CONTENTS• KEY LEARNINGS• BOND YIELD• BOND VALUATION AND

PRICING• CREDIT RATING• RISKS• YIELD CURVE• MALKEIL’S PROPERTIES

KEY LEARNINGSDebt instruments

Issuers of Bonds

Features of Bonds

Types of Debt Instruments

DEBT INSTRUMENTS• A bond is a debt security, in which the

issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed as maturity.

• Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

ISSUER OF BONDSBonds are generally issued by• Public authorities• Credit institutions• Companies• The most common process of issuing

bonds is through underwriting.

FEATURES OF BOND• Nominal, Principal or Face amount• Issue price• Maturity date• Coupon rate• Indentures and Covenants• Coupon dates• Optionality i.e. callability, putability, call

dates and put dates• Security

Types of Debt Instruments

• Secured and unsecured debentures• Convertible and Non-convertible

debentures• Zero interest fully convertible

debentures• Secured Premium Notes• Callable and Putable Bond

Floating Rate Bonds• Coupon rate of these bonds is tied

to some benchmark• Eg coupon rate =Bank rate +2%• Not popular in India

Deep Discount Bonds• Type of zero interest bond• Non convertible• Redeemed after expiry of specific period at

face value• Return on these bonds is difference between

issue price and maturity value• No coupon rate and no interest during life

of the DDB

Junk Bonds• High risk bonds• High yield bonds• No or low credit rating• Favourable for speculators

Municipal Bonds• Issued by civic authorities of a city• Objective is to raise funds for

development• Tax benefits may or may not be

available• Coupon rate is low• Credit rating of issuing municipiality

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BOND YEILD• Percentage rate of return on the

amount invested.

• Benchmark for evaluating investment instruments.

• It may or may not be same as coupon rate.

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Bond Yield Depends on:-1. PAR VALUE – The principal amount of a

bond. Issue price and Redemption value may be > or < face value.

2. COUPON RATE (Normal yield) – Rate at which fixed annual monetary amount is payable to lender by borrower.

3. MATURITY – Period after expiry of which redemption repayment is made to investor.

4. MARKET PRICE – Return depends on the price paid for debt.

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TYPES OF YIELDBOND YIELD

1. NORMAL YIELD2. CURRENT YIELD3. YIELD TO

MATURITY4. YIELD TO CALL5. REALISED

YIELD

PURPOSE

1. Coupon rate.2. Current year rate of

return.3. Annual rate of return

till maturity.4. Annual rate of return

till call5. Total return over the

holding period

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YIELD TO MATURITY• It is market rate of return on market

rate of interest.• CONDITIONS – 1. Bond is purchased today at current

market price.2. Bond is held by investor till maturity.3. Interest received are reinvested at

YTM itself.4. No interest default by the company.

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• P = Interest * PVAF(YTM,n) + RV * PVF(YTM,n)

P = Market PricePVAF = Present Value Annuity FactorPVF = Present Value FactorYTM = Yield to MaturityN = Life of the Bond in yearsRV = Redemption Value

YIELD TO MATURITY

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BOND PRICING AND

VALUATION

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QUESTION

Investors are generally faced with the question “To invest in a particular

bond or not”

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ANSWER • Compare the security’s market

price with its “value”• The security could be

Over priced

Under priced

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VALUE OF A BOND• The value of a bond is defined as the

sum of the present values of the future interest payments plus the present value of the redemption repayment.

• It is discounted at the required rate of return called the market interest rate

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VALUATION OF A ZERO COUPON BOND

Market price Face value of bond of = bond

Where, r = yield to maturity n = maturity period of the bond

(1+r )n

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VALUATION OF FIXED INTEREST RATE BONDS

Market price = Interest * PVAF(r,n) + RV *PVF (r,n)

Where, RV = Redemption value

CREDIT RATINGS• Each of the agencies assigns its ratings based

on an in-depth analysis of the issuer's financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond.

Credit Risk Moody's Standard and

Poor's FitchPrime Aaa AAA AAA

Excellent Aa AA AA

Upper Medium A A A

Lower Medium Baa BBB BBB

Speculative Ba BB BB

Very Speculative B, Caa B, CCC, CC B, CCC, CC, C

Default Ca, C D DDD, DD, D

Credit Ratings

Debt InstrumentsType Typical Features

Central Government Securities Medium – long term bonds issued by RBI on behalf of GOI.Coupon payment are semi annually

State Government Securities Medium – long term bonds issued by RBI on behalf of state govt.Coupon payment are semi annually

Government – Guaranteed Bonds Medium – long term bonds issued by govt agencies and guaranteed by central or state govt.Coupon payment are semi annually

PSU Medium – long term bonds issued by PSU.51% govt equity stake

Corporate Short - Medium term bonds issued by private companies.Coupon payment are semi annually

Risk Associated with Investing in Bonds

• Interest Rate Risk• The price of the bond will change in the opposite

direction from the change in interest rate. As interest rate rises the bond price decreases and vice versa.

• Reinvestment Income or Reinvestment Risk• The additional income from such reinvestment called

interest on interest, depends on the prevailing interest rate levels at the time of reinvestment.

• Credit Risk

• If the issuer of a bond will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed.

• Inflation Risk

• Purchasing power risk arises because of the variation in the value of cash flow from the security due to inflation.

• Exchange Rate Risk

• Risk associated with the currency value for non-rupee denominated bonds. Eg: US treasury bond

• Liquidity Risk

Trading in bonds is very thin. Risk that the investor may not be able to sell the bond when he wants.

Term Structure Of Interest Rates

• It depicts the relationship between maturity and interest rates.

• Graphical representation known as the YIELD CURVE.

• The curve deals with the YTM and there is an implied assumption that all the interest received will be reinvested at a rate equal to the YTM.

NORMAL YIELD CURVE

YIELD

MATURITY

INVERSE YIELD CURVE

YIELD

MATURITY

YIELD

MATURITY

FLAT YIELD CURVE

YIELD

MATURITY

MALKIEL’S PROPERTIES

REQUIRED RATE OF RETURN (YIELD TO MATURITY)

As interest rate changes , the bond value also changes. The change in bond value due to change in interest rates is known as Interest Rate Risk.

Yield to maturity

Bond value

Coupon Rate, YTM, Bond Value, and Par Value•If YTM =Coupon Rate ,then Bond value = Par Value

•If YTM < Coupon Rate,then Bond value > Par Value

•If YTM > Coupon Rate,then Bond value< Par Value

Bond Valuation and Time to Maturity

• The value of the bond approaches its par value as the time to maturity approaches its maturity date.

•Values of long-term bonds are more sensitive to interest rate variations than the short-term bonds.

BY:-Akanksha AilawadiAkanksha Sawant Akansha Agarwal Akshat Gupta Himanshi SachdevaPawan AgarwalSaahil ThukralTarandeep Singh SethiVaishali Jaiswal