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Transcript of Bond Valuation
Bond ValuationPresented By: Jignesh Madhura Chetna
Bond ValuationA Bond is a security that pays a stated amount of interest to the invester,period after period, until it is finally retired by the issuing company. A bond has a face value, it almost always has a stated maturity, which is the time when the company is obligated to pay the bondholder the face value of the instrument. Finally, the coupon rate or the nominal annual rate of interest, is stated on the bonds face.
Bond-A long-term debt instrument issued by a corporation or government. Face value- The stated value of an asset. Coupon Rate- The stated rate of interest on a bond, the annual interest payment divided by the bonds face value. Maturity Period-Bonds have a maturity period of 1-10 years, sometimes they have a longer maturity. At the time of maturity the par (face) value plus perhaps a nominal premium is payable to the bond holder.
Strategic role of Bond in Portfolio
Portfolio management can be viewed as a two level process (Macro, Micro). Bonds served as a kind of anchor to the winds of adversity. Bond returns are less than stock returns, bond investment involves less risk. Total risk of a portfolio may be thought of as the individual risk of each investment and its correlation to move relative to each other.
Types of Bonds
Government Securities Treasury Bills Zero Coupon Bonds Junk Bonds
These are debt instruments issued by the RBI on behalf of the Govt of India and are known as G.secs or Gilts, it carries full backing of the central govt and is also known as Sovereign debts. Once issued they can be traded in secondary markets. The major participants are banks and financial institution, mutual funds, insurance co, primary dealers, provident funds, trusts & individuals.
Zero Coupon Bonds
A bond that pays no interest but sells at a deep discount from its face value, it provides compensation to investors in the form of price appreciation.
The rate of interest is high compared to the market, as the rate of interest is high risk is high. No certainty about its redemption payment of the bond. Credit rating is very low.
Bond investment agencies evaluate the quality of bonds and rank them in categories according to relative probability of default. For Investors- Simplifies the task of assessing risk. Rating Agencies- 1) Moodys Investors service. 2) Standard & Poor corp.
How rating is done?
Moodys Investors Services Aaa Best Quality Aa High grade A Higher medium grade Baa Lower medium grade Ba Possess speculative element B Generally lack characteristics of desirable investment
Moodys Investors ServicesCaa Poor standing may be in default Ca Speculative to a high degree, often in default C Lowest grade
Standard & Poors Corp.AAA Highest grade AA High grade A Upper medium grade BBB Medium grade BB Lower medium grade B Speculative CCC-CC Outright speculation C Reserved for income bonds DDD-D In default,with rating indicating relative salvage value
Small issues & those placed privately are generally not rated. Sometimes the 2 agencies differ in their evaluation & classification. The rating is altered only when agencies deem that sufficient charges have occurred.
Pricing of Bond
Clean Price = Face Value + Capital Appreciation Dirty Price = Clean Price + Accrued Interest Eg: 7.46 % 901 2017 is quoted at clean price Rs.112.50,FV Rs.100 Int payment date-28th Aug 2001 Settlement date-11th Jan 2002.
Pricing of Bond (Cont..)
Accured Interest = Rate of int *no.of days since last int payment date/360 =7.46 * 133 / 360 =2.76 Hence Dirty Price = 112.50 + 2.76 = 115.26
The plot of the yield on various debt instrument against the time of maturity is known as yield curve. Under normal circumstancesLonger the maturity-high risk-high return (Government securities/Gilts) Shorter maturity-low risk-low return (Treasury Bills)
Help an investor to make a decision
An investor can make a choice between buying a long-term instrument or buying a short-term instrument and rolling will be at the time of reinvestment.
These are the tools by which the performance of a bond can be evaluated. The commonly emlpoyeed yield measures are : Current Yield, Yield to Maturity, Yield to Call.
The current yield relates the annual dollar coupon interest to the market price. Current Yield = I/P I = Annual Interest P = Current market price
Eg of Current Yield(1)
A bond paying Rs.10 p.a interest currently selling at Rs.80 Current Yield = 10/80=0.125 or 12.5% Conclusion: Current Yield > Rate of coupon That is bond is selling at a discount.
Eg of Current Yield(2)
A bond Paying Rs.10 p.a interest currently selling at Rs.120. Current Yield = 10/120=8.33% Conclusion: Current Yield < Rate of Coupon That is Bond is selling at premium.
Eg of Current Yield(3)
A bond paying Rs.10 p.a interest currently selling at Rs.100. Current Yield = 10/100=10% Conclusion: Current Yield = Rate of Coupon That is Bond selling at Par.
Yield To Maturity
The expected rate of return on a bond if bought at its current market price & held till maturity.
Yield to Call
Redemption before maturity Usually at Premium Yield to call is often compared with Yield to Maturity.