BOND VALUATION

What is a Bond?
• A bond is a debt instrument that provides a periodic stream of interest payments to investors
while repaying the principal sum on a specified maturity date.
• A bond’s terms and conditions are contained in a legal contract between the buyer and the
seller, known as the indenture.
• Different types of bonds offer investors different options. For example, there are bonds that
can be redeemed prior to their specified maturity date, and bonds that can be exchanged for
shares of a company.

Key Bond Characteristics

Each bond can be characterized by several factors. These include:
• Face Value
• Coupon Rate
• Coupon
• Maturity
 TYPES OF BONDS
• Corporate Bonds – Issued by Corporations to expand or finance a project, usually taxable and
offer higher returns.
• Government Bonds – Treasury bonds carry the lowest degree of risk and are the benchmark
against which all other types of bonds are measured. Although their market values fluctuate,
they are considered the safest.
• Municipal Bonds – Issued by the local government usually to finance specific projects.
• Other terminologies – Agency bonds, Collateralized bonds, Commercial papers, Convertible
bonds, Covenant bonds, Credit Rating, Debentures

What is Bond Valuation?

• 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.

• Because a bond's par value and interest payments are fixed, an investor uses bond valuation to
determine what rate of return is required for a bond investment to be worthwhile.
 BOND TERMINOLOGIES

a) Face/Par Value
The face value (also known as the par value) of a bond is the price at which the bond is sold to investors when first issued; it
is also the price at which the bond is redeemed at maturity. In the U.S., the face value is usually $1,000 or a multiple of
$1,000.

b) Coupon Rate
The periodic interest payments promised to bond holders are computed as a fixed percentage of the bond’s face value; this
percentage is known as the coupon rate.

c) Coupon
A bond’s coupon is the dollar value of the periodic interest payment promised to bondholders; this equals the coupon rate
times the face value of the bond.

For example, if a bond issuer promises to pay an annual coupon rate of 5% to bond holders and the face value of the bond
is $1,000, the bond holders are being promised a coupon payment of (0.05)($1,000) = $50 per year.

d) Maturity
A bond’s maturity is the length of time until the principal is scheduled to be repaid. Occasionally a bond is issued with a
much longer maturity. There have also been a few instances of bonds with an infinite maturity; these bonds are known
as consols. With a consol, interest is paid forever, but the principal is never repaid.
 BOND TERMINOLOGIES

h) zero-coupon bonds
A zero-coupon bond is a bond that makes no periodic interest payments and is sold at a deep discount from face value. The
buyer of the bond receives a return by the gradual appreciation of the security, which is redeemed at face value on a
specified maturity date.
j) The yield
This is the discount rate of the cash flows. Therefore, a bond's price reflects the value of the yield left within the bond. The
higher the coupon total remaining, the higher the price. A bond with a yield of 2% likely has a lower price than a bond
yielding 5%. The term of the bond further influences these effects.
 Bond Valuation in Practice
• Like a stock, the value of a bond determines whether it is a suitable investment for a
portfolio and hence, is an integral step in bond investing.

• Bond valuation, in effect, is calculating the present value of a bond’s expected future
payment(s). The theoretical fair value of a bond is calculated by discounting the
present value of its coupon payments by an appropriate discount rate.
 Valuating A Bond
A bond’s price equals the present value of its expected future cash flows. The rate of interest used to discount the bond’s
cash flows is known as the yield to maturity (YTM.)

a) Pricing Coupon Bonds

A coupon-bearing bond may be priced with the following formula:
where:
C = the periodic coupon payment
y = the yield to maturity (YTM)
F = the bond’s par or face value
t = time
T = the number of periods until the bond’s maturity date

Example:
Suppose that a bond has a face value of $1,000, a coupon rate of 4% and a maturity of four years. The bond makes annual
coupon payments. If the yield to maturity is 5%, the bond’s price is determined as follows:
 Valuating A Bond
b) Pricing Zero Coupon Bonds
A zero-coupon bond does not make any coupon payments; instead, it is sold to investors at a discount from face value. The
difference between the price paid for the bond and the face value, known as a capital gain, is the return to the investor.

The pricing formula for a zero coupon bond is:

Example:
Suppose that a one-year zero-coupon bond is issued with a face value of $1,000. The discount rate for this bond is 8%.
What is the market price of this bond?

Tips
In order to be consistent with coupon-bearing bonds, where coupons are typically made on a semi-annual basis, the yield
will be divided by 2, and the number of periods will be multiplied by 2:

Solution
Bond Valuation (Example 1)
• If X purchases a 5-year 1000 par value bond being nominal rate of
interest at 7% what should he be willing to pay now to get a required
rate of 8% to purchase the bond if on maturity he will receive the
bond value at par?
• Worked Excel
• Answer:960
Bond Valuation –Class Exercise
• You own a bond that pays Rs12 in annual interest, with a Rs 100 par
value. It matures in 15 years. Your required rate of return is 12% per
annum.
• Calculate Bond Value?
• Answer :100
• Formula
Interest Yield
• Interest Yield
Yield To Maturity
• The Yield To Maturity (YTM) is the measure of a bond’s rate of return
that considers both the interest income and any capital gain or loss.
YTM is the bond’s internal rate of return. It indicates the fully
compounded rate of return promised to an investor who
• buys the bond at prevailing prices, if two assumptions are met:
• • The investor holds the bond to maturity
• • The investor reinvests all the interim cash flows at the YTM rate.
• The Yield to Maturity is also known as redemption yield or coupon
rate of return.
Yield To Maturity (Example 1)
• Calculate the Yield to Maturity of a 5 year bond, paying 6% interest on
the face value of $1,000 and currently selling for $883.40
Yield To Maturity (Example 2)
• Calculate the YTM if the rate of interest on $1,000 par value perpetual
bond is 8% and its price is $800.
• Perpetual bond is a bond with no maturity
Yield to Maturity (Estimate)
• To calculate the approximate yield to maturity, you need to know the
coupon payment, the face value of the bond, the price paid for the
bond and the number of years to maturity. These figures are plugged
into the formula