Bond Valuation and Analysis (Part 1)

Author(s): Mishtert T

Originally published on Towards AI.

A Baby Step into World of Applied Finance

How to calculate Present Value, Future Value, Time Value of Money — an R Example

Bonds are units of corporate debt issued by companies and securitized as tradeable assets. A fixed-income instrument that traditionally paid a fixed interest rate (coupon) to debtholders (Variable or floating interest rates are also now quite common) — Investopedia

Characteristics of Bond

● Issuer: The entity that borrows the money

● Principal: The amount borrowed(par value or face value)

● Coupon Rate: The amount of interest issuer agrees to pay (Annually, semi-annually, or quarterly U+007C Fixed or floating rate)

● Maturity Date: Date when the principal amount is returned to the investor (Some bonds do not mature)

● Embedded Options:

• Example — callable bond ( Issuer can buyback bond earlier than maturity at a pre-agreed price)
• A more complex analysis required.

In this article, we’ll look at:

● Annual coupons

● Fixed-rate

● Fixed maturity

● No embedded options

Price vs. Value

● Sometimes, the terms “price” and “value” interchangeably, but there are distinctions:

• Price: Amount paid to acquire an asset
• Value: How much the asset is worth

● For actively traded assets, the price may be considered the best estimate of value

Time Value of Money (TVM)

● $1 today is worth more than $1 tomorrow

● Suppose you won $1,000 in a game, what would you choose?

• Receive the $1,000 today?
• Receive the $1,000 one year from now?

Future Value

● The future value is the value of an invested price at some point in the future

● Future value (fv) of one and two years from now can be calculated as:

fv1 <- pv * (1+r)
fv2 <- pv * (1+r) * (1+r)
*** r is interest rate
*** pv is present value

Present Value

● Reverse logic of future values

● The value of $1 in the future is worth less today

● So you will be willing to take less than $1 today instead of waiting to receive $1 one or two years from now

● This can be calculated as follows:

pv <- fv1 / (1 + r)
pv <- fv2 / ((1 + r) * (1 + r))
***fv1 is future value calculated for one year from above
***fv2 is future value calculated for two years from above

TVM Applied To Bonds

● We can apply this Time Value of Money concept to bonds

● Example:

• $100 par value, 5% coupon rate (= $5), 5 years to maturity
• Price = $100 today

Should you buy this bond?

To determine the value of the bond, we can show the cash inflow and cash outflow over time graphically.

Let’s assume today is the year ‘zero’ in which you’ll pay $100 to purchase the bond shown as CF Out in below table,

You’ll receive $5 year one through year four. In year 5 you’ll get the last coupon payment + $100 principal payment. After that, the bond matures and is no longer outstanding.

To know if it’s worth giving up $100 today, you’d need to know the present value(pv)of the coupons and principal payments is greater than $100.

To do this, you should take the $5 in year one and calculate it’s present value and do the same for the $5 in year one through year year four

In year five, you’ll calculate the value of the $105.

Comparing Cash Flows

The sum of the present value of those present value is equal to the value of the bond

#Using the above example i.e Bond with 5 year to maturity and has a yield of 6%, which acts as the discount rate.
# Create vector of cash flowscf <- c(5,5,5,5,105) #Create vector with cash flowcf <- data.frame(cf)# Convert to data framecf$t <- as.numeric(rownames(cf)) # Add column tcf$pv_factor <- 1 / (1 + 0.06)^cf$t # Calculate pv_factorcf$pv <- cf$cf * cf$pv_factor # Calculate pvsum(cf$pv)# Calculate the bond price95.78764

If sum of the present value exceed $100, you buy the bond.

Bond Valuation

For this section, we’ll consider a simple bond:

● Fixed Annual Coupon Rate

● Fixed Maturity Date

● No Embedded Options

Value of an Asset

As a matter of economics, the value of any asset is equal to the present value of expected future cash flows.

These cash flows are discounted at the appropriate risk-adjusted discount rate and this is reflected mathematically as below.

Bonds are no different, the first step in calculating the bond value is to layout the cash flows we’re discounting.

Prior to maturity, the bond investor receives coupon payments and at maturity, the bond investor receives the last coupon payment and the par value.

We can modify the above formula to account for how these cash flows are separated from a mechanical point of view.

How do we run this analysis in ‘R’

Creating a Cash Flow Vector

In ‘R’, we can create a cash flow vector (cf) by laying out the cash flows as-is.

cf <- c(c1,c2,c3,c4,c5....)
***last cash flow equals the last coupon rate + principal

Creating a Data Frame

To perform bond valuation, we need to add additional variables to the cash flow vector. To be able to do this, we need to convert our cash flow vector to a data frame.

cf <- data.frame(cf)

Creating Time Index

Because each cash flow occurs at a particular time, we need to add a time index variable. We’ll label this variable ‘t’

The time index is used as the number of periods, in our example ‘years’, that we will discount each of the bond cash flows.

cf$t <- c(1, 2, 3, 4, 5, . . . )

Calculate the Present Value(PV) Factor

Next, we will have to calculate pv factor to discount each bond cash flow.

The discount rate for bonds is called bond yield

cf$pv_factor <- 1 / (1 + y)^cf$t
***y is discount rate

For example, if we have a discount rate of 10%. The pv factor for cash flows received 2 years from now is

pv_factor <- 1 / (1 + .10)^2
pv_factor
[1] 0.8264463

PV of Cash Flows

The penultimate step is to calculate the present value of each of the bonds’ cash flow by multiplying each cash flow by the appropriate pv factor

cf$pv <- cf$cf * cf$pv_factor

Finally, we sum the PV of the cash flows to arrive at the bond’s value.

Creating a Function

Let’s now create a simple function to perform the valuation of many bonds instead of one like we learned above.

Input Generalizations

● p for par value

● r for coupon rate

● ttm for time to maturity

● y for yield

cf <- c(rep(p * r, ttm - 1), p * (1 + r))

●rep(x, y) — repeats y times the value of x

• x = p * r = coupon payment
• y = ttm — 1 = bond’s time to maturity minus one year

●p * (1 + r) = principal + final coupon payment

cf <- data.frame(cf) #Convert to data framecf$t <- as.numeric(rownames(cf))#create time index

• rownames() of “cf” vector is equal to 1, 2, 3, 4, until the “ttm” of bond
• as.numeric() needed to ensure values are read as numbers

cf$pv_factor #Calculate PV Factor
cf$pv <- cf$cf * cf$pv_factor #Calculate PV of each cash flow
sum(cf$pv) #Sum PV to arrive at bond’s value

Now wrapping everything together

bond_price <- function(p, r, ttm, y){
 cf <- c(rep(p * r, ttm - 1), p * (1 + r))
 cf <- data.frame(cf)
 cf$t <- as.numeric(rownames(cf))
 cf$pv_factor <- 1 / (1 + y)^cf$t
 cf$pv <- cf$cf * cf$pv_factor
 sum(cf$pv)
}

Check if the bond_price function gives us a price of $95.79 for the value of a bond with a $100 par value, 5% coupon rate, 5 years to maturity, and 6% yield to maturity.

Join thousands of data leaders on the AI newsletter. Join over 80,000 subscribers and keep up to date with the latest developments in AI. From research to projects and ideas. If you are building an AI startup, an AI-related product, or a service, we invite you to consider becoming a sponsor.

Published via Towards AI