L04s Bonds

Lecture 4 Question of the Week
From the question of the week for Lecture 3, you consider two possible
investment opportunities: a 10-year Treasury bond and a 7-year, A-rated
corporate bond. Given some information, you can predict yield for
each of these two investments.
Now suppose you decide to invest in the A-rated corporate bond
(hereafter called bond “X”).
QUESTION:
You are considering a 7-year, $1,000 par value bond. Its coupon
rate is 9%, and coupon is paid semiannually. Its yield to maturity
(YTM) is 8.96%.
a) How much should you be willing to pay for the bond today?
b) If you plan to hold the bond for 3 years then sell it, how
much should you sell the bond at the end of year 3,
assuming there is no change in YTM?
By the end of the lecture, you should be able to calculate bond X’s
price at t=0 and t=3.
0
Lecture 4: Bonds and Their Valuation
Learning Objectives
• Calculating the bond prices and discuss what the relationship is
between interest rates and bond prices
• Understand how a bond’s price changes over time as it
approaches maturity.
• Calculate a bond’s yield to maturity
• Understand the component of total return on bonds
• Explain the different types of risks that bond investors and issuers
face
1
AB1201:
Financial Management
Lecture 4: Bonds and Their Valuation
By: Chanika Charoenwong
2
Bonds and their valuation > What is a bond? > Zero coupon bond > Coupon bond > Key features of a bond > LL1 > Bond valuation
> Par, discount and premium bond > LL2 > Calculating yield to maturity > Total return identity > Changes in bond value over time >
Semi-annual coupon bonds > LL3 > Risks of a bond > Interest rate risk > Reinvestment rate risk > Default risk > LL4 > Conclusion
Bonds and Their Valuation
• What is a Bond?
• Key Features of Bonds
• Bond Valuation
• Measuring Yield
• Assessing Risk
3
What is a Bond?
• A long-term debt instrument in

which a borrower agrees to
make payments of principal
and interest, on specific dates, to the holders
of the bond.
• Most basic
− Zero coupon bond
− Coupon bond
4
Zero Coupon Bond (Bond A)
Company MNO will pay the bearer of this

bond certificate:
S$1,000
on August 31, 2022
5
Question
• If you paid $900 for Bond A,
$900
31/8/2018: You Co. MNO
Bond A
Bond A
31/8/2022: You Co. MNO
$1000
• How much return would you earn? (Annual

compounding)
6
What Return would You Earn?
• Time Line:
0 1 2 3 4
I% = ?
-$900 $1000
7
1000  9001  I 
4 In bond
terminology:
Yield = Return
= Interest rate
• Solves the equation for I.
• I = 2.67% << Yield to Maturity
INPUTS 4 -900 0 1000

N I/YR PV PMT FV
OUTPUT 2.67
8
Coupon Bond (Bond B)
Company MNO will pay the bearer of this

bond certificate:
S$1,000, on August 31, 2022
And the following coupons:
$60 $60 $60 $60

31/8/19 31/8/20 31/8/21 31/8/22
9
What is the return for Bond B if you paid

$900 for it?
• Time Line:
0 1 2 3 4
I%= ?
-$900 $60 $60 $60 $1060
10

60 60 60 1000
900      
1  I  1  I 2 1  I 4 1  I 4
• Solves the equation for I using FC

60  1  1000
900  1  4

I  1  I   1  I 4
INPUTS 4 -900 60 1000

N I/YR PV PMT FV
OUTPUT 9.09
11
Key Features of a Bond

• Par value – face amount of Company MNO will pay the
the bond, which is paid at bearer of this bond certificate:
maturity (assume $1,000).
• Maturity date – date S$1,000
the bond must be repaid.
On August 31, 2022
• Yield to maturity (YTM) – nominal rate of return

earned on a bond held until maturity
(also called the “promised yield”).
(e.g. 2.67%, or 9.09%)
12
Key Features of a Bond

• Coupon – amount paid by the
issuer regularly.
• Coupon interest rate – stated
interest rate (generally fixed)
paid by the issuer. Multiply by
par value to get dollar
payment of interest.
• Coupon = Coupon interest rate * Par Value
– E.g. $60 = 6% * $1000
13
What is fixed on a bond certificate and

what is not?
• Fixed on a bond certificate and cannot be
changed:
− Par value
− Coupon interest rate
− Maturity date
− Payment frequency
• Not fixed
− Price of bond
− Yield to maturity
14
Lessons Learnt 1
• Bond is a long-term debt instrument in which a borrower agrees
to make payments of principal and interest, on specific dates, to
the holders of the bond.
• If you purchase a zero coupon bond and hold it until maturity,
you will receive only par value at the maturity date.
• If you purchase a coupon bond and hold it until maturity, you
will receive a regular fixed dollar of coupon payment from t=1
until maturity (N) and the par value at maturity date.
• Coupon payment = coupon rate × par value
• Some features of bonds such as par value, coupon interest rate,
maturity date and payment frequency are fixed on the bond
certificate while price and yield to maturity of bond are not.
15
Bond Valuation
16
The Value of Financial Assets

0 r% 1 2 N
...
Value CF1 CF2 CFN
CF1 CF2 CFN
Value  1
 2
 ... 
(1  r) (1  r) (1  r)N
• Given future CFs you will receive from the asset, if you
pay a high price for the asset at P0, you will get low
return of r% from this investment. But if you want high
return (high r), you are willing to pay low price for the
asset today.
17
The Value of a Bond
0 r% 1 2 N
...
Value CF1 CF2 CFN
CF1 CF2 CFN
Value  1
 2
 ... 
(1  r) (1  r) (1  r)N
• For bonds, CF would be the coupon payments

and payment of par value at maturity
 For bonds, what is r?
18
What is the opportunity cost of debt capital?

• The discount rate (r) is the opportunity cost of debt
capital, and is the rate that could be earned on
alternative investments of equal risk.
− The discount rate is also known as the required rate of return
− Also, it can be referred as yield to maturity
• For annual bonds, the discount rate is given by
Implications: Two annual bonds with the same maturity and same risks must
have the same r!
19
What is the value of a 10-year, 13% annual

coupon bond, if rd = 10%? Assume par =
$1,000.
0 1 2 N
rd=10% ...
VB = ? 130 130 130 + 1,000
$130 $130 $1,000

VB  1
 ...  10

(1.10) (1.10) (1.10)10
VB  $1184.34
20
Using a Financial Calculator to Value

a Bond
• This bond has a $1,000 lump sum (the par value) due
at maturity (t = 10), and annual $130 coupon
payments beginning at t = 1 and continuing through t
= 10, the price of the bond can be found by solving for
the PV of these cash flows.
INPUTS 10 10 130 1000
N I/YR PV PMT FV
OUTPUT -1184.34
21
The same company also has 10-year

bonds outstanding with the same risk but
a 7% annual coupon rate
• Since the risk is the same, the bond has the
same yield to maturity as the previous bond
(10%).
INPUTS 10 10 70 1000
N I/YR PV PMT FV
OUTPUT -815.66
22
The same company also has 10-year

bonds outstanding with the same risk but
a 10% annual coupon rate
• This bond has an annual coupon payment of
$100. Since the risk is the same, the bond has
the same yield to maturity as the previous
bonds (10%).
INPUTS 10 10 100 1000
N I/YR PV PMT FV
OUTPUT -1000
23
Par, Discount, Premium Bond
• If yield = coupon rate, then bond price = par value

 par bond.
• If yield < coupon rate, then bond price > par value
 premium bond. Investors pay higher than par value
because coupon rate is higher than
their required yield.
• If yield > coupon rate, then bond price < par

value  discount bond.
24
Lessons Learnt 2
• If you hold a bond until maturity, the value of bond
is PV of all future coupon payments and par value
at maturity
• The discount rate for bond valuation is the required
rate of return on bonds
– Opportunity cost of debt
– Yield to maturity
• If yield = coupon rate, then bond price = par value.
• If yield < coupon rate, then bond price > par value.
• If yield > coupon rate, then bond price < par value.
25
Measuring Yield
26
What is the YTM on a 10-year, 9% annual

coupon, $1,000 par value bond, selling for $887?
• Must find the rd that solves this model.
INT INT M
VB  1
 ...  N

(1  rd ) (1  rd ) (1  rd )N
90 90 1,000
$887  1
 ...  10

(1  rd ) (1  rd ) (1  rd )10
INPUTS 10 - 887 90 1000
N I/YR PV PMT FV
OUTPUT 10.91
27
What is the YTM on a 10-year, 9% annual

coupon, $1,000 par value bond, selling
for $1,134.20?
• Solving for I/YR, the YTM of this bond is 7.08%.
This bond sells at a premium, because YTM <
coupon rate.
INPUTS 10 -1134.2 90 1000
N I/YR PV PMT FV
OUTPUT 7.08
28
What is fixed on a bond certificate and

what is not?
• Fixed on a bond certificate and cannot be
changed:
− Par value
− Coupon interest rate
− Maturity date
− Payment frequency
• Not fixed
− Price of bond
− Yield to maturity
29
The Total Return Identity

 Expected   Expected 
Expected total return  YTM      
 CY   CGY 
Annual coupon payment

Current yield (CY) 
Price
t
Price  Price
Capital gains yield (CGY)  t 1 t
Price
t
30
An Example on Expected Current

and Capital Gains Yield
• Find the expected current yield and the
expected capital gains yield for a 10-year, 9%
annual coupon bond that sells for $887, and
has a face value of $1,000.
$90
E(CY) 
$887
 0.1015  10.15%
31
Calculating Expected Capital Gains Yield
• Find the bond price in the next year.

− N = 10, PV = -$887, PMT = $90, FV = $1000.
We get I/YR = 10.91%
− N = 9, I/YR = 10.91%, PMT = $90, FV =
$1000. We get PV = -$893.79
893.79  887
E(CGY )   0.7651%
887
32
Calculating Expected Capital Gains

Yield (Another Method)
• YTM = E(Current yield) + E(Capital gains yield)
E(CGY)  YTM  E (CY)

 10.91%  10.15%
 0.76%
• Hence using the YTM identity gives the same
answer.
33
Changes in Bond Value over Time

• What would happen to the value of par,
premium and discount bonds if the required
rate of return, rd, remained at 10%?
VB
1,184
13% coupon rate
1,000 10% coupon rate
816 7% coupon rate

Years
to Maturity
10 5 0
34
Semi-annual Bonds
1. Multiply years by 2: Number of periods = 2N
2. Divide nominal rate by 2: Periodic rate (I/YR) =
rd/2
3. Divide annual coupon by 2: PMT = Annual
coupon/2
INPUTS 2N rd/2 OK Cpn/2 OK
N I/YR PV PMT FV
OUTPUT
35
Lessons Learnt 3
• Unlike the coupon interest rate, which is fixed, the bond’s
yield varies from day to day depending on current market
condition.
• An investor who purchases a bond and hold it until it
matures will receive the YTM that existed on the purchase
date
• Expected total return (YTM) = E(CY) + E(CGY)
• At maturity, the value of any bond (i.e. par, premium and
discount bond) must equal its par value.
• To value semi-annual coupon bond, number of periods is 2N,
coupon is annual coupon/2 and periodic rate is rd/2.
36
Risks of a Bond
• Investment Risk:
– Interest Rate Risk (Price Risk)
– Reinvestment Risk
• Default Risk
37
What is Interest Rate (or Price) Risk?

• Interest rate risk is the concern that rising rd
will cause the value of a bond to fall.
• All else being equal, bonds with longer
maturity have higher interest rate risk.
− Longer maturity bonds are more sensitive to
interest rate changes
Recall: Maturity Risk

Premium (MRP)
38
What is interest rate (or price) risk? Does a 1-

year or 10-year bond have more interest rate
risk?
• Interest rate risk is the concern that rising rd will
cause the value of a bond to fall.
rd 1-year Change 10-year Change
5% $1,048 + 4.8% $1,386 +38.6%
10% $1,000 $1,000
– 4.4% –25.1%
15% 956 749
• The 10-year bond is more sensitive to interest rate

changes, and hence has more interest rate risk.
39
What is Reinvestment Risk?

• Reinvestment risk is the concern that rd will
fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.
• Example: Suppose you just won $500,000

playing the lottery. You intend to invest the
money and live off the interest.
40
Reinvestment Rate Example

• You may invest in either a 10-year bond or a
series of ten 1-year bonds. Both the 10-year
and 1-year bonds currently yield 10%.
• If you choose the 1-year bond strategy:
− After Year 1, you receive $50,000 in income and
have $500,000 to reinvest. But, if 1-year rates fall
to 3%, your annual income would fall to $15,000.
• If you choose the 10-year bond strategy:
− You can lock in a 10% interest rate, and earn
$50,000 in annual income for 10 years.
41
Conclusions about Interest Rate and

Reinvestment Rate Risk
Short-term bonds Long-term bonds
Interest
Low High
rate risk
Reinvestment
High Low
risk
• Conclusion: Nothing is riskless!
42
Default Risk
• If an issuer defaults, investors receive less than
the promised return.
• Influenced by the issuer’s financial strength and
the terms of the bond contract.
• Bond ratings reflect the probability of a bond
issue going into default.
Investment Grade Junk Bonds
Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC C
43
Lessons Learnt 4
• Risks of a bond
– Investment Risk
 Interest Rate Risk (Price Risk)
 Reinvestment Risk
– Default Risk
• All else being equal, bonds with longer maturity

have higher interest rate risk.
• All else being equal, short-term bonds have
higher reinvestment risk.
• Bond ratings reflect the probability of a bond
issue going into default.
44
Where Do We Stand?
• Bond  Instrument to borrow money
• Bond valuation
Coupon Coupon Par Value
VB   ...  
(1  rd )1
(1  rd ) N
(1  rd ) N
− rd = opportunity cost of debt capital = discount rate =
required rate of return = yield to maturity = (capital gains
yield + current yield)  determined by market conditions
− rd = coupon rate unless bond price is at par
• Risks of bonds
− Interest rate risk
− Reinvestment risk
− Default risk
45
Lecture 4 Revisiting Question of the Week
You are considering a 7-year, $1,000 par value bond. Its

coupon rate is 9%, and coupon is paid semiannually. Its YTM
is 8.96%.
a) How much should you be willing to pay for the bond
today?
b) If you plan to hold the bond for 3 years then sell it, how
much should you sell the bond at the end of year 3,
assuming there is no change in YTM?
46
a) How much should you be willing to pay for the

bond today?
47
b) If you plan to hold the bond for 3 years then sell

it, how much should you sell the bond at the
end of year 3, assuming there is no change in
YTM?
48

L04s Bonds

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Lecture 4 Question of the Week

Lecture 4: Bonds and Their Valuation

By: Chanika Charoenwong

Bonds and Their Valuation

• A long-term debt instrument in

Zero Coupon Bond (Bond A)

Company MNO will pay the bearer of this

• How much return would you earn? (Annual

What Return would You Earn?

What Return would You Earn?

INPUTS 4 -900 0 1000

Coupon Bond (Bond B)

Company MNO will pay the bearer of this

$60 $60 $60 $60

What is the return for Bond B if you paid

-$900 $60 $60 $60 $1060

What Return would You Earn?

• Solves the equation for I using FC

INPUTS 4 -900 60 1000

Key Features of a Bond

• Yield to maturity (YTM) – nominal rate of return

Key Features of a Bond

What is fixed on a bond certificate and

The Value of Financial Assets

The Value of a Bond

• For bonds, CF would be the coupon payments

What is the opportunity cost of debt capital?

What is the value of a 10-year, 13% annual

VB = ? 130 130 130 + 1,000

$130 $130 $1,000

Using a Financial Calculator to Value

INPUTS 10 10 130 1000

The same company also has 10-year

The same company also has 10-year

INPUTS 10 10 100 1000

Par, Discount, Premium Bond

• If yield = coupon rate, then bond price = par value

• If yield > coupon rate, then bond price < par

What is the YTM on a 10-year, 9% annual

INPUTS 10 - 887 90 1000

What is the YTM on a 10-year, 9% annual

INPUTS 10 -1134.2 90 1000

What is fixed on a bond certificate and

The Total Return Identity

Annual coupon payment

An Example on Expected Current

Calculating Expected Capital Gains Yield

• Find the bond price in the next year.

Calculating Expected Capital Gains

E(CGY)  YTM  E (CY)

Changes in Bond Value over Time

1,000 10% coupon rate

816 7% coupon rate

INPUTS 2N rd/2 OK Cpn/2 OK

What is Interest Rate (or Price) Risk?

Recall: Maturity Risk

What is interest rate (or price) risk? Does a 1-

• The 10-year bond is more sensitive to interest rate

What is Reinvestment Risk?

• Example: Suppose you just won $500,000

Reinvestment Rate Example

Conclusions about Interest Rate and