St.

Xavier’s College (Autonomous), Kolkata

BONDS

Name: Ishika Agarwal

Room Number: 31

Roll Number: 37

Subject: Investment Analysis and Portfolio Management

Professor: Mrs. Basuli Dasgupta

Meaning of bond:

Bonds are the most famous type of fixed income security which promises to make a series of
interest payments in fixed amounts and to repay the principal amount at a later date, termed
as maturity date.

Thus, a bond is basically a loan where the holder of the bond is the lender and the issuer of
the bond is the borrower who pays interest in the form of coupons and returns the principal at
maturity. Interest payments are usually done at fixed intervals like semi-annually, annually or
monthly. A bond’s risk depends on the issuer’s creditworthiness.

Types of bond:

 Zero coupon bond – Some bonds pay no interest prior to maturity and are called zero
coupon bonds or pure discount bonds. Such bonds are called pure discount because of
the fact that these bonds are sold at discount to their par value and the interest is all
paid at maturity when bondholders receive the par value. For example: A 10 year, Rs
1000, zero coupon bond yielding 7% would sell at about Rs 500 initially and pay Rs
1000 at maturity.

 Perpetual Bond – Bonds that have no maturity date are called perpetual bonds. They
make periodic interest payments but do not promise to repay the principle amount.
For example: If a perpetual bond pays Rs 5000 per year in perpetuity and the discount
rate is assumed to be 5%, the present value would be : Rs 5000/0.05 = 100,000

 Coupon rated Bonds – Bonds can be divided in two types based on coupon
payments :
1. Floating rated – Some bonds pay periodic interest that depends on a current market
rate of interest.
2. Fixed rated – Fixed rated coupon bonds are divided into 4 types:
i) Plain vanilla bond – It is the simplest form of bond which has fixed coupon
and a defined maturity and it has no additional features. It is also known as
straight bond. For example : A bond with a face value of Rs 1000, 10 years to
 maturity, coupon rate is 8% to be paid annually, therefore the bondholders will
get 8%*1000= Rs 80 every year for ten years.
ii) Non plain vanilla bond – This is a type of bond where the coupon maybe
changed and the redemption of such bonds may be done in different phases.
For example: A bond with Rs 1000 face value and maturity of 10 years may
make coupon payments of Rs 100 for first 5 years and Rs 150 for the next 5
years. The repayment of principle can be Rs 500 after 5 years and another Rs
500 after the next 5 years.
iii) Callable bond – A callable bond gives the issuer the right to redeem all or part
of a bond issue at a specific price if they choose to. For example: Consider a
6% coupon, 20 year bond issued at par value of Rs 100 is callable after 12
years.
iv) Putable bond – A putable bond gives the bondholder the right to sell the bond
back to the issuer at a specified price if they choose to. For example : :
Consider a 8% coupon, 10 year bond issued at par value of Rs 100 is putable
after 6 years.

Yield of a bond:

Bond yield is the return realised by the investor on a bond.

Current yield – The current yield is the annual income from a bond based on it’s
current price. We can calculate it by dividing the annual coupon payment by it’s
current price. Current yield = (coupon/ current price)*100

For example: Consider a perpetual bond with a face value of Rs 1000, 8% coupon rate
and current market price of 850.

Current yield = (80/850)*100 = 9.41%

For a Zero coupon bond, current yield is not sufficient because there’s no coupon

For conventional bond, current yield does not take maturity into consideration, so
calculating current yield is not sufficient.

We need to calculate the Yield to Maturity for such bonds.

Yield to Maturity:

It is the total rate of return anticipated on a bond over a period upto it’s maturity.
Yield to maturity is the discount rate at which the sum of all future cash flows from
the bond is equal to it’s actual market price. It is the Internal Rate of Return (IRR)
earned by an investor.

YTM calculation for different types of bonds :

i) Zero coupon bond –

Consider a bond with a face value of Rs 10000. The maturity of the bond is 10
years and the current market price of the bond is Rs 3500. The YTM of the
bond is as follows:
Present Value(1+r)^n = Face value
Therefore, we solve for ‘r’.
3500(1+r)^10 = 10000
r = 11.069%
ii) Plain vanilla bond-
Consider a bond with Rs 1000 face value, maturity 8 years, coupon rate 8%
per annum and current market price of the bond is Rs 750.
To calculate the YTM of the bond we use the shortcut method;
YTM = [Interest + ( Redemption value – Market Price)/n] / Average of
redemption value and market price
Where, Interest = 8% of 1000= 80
Redemption value = 1000
Market price = 750
N=8
= [80 + (1000-750)/8] / [(1000+750)/2]
= 12.71% approximate
iii) Callable bond –
Suppose there is a Rs 1000 face value bond with coupon 8% p.a with a
maturity of 6 years. The bond’s current market price is Rs 900. The bond is
callable after 4 years at premium of 5%.
To calculate the Yield to call;
 YTC = [I + (RV – MP)/n] / [(RV+MP)/2]
where, I : Interest = 8% of 1000 = 80
RV: Redemption Value = 1000 + 5% of 1000 = 1050
MP: Market Price = 900
N: 4 years
= [80 + (1050-900)/4] / [(1050+900)/2]
= 12.05%

iv) Putable bond –

Suppose there is a Rs 1000 face value bond with coupon 7% p.a with a
maturity of 8 years. The bond’s current market price is Rs 900. The bond is
putable after 5 years at discount of 5%.
To calculate the Yield to put;
YTC = [I + (RV – MP)/n] / [(RV+MP)/2]
where, I : Interest = 7% of 1000 = 70
RV: Redemption Value = 1000 - 5% of 1000 = 950
MP: Market Price = 900
N: 5 years
= [70+(950-900)/5] / [(950+900)/2]
=8.21%

v) Non-plain vanilla bond

Consider a bond with face value Rs1000 with maturity of 6 years. The coupon
structure of the bond is; 10% for 3 years and 5% for next 3 years. The bond’s
current market price is Rs 900. The principle amount of 50% of the face value
i.e., Rs 500 is done after 3 years with a premium of 20% and the other 50% of
the face value i.e., Rs 500 is done at maturity of 6 years again with a premium
of 20%.
Coupon structure: Year 1 – 100, Years 2 – 100, Years 3 – 100, Year 4 – 50,
Year 5 - 50
Redemption of Rs 500 after 3 years at premium of 20% = 500 + 20% of 500=
600
Similarly, redemption of Rs 500 at maturity of 6 years = 600
To calculate YTM, let us first calculate the total income
 Total income = Cash inflows – Cash outflows
= (100+100+100+50+50+50+600+600)- 900
= 1650 – 900
= 750
Average income = 750/6= 125
Average return = (125/900)*100 = 13.89%
Suppose YTM = 14%
Bond price = 100/1.14 + 100/(1.14)^2 + 700/(1.14)^3 + 50/(1.14)^4 +
50/(1.14)^5 + 650/(1.14)^6
= 988.85
Suppose YTM = 13%
Bond price = 100/1.13 + 100/(1.13)^2 + 700/(1.13)^3 + 50/(1.13)^4 +
50/(1.13)^5 + 650/(1.13)^6
= 1022
Therefore, for 1% change in YTM the price changes by Rs 33.15
For change of 1022-1000= Rs. 22
YTM = 22/33.15 = 0.66%
Therefore, YTM = 13% + 0.66% = 13.66%

CONCEPT OF INTRINSIC VALUE AND MARKET PRICE

Intrinsic value - Intrinsic value is the value of a bond perceived by an investor. It is calculated
by discounting all the future cash flows of the bond back to its present value using investor’s
required rate of return. Intrinsic value of a bond is the price of the bond which a rational
investor is willing to pay considering his risk appetite regardless of the prevailing market
price of the bond.

Market price - Market price is the current price of the bond which is determined by
discounting all future cash flows at the market discount rate. It is the price of the bond which
the investor has to pay in order to buy the bond in the market.
Decision Criteria :

 When the intrinsic value of the bond is less than its market price, the bond is
considered to be overpriced and it’s advisable that the investor should not buy the
bond.
 When the intrinsic value of the bond is more than its market price, the bond is
considered to be under priced and it’s advisable that the investor should buy the bond.
 When the intrinsic value of the bond is equal to its market price, the bond is said to be
correctly or fairly priced and it’s advisable that the investor should buy the bond.\

Bond valuation

i) Conventional Bond –
Consider a bond with a face value of Rs 1000. The maturity of the bond is 6 years.
The YTM of the bond is 9%. The redemption value of the bond is 1100. The
coupon rate of the bond is 5% and the current market price of the bond is 800.
The intrinsic value of the bond is as follows:
Intrinsic Value = Present value of future cashflows
= 50*( Pvaf, 9%,6) + 1100*(Pvf, 9%, 6)
= 50*4.4859 + 1100*0.5963
= 880.19
The intrinsic value of the bond is more than the current market price; therefore the
bond is underpriced.
Rs 880.19> Rs 800
Therefore, we should buy the bond.

ii) Zero coupon Bond-

Consider a bond with a face value of Rs 5000. The maturity of the bond is 8 years
and the current market price of the bond is Rs 2350. The YTM of the bond is
10%. The intrinsic value of the bond is as follows:

Intrinsic value= Face value/ (1+r)^n

= 5000/(1+0.1)^8
 = 2332.54
The intrinsic value of the bond is less than the current market price; the bond is
overpriced.
Rs. 2332.54 < Rs. 2350
Therefore, we should not buy the bond.

iii) Perpetual Bond –

Consider a bond with a face value of Rs 1000. The YTM of the bond is 9%. The
coupon rate of the bond is 5% and the current market price of the bond is 500.
The intrinsic value of the bond is as follows:
Intrinsic value = Coupon Amount / r
= 50/.09
= 555.56
The intrinsic value of the bond is more than the current market price; therefore the
bond is underpriced.
Rs555.56 > Rs 500
Therefore, we should buy the bond

iv) Non-plain vanilla Bond -

Consider a bond with a face value of Rs 1000 with a maturity of 8 years and yield
to maturity of 15%. The current market price of the bond of 850. The bond is
redeemable at par. The coupon structure is at 10% for 4 years and 12% for 4
years.
Intrinsic Value = Present value of future cash flows
= 100*(pvaf 15%, 1-4) + 120*(pvaf 15%, 5-8) + 1000*(pvf 15%,8)
= 100*2.855 + 120*1.632 + 1000*0.3269
= 808.24
The intrinsic value of the bond is less than the current market price; the bond is
overpriced.
Rs. 808.24 < Rs. 850
Therefore, we should not buy the bond.