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CHAPTER THREE
VALUATION OF FIXED INCOME SECURITIES (BOND)

INTRODUCTION
You are aware that risk and return go together. If the risk is high returns will also is high, and
low risk followed by low return. There is no conception of risk without at the same time
considering return and vice-versa. In fact risk would be defined in terms of volatility or
variability of return.
There could be various behind investing money by small investors to acquisitions for prestige
and control, an average decision is founded on a buy-sell strategy with the expected holding
period return in the foreground.

It must be noted that all classes of investors are interested in knowing the values of securities i.e.
common stock, preference stock and bonds. They plan to hold them for periods ranging from
short to infinity. Since, the investor belongs to special class of goner buyers and sellers; he
would be influenced in his decision to buy/sell by two sets of values. One his own value and two
the value externally determined by the market and known as price. These are the determinants of
the buy – sell decisions of any goods or services in general. It is important to weigh. The risk
and return, which affect the valuation, process both of the individual investor and the whole
constellations of investors that constitute market.

Hence, the valuation is the key concept for investment decisions. No buy-sell action will take
place without values.

THE GENERAL VALUATION FRAME WORK

Most investors look at price movements in security markets. They perceive opportunities of
capital gains in such movements. All would wish if they could successfully predict them and
ensure gains. Few, however, recognize that value determines price and both change randomly. It
would be useful for an intelligent investor to be aware of this process.

The basic valuations model

Value of a security is a fundamental variable and depends on its promised return, risk and the
discount rate. You may recall the basic understanding of present value concept, with the mention

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of fundamental factors like returns and discount rate. In fact the basic valuation model is none
else than present value procedure. Given a risk adjusted discount rate and the future expected
earnings flow of security in the form of interest, dividend, earnings, or cash flow, you can
always determine the present value of follows.

PV = CF1 __ + CF2 + CF3 + ……. CFn

1+r (1 + r)2 (1 + r)3 (1 + r)n
PV = Present value
CF = Cash flow interest, dividend, earnings per time period up to ‘n’ number
of years
r = Risk adjusted discount rate
VALUATION OF BONDS

A bond is an instrument or acknowledgement issued by a business unit or government the

amount of loan, rate of interest and the terms of loan repayment. In order to value a bond you
must understand the following.

Par value.
value. It is the amount or value stated on the face of the bond. It represent the amount of the
firm borrows and promises to repay at the time of maturity. It can be any denomination.

Coupon Rate of Interest.

Interest. A bond carries a specific interest rate, which is called the coupon rate.
The interest payable to the bondholder is simply par value of bond multiplied by the coupon
rate.

Maturity period. Every bond will have maturity period. On completion of the maturity period
the principal amount has to be repaid as per the agreed terms while issuing such bonds call
provision. Some times bonds may be issued under a provision that the business unit will have an
option to pay back the bond amount before the maturity period. These are known as callable
bonds.

The intrinsic value of a bond is equal to the present value of its expected cash flows. The
coupon interest payments and principal payments are known and the present value is determined
by discounting these future payments from the issuer at an appropriate discount rate or market
yield. The usual present value calculating is made with the help of the following equation.

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n C TV
∑t = 1 (1 + r)t + (1 + r )n
PV =
PV = Present value of the bond today
C = Coupon rate of interest
TV = Terminal value repayable (The par value)
R = Appropriate discount rate or market yield
N = Number of years to maturity

Ex. A 10% bond of Birr 1,000 issued with a maturity of five years at par. The discounted rate
(the market rate of return) of the bond is 10%. The interest is paid annually. What would be the
bond value?
PV = 100 __ + 100__
100__ + 100___
100___ + 100___
100___ + 100+ 1000
(1 + .10) (1 + .10)2 (1 + .10)3 (1 + .10)4 (1 + .10)5
= 100 x .9091 + 100x .8264 + 100 x .7513 + 100x .6830 + 1100 x .620
= 90.91 +| 82.64 + 75.13 + 68.30 + 682.99
=Br 1000

Ex. A bond of Birr 1,000 at 6% is issued at par. The bond had a maturity period of five years. As
of today five more years are left for final repayment at par. The current discount rate is 10
percent. What is the present value?
PV = 60__ + 60___ + 60 __ + 60 60 + 1000
(1 + .10) (1 + .10)2 (1 + .10)3 (1 + .10)4 (1 + .10)5
= 60 x .9091 + 60 x .8264 + 60 x .7513 + 60 x .683 + 1060 x .6209
= 54.55 + 45.08 + 40.98 + 658.15
= 847.35

Relationship between coupon rate, required yield and price.

price.
You are aware that yields change in market place, price of bonds change to reflect the new
required yield. When the required yield on a bond rises above its coupon rate, the bond sells at a
discount. When the required yield on a bond equals its coupon rate, the bond sells at par. When
the required yield on a bond falls below its coupon rate, the bond sells at a premium.

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Current yield:
The current yield relates the annual coupon interest to the market price. It is expressed as
Current yield = Annual Interest
Market Price

Ex. A Birr 1000 Bond issued at 12% at par for a period of ten years. Now the market price of
the bond is Birr 950 what is the current yield of
Current yield = Annual interest
Price
= 120
950
= 0.1263 (12.63 Percent.)

Yield to maturity:
The yield to maturity (YTM) of a bond is the interest rate that makes the present value of the
cash flows receivable from owning the bond equal to the price of the bond. Mathematically, it is
the interest rate (r), which satisfies the equation.

P= C1 + C2__ + C3__ + Cn___ + TV_

(1 + r) (1 + r)2 (1 + r)3 (1 + r)n (1 + r)n
P = Price of the bond
C = Annual interest
M = maturity valu
N = Number of years left to maturity

Any time the calculations of bond required the trial and error method to know the rate of interest
which equates the price of bond.

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Eg.
A bond Birr 1000 is issued at par carrying coupon rate of interest of 9 percent. The bond
matures after 8 years. The bond is currently selling for Birr 800. What is the YTM on this bond?
Given:
800 = 90__
90__ + 1000_
(1 + r)t (1 + r)8
= 90 (PVFAr 8 years) + 1000 (PVFr 8 years)

We have to begin with trial and error base.

Let us begin with discount rate of 12 percent.
= 90 (PVFA 12%, 8 years) + 1000 (PVF12%, 8 years)
= 90 (4.968) + 1000 (0.404)
= 851.0

This is more than Birr 800 so we may have to try higher value of discount rate. Let us take 14
percent.
= 90 (PVFA14 8 years) + 1000 (PVF12 8 years)
= 90 (4.639) + 1000 (0.351)
= 768.1

The value is less than Birr 800, so let us try at 13 percent.

= 90 (PVFA13 8 years) + 1000 (PVF12 8 years)
= 90 (4.800) + 1000 (0.376)
= 808

Therefore, it lies between 13% and 14 percent.

= 13% + 808 – 800_ x 1%
808 – 768.1
= 13 + 8
40
= 13 + .2
13.2%

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BOND RATING
Credit ratings are forward looking opinions about an issuer’s relative creditworthiness. They
provide a common and transparent global language for investors to form a view on and compare
the relative likelihood of whether an issuer may repay its debts on time in full. Credit Ratings
are just one of many inputs that investors and other market participants can consider as part of
their decision-making processes. there are three known assessors of bonds these are standard and
poor’s (S&P), Moody’s and Fitch.

S&P Global Ratings (formerly Standard & Poor's) is an American credit rating agency that
publishes financial research and analysis on creditworthiness. It is one of the "Big Three" credit
rating agencies, along with Moody's and Fitch. S&P Global Ratings assigns credit ratings to
sovereign states, municipalities, and corporations, as well as structured finance products and
asset-backed securities.

Moody's Investors Service is an American credit rating agency, a subsidiary of Moody's

Corporation. It is one of the "Big Three" credit rating agencies, along with S&P Global Ratings
and Fitch. Moody's assigns credit ratings to sovereign states, municipalities, and corporations, as
well as structured finance products and asset-backed securities.

Fitch Ratings is an American credit rating agency, one of the "Big Three" credit rating
agencies, along with Moody's Investors Service and S&P Global Ratings. Fitch Ratings assigns
credit ratings to sovereign states, municipalities, and corporations, as well as structured finance
products and asset-backed securities.

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Characterization of Rating
bond and issuer S&P Moody's Fitch
Highest quality AAA Aaa AAA
AA+ Aa1 AA+
High Quality AA Aa2 AA
AA- Aa3 AA-

Strong payment capacity A+ A1 A+

A A2 A
A- A3 A-

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Adequate payment capacity BBB+ Baa1 BBB+

BBB Baa2 BBB
BBB- Baa3 BBB-

Likely to fulfill obligations, on BB+ Ba1 BB+

going obligation BB Ba2 BB
BB- Ba3 BB-

High credit risk B+ B1 B+

B B2 B
B- B3 B-

Very high credit risk CCC+ Caa1 CCC+

CCC Caa2 CCC
CCC- Caa3 CCC-

Near default with possibility CC Ca CC

of recovery C

Default SD C DDD
D DD
D

These assessors typically group bond ratings into 2 major categories:

 Investment-grade: refers to bonds rated Baa3/BBB- or better.

 High-yield (also referred to as "non-investment-grade" or "junk" bonds) pertains to
bonds rated Ba1/BB+ and lower.

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