Chapter 5

Bonds, Bond Valuation, and

Interest Rates

1
 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.

 A bond is a security that obligates the issuer to make specified interest and
principal payments to the holder on specified dates.

 Bonds are sometimes called fixed income securities.

2
 Key Features of a Bond

 Par value or face value – face amount of the bond, which is

paid at maturity (Normally fixed at Rs1,000).

 Coupon interest rate – stated interest rate (generally fixed)

paid by the issuer.

 Maturity date – years until the bond must be repaid.

 Issue date – when the bond was issued.

 Key Features of a Bond
 Yield to maturity (YTM) - rate of return earned
on
a bond held until maturity (also called the
“promised yield”).

 Indenture – Documents containing terms and

conditions of bond issue.

4
 Call Provision
 Most corporate bond contains call provision
 Call provision bond gives the right to issuing
company to call the bonds for redemption.
 Generally issuer must pay bond holders an
amount greater than the par value, if they are
called.
 The additional sum is known as Called Premium

5
 Call Provision
 Call provision is valuable to issuer but potentially
detrimental to investors

 Issuer can refund if int. rates decline. But will not call if
int. rate increase.

 That helps the issuer but hurts the investor.

 Therefore, borrowers are willing to pay more, and lenders

require more, on callable bonds.

6
What’s a sinking fund?
√ Provision to pay off a loan over its life
rather than all at maturity.
√ Issue is retired at an orderly fashion.
√ Similar to amortization on a term loan.
√ Reduces risk to investor.

7
 Classification

Bonds may be classified as

 treasury bonds,

 municipal bonds,

 corporate bonds.
 Types of Bonds within classification

 Pure Discount or Zero-Coupon Bonds (Zeroes)

• Pay no coupons prior to maturity.
• Pay the bond’s face value at maturity.
• Priced at a deep discount.
 Coupon Bonds
• Pay a stated coupon at periodic intervals prior to maturity.
• Pay the bond’s face value at maturity.
 Perpetual Bonds (Consols)
• No maturity date.
• Pay a stated coupon at periodic intervals.
 Types of Bonds
 Self-Amortizing Bonds
 Pay a regular fixed amount each payment period over the life of the bond.
 Principal repaid over time rather than at maturity.
 Debentures –
• unsecured bonds.
 Subordinated debentures –
• unsecured “junior” debt.
 Mortgage bonds –
• secured bonds.
 Junk bonds –
• speculative or below-investment grade bonds; rated BB and below.
Nepal Example Corporate Bond

NEA issued a power bond in 2064 to manage its’ budget deficit as

well as to invest in Middle Marsyangdi HEP, Chameliya HEP and
Kulekhani-III HEP
Par value & number of bonds: Face amount, e.g., Rs.1000. In 2008
(2064), NEA issued:
General public: 1,50,000 bonds @ Rs.1000 = Rs. 150m
Pvt placement: 1,350,000 bonds @ Rs.1000 = Rs.1350m.
Total 1,500,000 bonds @ Rs.1000 = Rs.1500m.
Secured by Chilime equity shares 4.896 m @ Rs.661
Interest (Coupon) rate : 7.75%
Features of Bond
 Senior versus subordinated bonds
 Convertible bonds

 Callable bonds

 Putable bonds

 Sinking funds
 Other types (features) of bonds

 Convertible bond – may be exchanged for common stock

of the firm, at the holder’s option.
 Putable bond – allows holder to sell the bond back to
the company prior to maturity.
 Income bond – pays interest only when income is
earned by the firm.
 Indexed bond – interest rate paid is based upon the rate
of inflation.
 Seniority
 Seniority indicates preference in position over other
lenders and debts are sometimes labeled as senior or
junior to indicate seniority.

 Some debt is subordinated

 The subordinated lenders will be paid off only after the

specified creditors have been compensated.
 However, debt cannot be subordinated to equity.
 Bond markets
 Bond market is bigger in value than stock market.
 Primarily traded in the over-the-counter (OTC) market. But also
listed in exchange.
 This means that there’s no particular place where buying and
selling occur.
 Instead dealers around the country (and around the world) stand
ready to buy and sell and they are connected electronically.
 Bond markets (contd…)
 Because Bond market is almost entirely OTC, it has little
transparency.

 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 NYSE.
 US Treasury
 Largest security market in the world is not NYSE but
U.S. Treasury Market.

 USD 16.1 Trillion

 Most liquid market in the world with average 200B

USD traded in hand daily.

17
 US Treasury

 Treasury Bonds are known as T-Bonds, Treasury Notes are called T-Notes, and
Treasury Bills are T-Bills.
 Treasury Bills are issued in three maturities. Bills with 91-day and 182-day
maturities are auctioned by the Treasury each Monday. 364-day Bills are
auctioned every four weeks on Thursday, 13 times a year.
 U.S. Treasury Notes are issued in two-, three-, five-, and ten-year maturities.

 The two year and five year Notes are auctioned each month, while the three
year Notes are issued quarterly, and ten year Notes are auctioned six times a
year. All Notes pay interest twice a year, and expire at par value.

 Treasury Bonds are usually issued in thirty-year maturities, and pay interest
twice a year.
 History of Bond Market in
Nepal
 First Government Bond issued by NRB in 1964
 Under the company act 1964

 6% interest rate, 5 year maturity

 To collect development expenditure

 Security Exchange Centre (SEC) established in 1976 to

facilitate growth of capital market
 Nepalese context
√ Very few trading in bond market

√ Not considered as lucrative as stock

√ Total Govt. Bond listed at NEPSE is 19 and with 31940M face value

√ Total Corporate bond listed at NEPSE is 14 with 7572M face value

√ Out of total transactions of securities in 2069/70 (20418M), the

bond transaction was only 115.95M which is 0.05%
 Current Status

Source: Annual Report (2012/13) NEPSE

21
 Security Valuation
 In general,

The intrinsic value of an asset = the

present value of the stream of expected
cash flows discounted at an
appropriate required rate of return.
 Bond Valuation (contd…)

 To determine the value of a bond at a particular point in

time, we need to know:
• Number of periods remaining until maturity

• The Face Value of the Bond

• The Coupon (Interest)

• The market interest rate for bond with similar

features.
 Interest rate required in the market on particular bond
type is called the bond’s YIELD.
 Financial Asset Valuation

0 1 2 n
r
...

Value CF1 CF2 CFn

CF1 CF2 CFn

PV = + + ... + .
1+ r 1
1 + r 2
1+ r n
24
  1 
The Bond Pricing
 (1  rEquation
1 -
d)
t 
F
Bond Value  C  
 (1  rd)
t
 rd
 
OR
1 1  F
Bond Value  C   t 

 rd rd(1  rd)  (1  rd)
t
 Example 1
Consider a 10 year, 12 % coupon bond with a par value
of Rs 1000. Let the required yield on this bond is 13%.

The cash flows for this bond are as follows:

• 10 annual coupon payment of Rs 120

• Rs 1000 principal repayment 10 years from now. Using

formula, you will get

 Rs 946.1
 Example
 Suppose the bond was issued 20 years ago and now has 10
years to maturity. What would happen to its value over time if
the required rate of return(rd ) remained at 10%, or at 13%, or
at 7%?

27
 From table
If rd = 7%:
VB= (PVIFA7%,10Yrs)Rs.100 +(PVIF7%,10thyr)Rs.1000
VB = (7.0236 x Rs. 100) + (0.5083 x Rs. 1000)
VB = 702.4 + 508.4 = 1211

If rd = 13%:
VB= (PVIFA13%,10Yrs)Rs.100 +(PVIF13%,10thyr)Rs.1000
VB = (5.4262 x Rs. 100) + (0.2946 x Rs. 1000)
VB = 542.6 + 294.6 = 837

If rd = 10%:
VB= (PVIFA10%,10Yrs)Rs.100 +(PVIF10%,10thyr)Rs.1000
VB = (6.1446 x Rs. 100) + (0.3855 x Rs. 1000)
VB = 614.5 + 385.5 = 1000
Bond Values with Semi-Annual Interest

 1 
1 - (1  r/2) tX2  F
Bond Value  C  
 (1  r/2)
tX2
 r/2
 
 Example 2
What is the market price of a U.S. Treasury bond that has a coupon rate of
9%, a face value of Rs. 1,000 and matures exactly 10 years from today if
the required yield to maturity is 10% compounded semiannually?

0 6 12 18 24 ... 120 Months

45 45 45 45 1045
P  Rs.937.69
 Real world example
Find out the value of NEA power bond.
 We know: face value : Rs.1000

 Coupon rate : 7.75%, payment semiannual

 Maturity : Assume 2 years left (Issued in 2064,

now 2070)
 Current market interest rate (yield) = ?

 What is the value of NEA power bond?

 Exercise
 S’pose our firm decides to issue 20-year bonds with a
par value of Rs.1,000 and annual coupon payments.
The return on other bonds of similar risk is currently
12%, so we decide to offer a 12% coupon interest
rate.

 What would be a fair price for these bonds?

 1000
120 120 120 . . . 120

0 1 2 3 ... 20
Period/Yr = 1
N = 20
r% per year = 12
FV = 1,000
Coupon = 120
Solution:
P = Rs.1,000

Note: If the coupon rate = yield, the bond

will sell for par value.
 Exercise (contd…)
 Suppose interest rates fall immediately after we issue
the bonds. The required return on bonds of similar risk
drops to 10% i.e. Yield falls to
10 %

 What would happen to the bond price?

 Period/Yr = 1
N = 20
r% per Year = 10
Coupon = 120
FV = 1000
Solution:
P = Rs.1,170.27

Note: If the coupon rate > yield, the bond will sell for a premium.
 Exercise (contd…)
 Suppose interest rates rise immediately after we issue
the bonds. The required return on bonds of similar risk
rises to 14%.

 What would happen to the bond price?

 Period/Yr = 1
N = 20
r% per year = 14
Coupon = 120
FV = 1000
Solution:
P = Rs. 867.54

Note: If the coupon rate < yield, the bond will sell for a discount.
 Interest Rate (Price) Risk
 The risk that arises for bond owners from fluctuating
interest rates is called interest rate risk.
 This sensitivity directly depends on two things:
1. The time to maturity

2. The coupon rate.

 All other things being equal, the longer the time to

maturity, the greater the interest rate risk.
 All other things being equal, the lower the coupon rate, the
greater the interest rate risk.
 Interest Rate Risk (contd…)
 Reason that longer-term bonds have greater interest rate
sensitivity:
• A large portion of a bond’s value comes from the
discounting of face value at maturity,
• The PV of this amount isn’t greatly affected by a small
change in interest rates if the amount is to be received in
smaller years to maturity,
• Even a small change in the interest rate, however, once it
is compounded for greater years to maturity, can have a
significant effect on the present value.
 Interest Rate Risk (contd…)
 Reasons that the bonds with lower coupons have
greater interest rate risk:
• Value of the bond depends on the PV of coupons and the
PV of the face value.
• Value of one with the lower coupon is proportionately
more dependent on the discounted value of face value.
• The bond with higher coupon has a larger cash flow early
in its life, so its value is less sensitive to the changes in
the discount rate.
 What is reinvestment rate risk?
 Reinvestment rate risk is the concern that rd will fall, and
future CFs will have to be reinvested at lower rates, hence
reducing income.

EXAMPLE: Suppose you have

Rs. 1,000,000. You
intend to invest the money and
live off the interest.
 Reinvestment rate risk example

 You may invest in either a 10-year bond or a series of ten 1-year

bonds. Both 10-year and 1-year bonds currently yield 10%.

 If you choose the 1-year bond strategy:

• After Year 1, you receive Rs. 100,000 in income and have Rs.
1,000,000 to reinvest. But, if 1-year rates fall to 3%, your
annual income would fall to Rs. 30,000.

 If you choose the 10-year bond strategy:

• You can lock in a 10% interest rate, and Rs. 100,000 annual
income.
 Conclusions about interest rate and reinvestment
rate risk

Short-term AND/OR Long-term AND/OR

High coupon bonds Low coupon bonds

Interest Low High

rate risk

Reinvestment High Low

rate risk

CONCLUSION: Nothing is riskless!

What’s “yield to maturity”?
 YTM is the rate of return earned on a
bond held to maturity. Also called
“promised yield.”
 It assumes the bond will not default.

44
 YTM on a 10-year, 10% annual coupon,
Rs. 1,000 par value bond selling for at
90% of par (900)

0 1 9 10
rd=?
...
100 100 100
PV1 1,000
.
.
.
PV10
PVM
900 Find rd that “works”!
45
 More precise approximate method
Yield to Maturity

FV – MV 1000-900
CI + ------------- 100 + -------------
n 10
YTM = -------------------------- = ----------------------
FV + 2MV 1000+1800
------------ --------------
3 3
= 110/933.33= 11.79 percent.
CI : Coupon interest in rupees.
FV : Face value or maturity value of a bond.
MV : Market value of a bond
n : Maturity period of a bond
OR: Yield to Maturity

 Example: ABC company has 10% coupon bonds on the market

with 10 yrs to maturity which currently sell at 90% par. Find
YTM?
 Yield to Maturity
 To find more precise YTM:
 Trying at 11%
 Vo = Rs. 941 > 900, so
 Trying at 12%
 Vo = Rs. 887 < 900
 Find PV of HR and LR
 Try 11%:
VB = (PVIFAi,n)C +(PVIFi,n)M”
Rs.900=(PVIFA 11%,10yrs) Rs.100 + (PVIF 11%, 10th Yr) Rs.1000
Rs.900 = (5.889) Rs. 100+ (0.352) Rs.1000
Rs.900 = Rs.588.9 + Rs. 352
Rs.900 = Rs. 941
 Try 12%:
Rs.900 = (PVIFA 12%,10yrs) Rs. 100+ (PVIF 12%, 10th Yr) Rs.1000
900 = (5.6502) Rs.100 + Rs.1000(0.322)
900 = 565 + 322
900 = 887 PV of LR - Market value
LR + ---------------------------------------- Diff. in rates
PV of LR - PV of HR
49
Yield to Maturity
 By Interpolation,

 Thus, actually maturity for Rs. 1000. 10% coupon 10

Yrs bond selling at Rs. 900 is 11.76%
 Definitions
Annual coupon pmt
Current yield = Current price

Capital gains yield = Change in price

Beginning price

Exp total Exp Exp cap

= YTM = +
return Curr yld gains yld
51
 10% coupon, 10-year bond, P
= Rs.900, and YTM = 11.76%

Rs.100
Current yield = Rs.900

= 0.11 = 11.11.

52
YTM = Current yield +
Capital gains yield.

Cap gains yield = YTM - Current yield

= 11.76% - 11.11%
= 0.65%.

53
 Yield to Call (YTC)

It refers to the return the investors receive if it is called before maturity period
which is known as the yield to call (YTC) or realised rate of return.

Example: An 8-year, 10 percent annual coupon bond, with a par value of Rs.1,000
is likely to be called in 2 years at a call price of Rs.1,050. The bond sells for
Rs.1080. Assume that the bond has just been issued. What is the bond’s yield to
call?

FV – MV 1050-1080
CI + ------------- 100 + -------------
n 2
YTM = ------------------------ = ------------------------ = 7.9%
FV + 2MV 1050+1080
------------ --------------
3 3
a)Try 7%
VB = (PVIFAi%,n yrs.)C + (PVIFi%, nth yr) Call Price
Rs.1,080=(PVIFA7,2)Rs.100+(PVIF7,2)Rs. 1050
Rs.1,080 = (1.808)100 + (0.8734)1050
Rs.1,080 = 180.8 + 917.1 = 1097.9 or 1098
Try 8%
Rs.1,080=(PVIFA8,2)Rs.100+(PVIF8,2)Rs.1050
Rs.1,080 = (1.7833)100 + (0.8573)1050
Rs.1,080 = 1078 PV of LR - Market value
By interpolation, LR + ---------------------------------------- Diff. in rates
PV of LR - PV of HR
YTC=7+[(1098-1080)x(8-7)/(1098 -1078)] =7.9%.
 Default risk
 If an issuer defaults, investors receive less than the
promised return. Therefore, the expected return on
corporate and municipal bonds is less than the
promised return.

 Influenced by the issuer’s financial strength and the

terms of the bond contract.
 Evaluating default risk:
Bond ratings

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

 Bond ratings are designed to reflect the probability of a bond

issue going into default.
 Bond ratings are an assessment of the creditworthiness of the
bond issuer.
 Bond ratings don’t address the issue of interest rate risk
 Bond Ratings
Moody’s S&P Quality of Issue
Aaa AAA Highest quality. Very small risk of default.

Aa AA High quality. Small risk of default.

A A High-Medium quality. Strong attributes, but potentially

vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially
unreliable.
Ba BB Some speculative element. Long-run prospects
questionable.
B B Able to pay currently, but at risk of default in the future.
Caa CCC Poor quality. Clear danger of default .

Ca CC High specullative quality. May be in default.

C C Lowest rated. Poor prospects of repayment.

D - In default.
 Factors affecting default risk and bond ratings
 Financial performance
 Debt ratio

 TIE ratio

 Current ratio

 Bond contract provisions

 Secured vs. Unsecured debt

 Senior vs. subordinated debt

 Guarantee and sinking fund provisions

 Debt maturity
 Terms of Bond
 Face Value / Par Value / Principal Value
 Corporate bonds are usually in registered form.
 This means that the company has a registrar who will record the
ownership of each bond and changes on ownership.
 For eg, it might read as:
Interest is payable semiannually on July 1 and January 1 of each year to
the person in whose name the bond is registered at the close of
business on June 15 or December 15 respectively.
 A corporate bond may be registered and have attached “coupon”
 Alternatively, the bond could be in bearer form.
 Difficult to recover if they are lost or stolen

 Company cannot notify bondholders of important events.

 Security
 Debt securities are classified according to the collateral and
mortgages used to protect the bondholder.

 Collateral – general term that frequently means securities

(for eg. Bonds and Stocks) that are pledged as security for
payment of debt. However, the term collateral is commonly
used to refer to any asset pledged on a debt.

 Mortgage securities are secured by a mortgage on the real

property of the borrower.

 The property involved is usually real estate.

 Security (contd…)
 The legal document that describes the mortgage is called a mortgage
trust indenture or trust deed.

 A blanket mortgage pledges all the real property owned by the

company.

 A debenture is an unsecured bond, for which no specific pledge of

property is made.

 Debenture holders only have a claim on property that remains after

mortgages and collateral trusts are taken into account.

 Note is an unsecured debt usually with a maturity under 10 years.

 Repayment
 Can be repaid at maturity.
 The may be repaid in part or in entirely before maturity.
 Early repayment in some form is more typical and is often
handled through a sinking fund.
 A sinking fund is an account managed by the bond trustee
for the purpose of repaying the bonds.
 The company makes annual payments to the trustee, who
then uses the funds to retire a portion of debt.
 Other factors affecting default risk
 Earnings stability
 Regulatory environment
 Potential labor problems
 Accounting policies
Want to know more about it ?

Visit:
www.standardandpoors.com
www.moodys.com
www.fitchinv.com
End of session