Valuation of Bonds and Shares: What Is A Bond?

7/13/2020
CHAPTER 4 WHAT IS
• Long term debt instrument.
• Fixed income securities.
A BOND? • Bonds are traded on exchanges, some
are traded over the counter (OTC).
VALUATION OF • Bonds issued at par value are traded

in market price, influenced by factors
BONDS AND such as quality of issuer, length of
time until expiration, coupon rate etc.
SHARES
1 2
FEATURES OF A BOND
Bond Values and Yields
• Face Value: this is the par value of the bond.
• Interest rate: it is fixed and known to investors. Mentioned as coupon • Total expected cash flow (discounted) is the combination
rate. This interest is tax deductible. of annual interest payments and principal.
• Maturity: specific time period and repaid on maturity. • 3 categories of bonds:
• Redemption value: the value that bondholder gets on maturity. It may
– Bonds with maturity.
be redeemed at par or premium or discount when traded before
maturity. – Pure discount bond.
• Market value: Traded in stock exchange. It is not necessary that market – Perpetual bond.
value will same as par or redemption value.
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Bond with Maturity

Bond with • Secondly, we will compare the
present value with the bond’s
• Bond with a fixed maturity period and specific interest rate. Maturity market value, to make sound
• The most common type. (Cont.) investment decision.
• Calculation will be the discounted cash flows, which include
annual interest payments and terminal or maturity value. • From investors point of view.
• Firstly, from the investor point of view we will calculate the Bond
• If Overvalued - ?
value (PV) given the required rate of return and bond coupon
rate. • If Undervalued - ?
5 6
Calculation Yield-to-Maturity
• Bond value = Present value of annual interest + Present value of maturity
• If we know the present value and cash flows of a bond, we can find the rate of
value/terminal value
return.
• B0 =∑ + • This required rate of return is the YTM.

• YTM is the measure of a bond’s rate of return that consider both the interest
income and any capital gain or loss.
• Example: Suppose an investor is considering the purchase of a five • The calculation we do for YTM is trial and error basis.
year, 1000 par value bond, bearing a nominal rate of interest of 7%
per annum. The investor’s required rate of return is 8%. What
should he be willing to pay now to purchase the bond if it matures • B0 = ∑ +
at par?
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Example Yield-to-Call
• Suppose market price of a bond is 950 (present value). Face value being • Bond can be redeemed or called before maturity if bought with call
1000, bond will pay interest at 6% per annum for 5 years. What is the bond’s provision.
YTM?
• Concern is to find out the required rate of return for the bond if redeemed
before maturity.
• We will use the trial and error basis. • Therefore, the calculation is same as YTM, only difference is the time period.
• Example: Bond par value is 1000, 10 year tenure, 10% coupon rate, and
callable in 5 years at a call price of 1050. Current price/market price/PV of the
• 950 = + + + +
bond is 950. What is bond’s yield-to-call?
9 10
Calculation Bond and Amortization of Principal

• 950 = + + + + • Here, the bond value is amortized every year.
• Meaning, each year cash outflow will be uneven and includes
• Same trial and error method. (if answer is lower than PV, decrease both the interest and partial repayment of principal.
the rate vice versa) • Each year principal will decline and next year’s interest will be
calculated based on the reduced principal.
• Now, if the bond is redeemed at 1050 on maturity?
• Or, if the bond is redeemed at face value on maturity?
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Example • The government is proposing • B0= + + +

to sell a 5 year bond of BDT Calculation . . .
1000 at 8% coupon rate. The +

. .
bond amount will be
amortized equally over its life. = 261.80 + 230.47 + 202.37 + 177.02 +
If the minimum required rate 154.00
of return is 7%, what is the
bond’s current value? = BDT 1025.66
13 14
Bond values and semi-annual Pure Discount Bonds

interest Payment • Pure discount bond also know as deep-discount bond or zero-interest
• Changes will be made on the time period (n), Interest amount and required bond or zero-coupon bond.
interest rate (k). • They do not carry an explicit rate of interest rather purchased at
∗ / ( ) current price of the bond to get the par value after maturity.
• B0 = ∑ +
/ / • Thus, the difference between the price is the return from investment.
• Example: A 10 year bond of BDT 1000 has an annual rate of interest of 12%.
• Example: company issued a pure discount bond of BDT 1000 face
The interest is paid half-yearly. What is the value of the bond if the required
value for BDT 520 today for a period of 5 years. What will be the rate
rate of return is 16%?
of interest?
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7/13/2020
Perpetual Bonds Some Relationships

• From the name we can understand it is for infinite time period, therefore, no • Bond value decreases if market int. rate/ RRR increases and vice versa.
maturity value.
• Bond value decreases if maturity period increases and vice versa.
• Value of the bond will be the discounted value of the infinite steam of interest flows.
• These relationships have consequences over the market price of the bond. For
example, if the market int. rate goes up (bond coupon rate is unchanged), the
• Example: 10% bond BDT 1000 bond will pay 100 annual interest into perpetuity.
current price of bond will decrease and vice versa. The risk coming from interest
What would be the value of bond if the interest rate/ market yield/ required rate is
15%? rate fluctuation is called the interest rate risk (bond investors are exposed to
this risk)
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
• B0 = = 100/0.15 = BDT 667 • The bond is more sensitive to interest rate risk, if the maturity is longer and vice
𝑲𝒅
versa.
• Bond value will decrease with increasing RRR and vice versa.
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END of part one, BOND
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7/13/2020

VALUATION OF • Bonds issued at par value are traded

Bond with Maturity

• B0 =∑ + • This required rate of return is the YTM.

Calculation Bond and Amortization of Principal

Example • The government is proposing • B0= + + +

1000 at 8% coupon rate. The +

Bond values and semi-annual Pure Discount Bonds

Perpetual Bonds Some Relationships

END of part one, BOND

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