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1. BOND VALUATION Prepared by HARENDRA SINGH

2. What is a bond? A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. The basic character of these instruments is that they promise to pay a stipulated stream of cash flows. This generally comprise of periodic interest payment over the life of the instrument and principal payment at the time of maturity. Prepared by HARENDRA SINGH

3. Bond markets Primarily traded in the over-the-counter (OTC) market. Most bonds are owned by and traded among large financial institutions. Full information on bond trades in the OTC market is not published, but a representative group of bonds is listed and traded on the bond division of the EXCHANGE. Prepared by HARENDRA SINGH

4. Key Features of a Bond Par value – face amount of the bond, which is paid at maturity (assume Rs.1,000). Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get payment of interest. Maturity date – years until the bond must be repaid. Issue date – when the bond was issued. Yield to maturity - rate of return earned on a bond held until maturity (also called the “promised yield”). Prepared by HARENDRA SINGH

5. Types of bonds Government Bonds Corporate bond/ Debentures Prepared by HARENDRA SINGH

6. Government bonds A debt security issued by a government to support government spending, most often issued in the country's domestic currency. Government debt is money owed by any level of government and is backed by the full faith of the government. Central and state government issue the bonds through the RBI. Also called as G- secs , gilt- edged securities. Prepared by HARENDRA SINGH

7. Corporate Bonds Companies, like the Government, borrow money by issuing bonds called corporate debenture. These are more riskier than the government bonds so interest rate is also high. Prepared by HARENDRA SINGH

8. Types of corporate bonds Straight bonds Plain vanilla bonds Fixed interest over life and principal on maturity Zero coupon bonds- Does not carry any interest rate Issued at discount and redeem at par value Floating rate bonds linked to a benchmark rate such as t- bills Prepared by HARENDRA SINGH

9. Types of corporate bonds Bonds with embedded options Convertible bonds Callable bonds Puttable bonds – Right with investor Commodity- Linked bonds Payoff will depend upon the price of the commodity. Prepared by HARENDRA SINGH

10. Bond Price The value of the bond is equal to the present value of the expected cash flows from it. So in order to determine the value of a bond requires: An estimate of expected cash flows An estimate of the expected return. Prepared by HARENDRA SINGH

11. Assumptions The coupon interest rate is fixed for the term of the bond The coupon payments are made every year and the next coupon payment is receivable exactly a year from now. The bond will be redeemed at par on maturity. Prepared by HARENDRA SINGH

12. BOND PRICING (VALUATION) n C M P =  + t =1 (1+ r ) t (1+ r ) n Or C X PVIFA + M X PVIF If interest rate is semi- annually. 2 n C /2 M P =  + t =1 (1+ r /2) t (1+ r /2) 2 n Prepared by HARENDRA SINGH

13. Example A RS.600 FACE VALUE BOND CARRIES A COUPON RATE OF 12 PERCENT P.A. PAYABLE. THE BOND IS REDEEMBALE AT PAR AFTER 5 YEARS. IF INVESTORS REQUIRE A RETURN OF 9% PER ANNUM, WHAT WILL BE THE PRICE OF THE BOND if Interest paid is annually. Interest paid is semi- annually. Prepared by HARENDRA SINGH

14. Price- Yield Relationship A basic property of a bond its price varies inversely with yield. The reason is simple as the required yield increases, the present value of the cash flows decreases; hence the price decreases. Prepared by HARENDRA SINGH

15. PRICE - YIELD RELATIONSHIP PRICE YEILD Prepared by HARENDRA SINGH

16. Bond Yield Bonds are generally traded on the basis of their prices. Current yield Yield to maturity Yield to call Realised yield to maturity. Prepared by HARENDRA SINGH

17. BOND YIELDS • CURRENT YIELD ANNUAL INTEREST PRICE • YIELD TO MATURITY C C C M P = + + …. + (1+ r ) (1+ r ) 2 (1+ r ) n (1+ r ) n 8 90 1,000 800 =  + t =1 (1+ r ) t (1+ r ) 8 AT r = 13% … RHS = 808 AT r = 14% … RHS = 768.1 808 - 800 YTM = 13% + (14% - 13%) = 13.2% 808 - 768.1 C + ( M - P ) / n YTM ≃ 0.4 M + 0.6 P • YIELD TO CALL n* C M * P =  + t =1 (1+ r ) t (1+ r ) n Prepared by HARENDRA SINGH

18. Realised yield to maturity. The YTM calculation assumes that the cash flows received through the life of a bond are reinvested at a rate equal to the YTM. This assumption may not be valid as reinvestment rate applicable to future cash flows may be different. Consider a Rs 1000 par value bond, carrying an interest rate of 15% and maturing after 5 years. The present market price of this bond is Rs 850. The reinvestment rate applicable to the future cash flows of this bond is 16%. Prepared by HARENDRA SINGH

19. REALISED YIELD TO MATURITY FUTURE VALUE OF BENEFITS (1+ r* ) 5 = 2032 / 850 = 2.391 r* = 0.19 OR 19 PERCENT Prepared by HARENDRA SINGH

20. THE YIELD CURVE THE YIELD CURVE., OR THE TERM STRUCTURE OF INTEREST RATES, SHOWS HOW YTM IS RELATED TO TERM TO MATURITY FOR BONDS THAT ARE SIMILAR IN ALL RESPECTS, EXPECTING MATURITY. YIELD CURVE YIELD TO MATURITY (YTM) 14.0 13.0 12.0 1 2 3 4 5 TERM TO MATURITY (YRS) Prepared by HARENDRA SINGH

21. TYPES OF YIELD CURVE YTM A. UPWARD SLOPING YTM B. DOWNWARD SLOPING TERM TERM YTM C. FLAT YTM D. HUMPED TERM TERM Prepared by HARENDRA SINGH

22. RISKS IN BOND INVESTMENT • INTEREST RATE RISK INTEREST BOND (MARKET RISK) RATE PRICE . REINVESTMENT INTEREST RATE ON RISK INTERIM CASH FLOW • DEFAULT RISK ISSUER MAY DEFAULT (CREDIT RISK) • INFLATION RISK PURCHASING POWER RISK • CALL RISK ISSUER MAY RECALL THE BONDS • EXCHANGE RATE RISK A NON-RUPEE DENOMINATED BOND • LIQUIDITY RISK MARKETABILITY RISK Prepared by HARENDRA SINGH

23. Bond Rating WHAT IS IT ? Probability of timely payment of interest & principal by a borrower WHAT IT ‘IS NOT’ ? Not a recommendation Not a general eval’n of the issuing organisation Not a one-time evaluat’n credit risk . . valid entire life HOW IS IT DONE ? Industry & business analysis. Financial analysis Prepared by HARENDRA SINGH

24. India CRISIL ICRA CARE Fitch Ratings Phelps and Duff. Prepared by HARENDRA SINGH

25. FUNCTIONS OF DEBT RATING Provide superior information Offer low-cost information Serve as a basis for a proper risk-return tradeoff. Impose healthy discipline on corporate borrowers. Lend greater credibility to financial and other representations. Facilitate the formulation of public policy guidelines on institutional investment. Prepared by HARENDRA SINGH

26. CREDIT RATING CRISIL’S RATING SYMBOLS AAA : HIGHEST SAFETY AA : HIGH SAFETY A : ADEQUATE SAFETY BBB : LOW SAFETY BB : INADEQUATE SAFETY B : HIGH RISK C : SUBSTANTIAL RISK D : IN DEFAULT KEY FACTORS CONSIDERED IN CREDIT RATING INDUSTRY & BUSINESS ANALYSIS FINANCIAL ANALYSIS • GROWTH RATE & REL’N WITH THE ECONOMY • EARNING POWER • INDUSTRY RISK CHARACTERISTICS • BUSINESS & FINANCIAL RISKS • STRUCTURE OF INDUSTRY & NATURE • ASSET PROTECTION OF COMPETITION • COMPETITIVE POSITION OF THE ISSUER • CASH FLOW ADEQUACY • MANAGERIAL CAPABILITY OF THE ISSUER • FINANCIAL FLEXIBILITY • QUALITY OF ACCOUNTING Prepared by HARENDRA SINGH