific rate of interest paid on bond is called as coupon rate of bond. The
coupon rate is paid bi-annually or annually. The bonds have maturity period.
After the end of maturity period, borrower has to pay back the amount borrowed
from lender along with interest which is called as maturity value.
Features of Bond
Face value: Par value of the bond
Market value: The price at which bond is traded in market place
Coupon rate: Interest rate on bond
Tenure: Time period of bond
Maturity date: The redemption date of bond
Maturity value: Redemption value of bond i.e., principle along with interest
Features of Bond
Yield: If, the bond is held till maturity, then the return is termed as yield from
bond. It is calculated by considering face value, interest rate, maturity date and
maturity value of bond.
Tax benefit: The bonds issued by govt. and municipal authorities are tax
exempt. Thus, any income or capital gain earned from such bonds are not
liable to pay tax.
Types of Bond
1. Fixed rate bond: These bonds pay fixed rate of interest consistently till
maturity date. Bondholders can earn predictable and guaranteed return till
maturity regardless of prevailing market condition.
2. Floating rate bond: These bond do not pay fixed rate of return each year. The
rate of return varies depending upon current market condition.
3. Zero coupon bond: These bonds do not pay periodic coupon rate to the
investors during their holding period. These bonds are issued at discount and
repayable at par. Difference between the two is yield to maturity for
bondholders.
4. Perpetual bond: These bonds do not have maturity period. Issuer will not
repay principle amount to the bondholder. But he keeps on paying steady
coupon rate perpetually.
Types of Bond
5. Inflation –linked bond: These are the special debt instruments designed to
curb impact of inflation on face value and coupon rate of bonds. The coupon rates
offered on inflation –linked bonds are usually lower than fixed interest bonds.
6. Convertible bonds: The holders of these bonds have right to convert their
bonds into predefined number of equity shares of the issuing company after
specified time period.
7. Callable bonds: These are high coupon rate paying securities that give the
issuer right to call back the bonds at pre-agreed price and date.
8. Puttable bonds: These bonds give the bondholder right to return their bonds
ask for repayment of principle amount at pre-agreed date before maturity. Since
the benefit is offered for investors, these bonds pay lower return.
Determinants of coupon rate of
bonds
The determinants of coupon rate of bonds are:-
Prevailing interest rate in the market
Yield on bonds
Credit worthiness of issuer.
Prevailing interest rate in the market: Changes in the market interest rate
will have direct effect on the bond price and coupon rate of bonds. If value of
bond is less, then it offers high coupon rate to bondholders than prevailing
interest rate in order to compensate bondholders by assuming additional credit
risk.
If, the value of bond is high, than it offers a coupon rate which
is lower than prevailing interest rate in the market.
Determinants of coupon rate of
bonds
Yield on bonds: It is the total amount of return earned on bond if it is held till
maturity. Bond’s yield is the present value of all cash flows which is
equivalent to principal amount plus coupon rate. If, investor purchases bond at
discount, then yield to maturity will be higher than coupon rate. If, bond is
purchased at premium, then yield to maturity will be lower than coupon rate of
bond.
Credit worthiness of issuer: If company is rated low by top credit rating
agencies, then it must offer coupon rate higher than prevailing interest rate in
the market in order to compensate investors for assuming additional credit
risk. Thus credit worthiness of issuing company will have greater influence on
coupon rate of bonds.
Bond Risk
Various types of bond risk are:-
1. Interest rate risk
2. Default risk
3. Marketability risk
4. Call ability risk
1. Interest rate risk: Variability in the coupon rate of bonds is caused by
changes in market interest rate. There is direct relationship between coupon rate
and market interest rate. If interest rate goes up, then coupon rate also increases
with the reduced bond value and vice versa.
Bond Risk
2. Default risk: It occurs due to failure to pay the agreed value of debt
instrument by issuer in full and on time. Such risk occur due to macro
economic factors or firm specific factors. Default risk will not be there when
bonds issued by govt. or municipal authorities. But such risk will be assumed
by bonds issued by corporate bodies.
3. Marketability risk: Variation in return caused by difficulty in tradability of
bonds without having to make substantial price concession. This risk is
different from market risk as it is firm specific risk. In case of govt. and
municipal authority bond, marketability risk is less as compared to corporate
bonds.
Bond Risk
4. Call-ability risk: Uncertainty in investors return caused by call-ability feature
of bond. Issuer can call the bond with high coupon rate and again raise the fund
with low coupon rate.
Since the bond is called at any time, there is an uncertainty
regarding maturity period of bond. This feature may depress price level of bond
and uncertainty element attached with bond make the investors to ask for higher
yield on bonds.
Present Value / Intrinsic Value of Bond: It is the current value of all future cash
flows of a bond at a specified rate of return for certain time duration. The
discounted value of all future cash flows of a bond is called as present value of
bond.
Current Yield: It is the annual coupon payment received as a percentage of
current market price of bond.
Bond Yield
Yield to Maturity (YTM): It is the rate of return which investor expects to earn
if bond is held till maturity. It is the discount factor which makes present value of
all future cash flows from bond equals to current market price of bond.
Yield to Call (YTC): It is the rate of return which investor earns if, the bond is
called before its maturity period. When company calls back bond before maturity,
the return earned by investor will be comparatively more the return earned at the
time of maturity.
Realized yield to maturity (RYTM) It is the total return earned when investor
sells bond before maturity. In short it is the yield realized by an investor if,
coupon payments is reinvested at a reinvestment rate for future duration.
Bond Pricing / Bond Valuation
Theorems
Value of bond depends upon three major factors namely coupon rate, duration and
yield to maturity. On the basis of this, bond pricing (valuation) theorems have
been classified into 5 categories namely:-
Theorem 1: If, market price of bond increases then yield of that bond
decreases vice-versa: Both market price and yield of a bond are inversely
correlated. If, market price increases, yield decreases. And if, yield increases,
market price decreases.
Theorem 2: If, bonds yield remains same over its life, then discount or
premium of a bond depends upon its maturity period: It means bonds with
short term maturity sells at lower discount rate or at premium. And the bond with
long term maturity sells at high discount rate to keep the yield earned on bond at
same rate.
Bond Pricing / Bond Valuation
Theorems
Theorem 3: If, bonds yield remains constant over its life, then discount or
premium amount will decrease at an increasing rate as its life get shorter.
Theorem 4: Raise in bond price for decline in bond’s yield is greater than fall
in bond price for raise in yield: Bond price increases at a higher rate when yield
declines is comparatively more than yield increases by decline in price for a same
duration.
Theorem 5: Change in bond price will be less for a percentage change in
bond yield if, coupon rate is high: The proportionate change in bond price for a
percentage change in yield is comparatively less when company pays high coupon
rate to its investor.
Convexity of Bond
Meaning: It is a measure of curvature relationship between bond price and bond
yield. There exists a inverse correlation between bond price and yield. Convexity
demonstrates how duration of bond changes as a result of change in yield. Higher
the duration, more sensitive the bond price is to the change in rate of yield.
Y
Price
Yield X
Bond Duration
Meaning: Duration of bond measures time structure of bond and the bonds
interest rate risk. It measures the average time taken until all coupon payments
and principal amount are recovered. Thus, duration of bond is the weighted
average time period to maturity and the weights are being present value all cash
flows in each time period.
Modified duration of bond: It measures change in value of bond in respect to
change in Base Point (BP) (1% = 100 BP) which causes change in yield rate.
Duration and price changes: Price of bond changes according to yield rate
which is called as volatility of bond. Duration analysis helps to find-out change in
bond price as yield to maturity changes and the relationship between duration of
bond and its price volatility as per market interest rate is called as “Percentage
change in bond price if yield changes.”
