FINVEST Fundamentals of Bond Valuation Slides

FUNDAMENTALS OF BOND VALUATION
Investment Analysis & Portfolio Management (FINVEST)

K31 & K32 2nd Term AY 2009-2010
Mr. Clive Manuel O. Wee Sit, CTP
Chapter Outline
Bond Definition Typical Issuers of Bonds Types of Bonds as to Place and Currency of Issue Traditional Types of Bonds (as to Timing of Cash Flows, Optionality, and Convertibility) Bond Payment Structures Elements of a Bond Bond Price vs. Yield-to-Maturity General Bond Pricing Formula Bond Formula Adjustments Price Distinctions Holding Period Return
De La Salle University - Manila College of Business and Economics
Bonds
Are capital market instruments
have a maturity of more than 1 year
Typical Issuers of Bonds

Supranationals
i.e. government or government-related issuers; in the Philippines, an example would be PLDT
Are fixed income securities

a contract specifying the timing and amounts of cash flows over time
Multilateral Organizations
e.g. World Bank, Asian Development Bank, etc.
Is a contract of an institution which binds the institution that issued the bond to pay certain amounts of money to the owner of the bond on certain dates.
Private Sector Corporates

e.g. British Petroleum
Banks Municipal Governments

Types of Bonds as to Place and Currency of Issue

Domestic Bonds Foreign Bonds Eurobonds
Domestic Bonds
Issued by a borrower resident in the country and denominated in the local currency Example: Singapore Airlines issues bonds denominated in Singapore Dollars in Singapore.
Foreign Bonds
Issued by a borrower which is nonresident in the country in which the bond is being issued Example: General Electric USA issues a 10-year bond in Singapore Dollars and sells this in Singapore.
Eurobonds
A Eurobond is any bond with a payment currency which differs from the currency of the country in which the bond is issued. Eurobond markets developed as a means of escaping domestic regulations, especially (withholding) tax, and now rival the size of domestic markets. Euro is used in the same sense as Eurodollars. Example: PLDT issues USD-denominated bond in Europe.
Traditional Types of Bonds

Level Coupon or Fixed Rate Bonds
The coupon is a fixed amount paid throughout the bonds tenor. The principal is a bullet payment at maturity.
Bond Payment Structures

Bullet
Bullet repayment of principal means that 100% of the principal is paid at the maturity of the bond.
Variable Coupon or Floating Rate Bonds

The coupon is not a fixed amount (variable). The coupon is normally based on a benchmark PLUS a spread. Floating rate bonds have coupon rates that are reset periodically according to some pre-determined benchmark. The principal is a bullet payment at maturity.
Amortizing
Amortizing principal repayment means that some of the principal is paid prior to maturity.

Zero Coupon Bonds (Zeroes)
A pure discount bond that does not have periodic coupon payments The investor merely receives a bullet payment of its maturity value. Since zero coupon bonds repay the holder only on maturity, the price is substantially below the principal value (sold at a deep discount).

Income Bonds
Bonds whose coupons are dependent on the profitability or income generation of the issuer The coupons are usually non-cumulative.
Callable Bonds
Normally a fixed rate bond with a call option embedded by the issuer This call option involves a price higher than the face/maturity value and a call date which is significantly ahead of its maturity date.

Convertible Bonds
Bonds with a convertibility option embedded by the issuer These bonds are normally convertible to the issuers equity at a stated strike price and number of shares (other issuer assets may also be used). The convertibility date is normally its maturity date.
Elements of a Bond
Bonds are a claim to a set or stream of future cash flows. They have two primary cash flow components:
Face/Par/Redemption/Maturity Value (Principal) Component Periodic Coupon (Interest) Payment Component
The face value (principal) of a bond is the amount that the issuer agrees to repay the bondholder at the maturity date. The periodic amount of interest payment to bondholders during the life of the bond is called the coupon.
Elements of a Bond
The coupon payments represent the interest on the bond and are made at regular intervals. Final interest payment and principal are paid at specific date of maturity (terminal value; final cash flows). The coupon amount divided by the face value is the coupon rate. A bonds price and coupon rate are often expressed as a percentage of the face value.
Sample Bond Table

Issuer: company, state, or country Coupon: fixed interest rate that issuer pays to lender (investor) Maturity Date: date when borrower will pay the lender the face value (principal) back Bid Price: a certain percentage of the bonds face value (100) that someone is willing to pay to receive the entire face value upon maturity Yield: indicates the annual return on the bond until it matures
Bonds
Which would you buy?
FXTN with 5 years to go till maturity earning a semi-annual coupon of 8.50% and trading at 99.05 per 100 face FXTN with 9 years to go till maturity earning a semi-annual coupon of 8.25% and trading at 95.44 per 100 face Both FXTNs have the same issuer (Philippine government) and are denominated in PHP.
Price and Yield to Maturity

How do we obtain the price of a bond? Price of a bond is the sum of the present value of its cash flows
It does not tell us the rate of return of the investment and so it is difficult to compare prices across different bonds.
Comparing prices on bonds may not be so helpful

Different coupons Different maturities

The single discount rate that makes the present value of the cash flows equal to the price of the bond is called the Yield to Maturity (YTM)

A bonds price may be higher or lower than its face value A bonds YTM may or may not be equal to its coupon rate
YTM is market dictated/determined The coupon rate is the periodic rate of interest (as a percentage of face value) paid during the life of the bond and is set during the bonds initial offering/issuance

Price is inversely proportional to Yield.
Price = Face Value if YTM = Coupon Rate Par Price < Face Value if YTM > Coupon Rate Discount Price > Face Value if YTM < Coupon Rate Premium
Price of a Fixed Rate Bond

2 Primary Components: Present Value of the Face Value + Present Value of the Coupons
Present Value of the Face Value

PV ofFV = FV
Present Value of the Coupons

PVofCoupon =
(1 + YTM )N
(1 + YTM )
n =1
Where: FV YTM N
= = =
face value yield to maturity Nth (final) cash flow
Where: C = = YTM = n =
future coupon amount FV x coupon rate yield to maturity nth cash flow until maturity (N)
Price of a Fixed Rate Bond

P = PV of Coupons + PV of Face Value
YTM Example 1 (Par)

4-year 5% bond yielding 5%
Year 1 Cash Flow 5 5 5 105 Discount Factor 1/1.05 = 0.9524 1/(1.05)^2 = 0.9070 1/(1.05)^3 = 0.8638 1/(1.05)^4 = 0.8227 Present Value 4.7619 4.5351 4.3192 86.3838 100.0000 (par bond)
In notation form:
2 3
P=
n =1
(1 + YTM )n (1 + YTM )N
5 5 5 4.7619 100 4.5351 4.3192
FV
4 Total
105
Future Values
86.3838
Present Values
YTM Example 2 (Discount)

Year 1 2 3 4 Total Cash Flow 5 5 5 105 Discount Factor 1/1.06 = 0.9434 1/(1.06)^2 = 0.8900 1/(1.06)^3 = 0.8396 1/(1.06)^4 = 0.7921 Present Value 4.7170 4.4500 4.1981 83.1698 96.5349 (discount bond)
YTM Example 3 (Premium)

Year 1 2 3 4 Total Cash Flow 5 5 5 105 Discount Factor 1/1.04 = 0.9615 1/(1.04)^2 = 0.9246 1/(1.04)^3 = 0.8890 1/(1.04)^4 = 0.8548 Present Value 4.8077 4.6228 4.4450 89.7544 103.6299 (premium bond)
105 5 5 5
105
Future Values
Future Values
4.7170 96.5349
4.4500
4.1981
83.1698
Present Values
4.8077 103.6299
4.6228
4.4450
89.7544
Present Values
Summary of Examples
From the previous slides: Price of the Bond Yield to Maturity 100.0000 5% 96.5349 6% 103.6299 4%
General Bond Pricing Formula

P = PV of Coupons + PV of Face Value In notation form:
P=
n =1
(1 + YTM )
FV (1 + YTM )N
Understanding Yield to Maturity

Yield to Maturity can be understood in different ways:
YTM is the discount rate that equates the present value of the bonds future cash flows to its price. YTM is the expected return to the bond investor YTM is the assumed reinvestment rate of the bonds coupons YTM is the equivalent rate on a deposit of the bonds price for the time to maturity of the bond.
Expected Return
If an investor buys a 5% five-year annual coupon bond yielding 6%, the investor expects to earn a 6% return. Yield is forward looking. Return is backward looking. The return is the single interest rate that equates the final investment proceeds to the future value of the bonds purchase price.
YTM as Assumed Reinvestment Rate

5% coupon 5-year bond yielding 6%; P = 95.787636
Year 1 2 3 4 5 Total Cash Flow 5 5 5 5 105 FV in Five Years 5 x (1.06)^4 5 x (1.06)^3 5 x (1.06)^2 5 x (1.06)^1 = = = = Future Value 6.312384 5.955080 5.618000 5.300000 105.000000 128.185464
Bank Account Deposit Rate

Today Year 1 Year 2 Year 3 Year 4 Year 5 Deposit 95.79 Total 101.53 Total 102.33 Total 103.17 Total 104.06 Total 105 Pay 5 Pay 5 Pay 5 Pay 5 Pay 105 Deposit 96.53 Deposit 97.33 Deposit 98.17 Deposit 99.06
Discounting the FV: 128.1854648/(1.06)^5 = 95.78763 or Compounding the PV: 95.78763 x (1.06)^5 = 128.185464 Yield to Maturity is like a bank deposit rate it is the implied reinvestment rate of all cash-flows.
Using the bank account, we have replicated the cash flows of the bond: YTM is the equivalent rate to depositing the cash price of the bond in a bank account.
Bond Formula Adjustments

The general bond valuation equation works on the assumption of no-transaction costs, pricing during issue/coupon date only, and coupon payments made only once a year. In reality, bonds are not always purchased during the issue/coupon date (secondary market trading exists), nor do they always have coupons that are paid out once a year, nor are they always free from taxes. Because of these apparent realities, the general bond pricing formula must be adjusted to take into account the aforementioned.
Bond Formula Adjustments

For actual application, the general bond valuation formula must be adjusted for:
Accrued Interest Coupon Payment Frequency Pricing on non-repricing dates or non-issue dates Withholding Tax
Coupon Payment Frequency

Refers to the number of times a bonds coupon is to be paid out within a year Coupon Frequency
Annual Semi-annual Quarterly Monthly = = = = 1 2 4 12

How is coupon payment frequency reflected in the general bond pricing formula?
Both the coupon rate and the YTM must be adjusted accordingly to take into account the multiple coupon payment periods per year.

Coupon Rate Adjustment
C = FV CR
Withholding Tax
In the Philippines, all government securities are subject to a 20% final withholding tax on interest income. How is withholding tax reflected in the general bond pricing formula?
Both the coupon rate and the YTM must be expressed net of final withholding tax of 20%
C p

n
YTM Adjustment
YTM 1 + p
Where: p =
coupon payment frequency

Withholding Tax
Coupon Rate Adjustment
C p (0.8)
Pricing on NonRepricing/Non-Issue Dates

The general bond valuation formula assumes the bond is being priced either during issue date or during coupon/repricing dates, which is why the exponents used when discounting the coupons and face value to their respective present values are expressed as whole numbers.
YTM Adjustment
(YTM )(0 . 8 ) 1 + p
n

In reality, it is possible for the bond to have been purchased or sold after issue date or between coupon/repricing dates (secondary market trading of bonds). How is pricing during non-issue/non-coupon dates reflected in the bond pricing formula?
The exponents (which represent the time component during discounting) will have to be changed to fractional exponents to account for the discounting of future cash flows wherein a number of days had already run/accrued.

The Discount Factor would have to be adjusted in the general bond pricing formula as follows:
(YTM )(0 .8 ) 1 + p
Where: YTM p N DSC E = = = = =
N 1 +
DSC E
yield to maturity coupon payment frequency nth cash flow until maturity (N) number of days from settlement date to next coupon date number of days in coupon period
Day-Count Conventions
Valuation of most bonds in the Philippines uses the 30/360 day-count convention.
This simply means that, when counting the DSC, each month is assumed to have 30 days while each year is assumed to have 360 days.
Accrued Interest
Accrued interest, by definition, is the amount of interest that has accrued from the issue/last coupon date up to the settlement date.
Coupon Frequency Annual (p=1) Semi-annual (p=2) Quarterly (p=4) Monthly (p=12)
E 360 180 90 30
Accrued Interest
C p (0.8)( A) AccruedInterest = t
Accrued Interest
The price of a fixed rate bond after adjusting for accrued interest may be obtained through the following: Present Value of the Coupons + Present Value of the Face Value Accrued Interest
Where: C = = p = A = t =
future coupon amount FV x coupon rate coupon payment frequency accrued number of days number of days in a coupon period (same as E)
Adjusted Bond Pricing Formula

Allowing for the presence of accrued interest, withholding tax, coupon payment frequency, and pricing during nonissue/non-coupon dates gives us the adjusted bond valuation equation:
P= FV (YTM )(0.8) 1 + p
DSC N 1+ E
Price Distinctions
Clean Price
Also known as the Flat Price or Acquisition Cost of the bond Is equal to the Net Present Value (NPV) of all the bonds expected future cash flows less Accrued Interest Is the basis for the marking-to-market of bonds
+
n =1
C p (0.8) (YTM )(0.8) 1 + p

DSC N 1+ E
C p (0.8)( A) t
Price Per Hundred (PPH)

Is the Clean Price of the bond taken as a percentage of its Face Value and expressed per 100 Face Value
PPH = Clean Pr ice 100 FV
Price Distinctions
Dirty Price
Is the total amount that is to be paid (received) by a buyer (seller) of a bond to (from) the bonds seller (buyer) Is equal to the Net Present Value (NPV) of all the bonds expected future cash flows May be arrived at by adding the Clean Price of the bond to Accrued Interest
Is the basis for secondary market quotations (bid and offer) of bonds
Sources of Return for Bonds

Coupons
Current Income Interest payments made by issuer
Holding Period Return (HPR)

Is the rate of return on an investment based on the actual cash flows received by an investor for the time he/she holds on to a bond
Capital Gains (Losses)

Capital Appreciation (Depreciation) When security matures, is called, or sold
(DP
HPR =
sale
DPpurchase ) + DPpurchase
n n = purchase
sale
Reinvestment Income
Interest earned from reinvesting interim cash flows (interest and/or principal)
Problem 1
What is the price of a 3-year, 11% semiannual bond with face value of PHP500,000.00 if the YTM is 10.75%? Assume that the bond was issued free from transaction costs. Was the bond sold at par, at a premium, or at a discount?
Problem 2
A bank has given you its bid and ask for a 2-year, 11.00% semi-annual bond with a par value of PHP1,000,000.00. Its bid for the bond is 11.25% while its offer is 10.75%. Assuming that the bond is subject to 20% final withholding tax on interest income, what is the price per hundred (PPH) equivalent of its bid and offer quotation for the bond?
Problem 3
What is the price of a 2-year, 10% semiannual bond with par value of PHP750,000.00 if the YTM is 10.50%? If it is sold 1 year later at a YTM of 10.25%, what is the price at sale? Did the investor make money from the sale? What is the investors holding period return (HPR)? For this problem, assume that the bond is subject to 20% final withholding tax on interest income.
Problem 4
On May 30, 2006, an investor purchases a PHP10,000,000.00 par value worth of a Fixed Rate Treasury Note (FXTN) with a coupon rate of 8.50% p.a. and a maturity date of March 3, 2011 at a YTM of 8.75%. Provide the following information: a) Dirty Price of the FXTN; b) Accrued Interest; c) Clean Price of the FXTN.
References
Treasury Certification Program (TCP) Money Market Module Ateneo-BAP Institute of Banking Fixed Income Seminar Notes Fund Managers Association of the Philippines (FMAP) and UBS Investment Bank Lecture Notes Treasury Operations (FIN538M) Lecture Notes Fixed Income Securities Special Topics in Financial Engineering (FIN570M)
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FUNDAMENTALS OF BOND VALUATION

Investment Analysis & Portfolio Management (FINVEST)

De La Salle University - Manila College of Business and Economics

Typical Issuers of Bonds

Are fixed income securities

Private Sector Corporates

Banks Municipal Governments

Types of Bonds as to Place and Currency of Issue

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

Traditional Types of Bonds

Bond Payment Structures

Variable Coupon or Floating Rate Bonds

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

Traditional Types of Bonds

Traditional Types of Bonds

De La Salle University - Manila College of Business and Economics

Traditional Types of Bonds

Sample Bond Table

De La Salle University - Manila College of Business and Economics

Price and Yield to Maturity

Comparing prices on bonds may not be so helpful

Price and Yield to Maturity

Price and Yield to Maturity

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

Price and Yield to Maturity

Price of a Fixed Rate Bond

De La Salle University - Manila College of Business and Economics

Present Value of the Face Value

Present Value of the Coupons

face value yield to maturity Nth (final) cash flow

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

Price of a Fixed Rate Bond

YTM Example 1 (Par)

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

YTM Example 2 (Discount)

YTM Example 3 (Premium)

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

General Bond Pricing Formula

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

Understanding Yield to Maturity

De La Salle University - Manila College of Business and Economics

YTM as Assumed Reinvestment Rate

Bank Account Deposit Rate

Bond Formula Adjustments

Bond Formula Adjustments

De La Salle University - Manila College of Business and Economics

Coupon Payment Frequency

Coupon Payment Frequency

De La Salle University - Manila College of Business and Economics

De La Salle University - Manila College of Business and Economics

Coupon Payment Frequency

coupon payment frequency

De La Salle University - Manila College of Business and Economics

Pricing on NonRepricing/Non-Issue Dates