Bonds and Their Valuation

Key features of bonds

Bond valuation
Measuring yield
Assessing risk
 Key Features of a Bond

1. Par value: Face amount; paid

at maturity. Assume $1,000.

2. Coupon interest rate: Stated

interest rate. Multiply by par
value to get dollars of interest.
Generally fixed.
(More…)
 Key Features of a Bond

3. Maturity: Years until bond

must be repaid. Declines.

4. Issue date: Date when bond

was issued.

5. Default risk: Risk that issuer

will not make interest or
principal payments.
 How does adding a call
provision affect a bond?
• Issuer can refund if rates decline.
That helps the issuer but hurts the
investor.
• Therefore, borrowers are willing to
pay more, and lenders require more,
on callable bonds.
• Most bonds have a deferred call and
a declining call premium.
 What’s a sinking fund?

• Provision to pay off a loan over its life

rather than all at maturity.
• Similar to amortization on a term loan.
• Reduces risk to investor, shortens
average maturity.
• But not good for investors if rates
decline after issuance.
Sinking funds are generally handled
in 2 ways

1. Call x% at par per year for sinking

fund purposes.
2. Buy bonds on open market.
Company would call if rd is below the
coupon rate and bond sells at a
premium. Use open market purchase
if rd is above coupon rate and bond
sells at a discount.
 Financial Asset Valuation

0 1 2 n
r ...
Value CF1 CF2 CFn

CF1 CF2 CFn

PV = 1 + 2 + ... + n .
(1+ r ) (1 + r ) (1+ r )
• The discount rate (ri) is the
opportunity cost of capital, i.e.,
the rate that could be earned on
alternative investments of equal
risk.

ri = r* + IP + LP + MRP + DRP

for debt securities.

 What’s the value of a 10-year, 10%
coupon bond if rd = 10%?

0 1 2 10
10% ...
V=? 100 100 100 + 1,000

$100 $100 $1,000

VB = 1 + . . . + 10 +
(1 + rd ) (1 + r d ) (1+ r d )10
= $90.91 + . . . + $38.55 + $385.54
= $1,000.
The bond consists of a 10-year, 10% annuity
of $100/year plus a $1,000 lump sum at t = 10:

PV annuity = $ 614.46
PV maturity value = 385.54
Value of bond = $1,000.00

INPUTS 10 10 100 1000

N I/YR PV PMT FV
OUTPUT -1,000
 What would happen if expected
inflation rose by 3%, causing r = 13%?

INPUTS 10 13 100 1000

N I/YR PV PMT FV
OUTPUT -837.21

When rd rises, above the coupon rate,

the bond’s value falls below par, so it
sells at a discount.
What would happen if inflation
fell, and rd declined to 7%?

INPUTS 10 7 100 1000

N I/YR PV PMT FV
OUTPUT -1,210.71

If coupon rate > rd, price rises above

par, and bond sells at a premium.
Suppose the bond was issued
20 years ago and now has 10
years to maturity.
What would happen to its
value over time if the required
rate of return remained at
10%, or at 13%, or at 7%?
Bond Value ($)
1,372 rd = 7%.
1,211

rd = 10%. M
1,000

837
rd = 13%.
775

30 25 20 15 10 5 0

Years remaining to Maturity

• At maturity, the value of any bond
must equal its par value.
• The value of a premium bond
would decrease to $1,000.
• The value of a discount bond would
increase to $1,000.
• A par bond stays at $1,000 if rd
remains constant.
 What’s “yield to maturity”?

• YTM is the rate of return earned on

a bond held to maturity. Also
called “promised yield.”
What’s the YTM on a 10-year, 9% annual coupon,
$1,000 par value bond that sells for $887?

0 1 9 10
rd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find rd that “works”!
 Find rd
INT ... INT M
VB = 1 + + N +
(1 + r d ) (1 + r d ) (1 + r d )N
90 ... + 90 10 + 1,000 10
887 = 1 +
(1 + r d ) (1+ r d ) (1 + r d )

INPUTS 10 -887 90 1000

N I/YR PV PMT FV
OUTPUT 10.91
• If coupon rate < rd, bond sells at a
discount.
• If coupon rate = rd, bond sells at its par
value.
• If coupon rate > rd, bond sells at a
premium.
• If rd rises, price falls.
• Price = par at maturity.
Find YTM if price were $1,134.20.

INPUTS 10 -1134.2 90 1000

N I/YR PV PMT FV
OUTPUT 7.08

Sells at a premium. Because

coupon = 9% > rd = 7.08%,
bond’s value > par.
 Definitions

Current yield = Annual coupon pmt

Current price

Capital gains yield = Change in price

Beginning price

Exp total Exp Exp cap

= YTM = +
return Curr yld gains yld
 Find current yield and capital gains yield for a 9%,
10-year bond when the bond sells for $887 and YTM
= 10.91%.

$90
Current yield =
$887
= 0.1015 = 10.15%.
YTM = Current yield + Capital gains yield.

Cap gains yield = YTM - Current yield

= 10.91% - 10.15%
= 0.76%.

Could also find values in Years 1 and 2,

get difference, and divide by value in
Year 1. Same answer.
 What’s interest rate (or price) risk?
Does a 1-year or 10-year 10% bond have
more risk?

Interest rate risk: Rising rd causes

bond’s price to fall.
rd 1-year Change 10-year Change
5% $1,048 $1,386
10% 1,000 4.8% 1,000 38.6%

15% 956 4.4% 749 25.1%

 Value
1,500 10-year

1,000 1-year

500

0 rd
0% 5% 10% 15%
 What is reinvestment rate
risk?
The risk that CFs will have to be
reinvested in the future at lower rates,
reducing income.
Illustration: Suppose you just won
$500,000 playing the lottery. You’ll
invest the money and live off the
interest. You buy a 1-year bond with a
YTM of 10%.
What is reinvestment rate risk?
Cont.

Year 1 income = $50,000. At year-

end get back $500,000 to reinvest.

If rates fall to 3%, income will drop

from $50,000 to $15,000. Had you
bought 30-year bonds, income
would have remained constant.
 Implications

• Long-term bonds: High interest rate

risk, low reinvestment rate risk.
• Short-term bonds: Low interest rate
risk, high reinvestment rate risk.
• Nothing is riskless!
True or False: “All 10-year bonds
have the same price and
reinvestment rate risk.”

False!
Low coupon bonds have
Less reinvestment rate risk
but more price risk
than high coupon bonds.
 Semiannual Bonds
1. Multiply years by 2 to get periods = 2n.
2. Divide nominal rate by 2 to get periodic
rate = rd/2.
3. Divide annual INT by 2 to get PMT =
INT/2.

INPUTS 2n rd/2 OK INT/2 OK

N I/YR PV PMT FV
OUTPUT
Find the value of 10-year, 10% coupon,
semiannual bond if rd = 13%.

2(10) 13/2 100/2

INPUTS 20 6.5 50 1000
N I/YR PV PMT FV
OUTPUT -834.72
Spreadsheet Functions for
Bond Valuation
• See Ch 06 Mini Case.xls for
details.
– PRICE
– YIELD
You could buy, for $1,000, either
a 10%, 10-year, annual payment
bond
or
an equally risky 10%, 10-year
semiannual bond.

Which would you prefer?

 The semiannual bond’s EFF% is:
m 2
Ê iNom ˆ Ê 0.10ˆ
EFF % = Á 1 + ˜ - 1 = Á 1+ ˜ - 1 = 10.25% .
Ë m¯ Ë 2 ¯

10.25% > 10% EFF% on annual bond, so buy

semiannual bond.
 If $1,000 is the proper price for the
semiannual bond, what is the proper
price for the annual payment bond?

• Semiannual bond has rNom = 10%, with

EFF% = 10.25%. Should earn same EFF%
on annual payment bond, so:

INPUTS 10 10.25 100 1000

N I/YR PV PMT FV
OUTPUT -984.80
• At a price of $984.80, the annual
and semiannual bonds would be
in equilibrium, because investors
would earn EFF% = 10.25% on
either bond.
A 10-year, 10% semiannual coupon,
$1,000 par value bond is selling for
$1,135.90 with an 8% yield to maturity.
It can be called after 5 years at $1,050.
What’s the bond’s nominal yield to
call (YTC)?

INPUTS 10 -1135.9 50 1050

N I/YR PV PMT FV
OUTPUT 3.765 x 2 = 7.53%
rNom = 7.53% is the rate brokers
would quote. Could also calculate
EFF% to call:

EFF% = (1.03765)2 - 1 = 7.672%.

This rate could be compared to

monthly mortgages, and so on.
 If you bought bonds, would you be
more likely to earn YTM or YTC?
• Coupon rate = 10% vs. YTC = rd =
7.53%. Could raise money by selling
new bonds which pay 7.53%.
• Could thus replace bonds which pay
$100/year with bonds that pay only
$75.30/year.
• Investors should expect a call, hence
YTC = 7.5%, not YTM = 8%.
 Implications

• In general, if a bond sells at a

premium, then (1) coupon > rd, so
(2) a call is likely.
• So, expect to earn:
– YTC on premium bonds.
– YTM on par & discount bonds.
• Disney recently issued 100-year bonds
with a YTM of 7.5%--this represents the
promised return. The expected return
was less than 7.5% when the bonds were
issued.
• If issuer defaults, investors receive less
than the promised return. Therefore, the
expected return on corporate and
municipal bonds is less than the promised
return.
 Bond Ratings Provide One
Measure of Default Risk

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

What factors affect default
risk and bond ratings? I
• Financial performance
– Debt ratio
– Coverage ratios, such as
interest coverage ratio or
EBITDA coverage ratio
– Current ratios

(More…)
 What factors affect default
risk and bond ratings? II
• Provisions in the bond contract
– Secured versus unsecured debt
– Senior versus subordinated debt
– Guarantee provisions
– Sinking fund provisions
– Debt maturity

(More…)
What factors affect default
risk and bond ratings? III
• Other factors
– Earnings stability
– Regulatory environment
– Potential product liability
– Accounting policies
 Bankruptcy

• Two main chapters of Federal

Bankruptcy Act:
– Chapter 11, Reorganization
– Chapter 7, Liquidation
• Typically, company wants Chapter
11, creditors may prefer Chapter 7.
 Implications
• If company can’t meet its
obligations, it files under Chapter 11.
That stops creditors from
foreclosing, taking assets, and
shutting down the business.
• Company has 120 days to file a
reorganization plan.
– Court appoints a “trustee” to supervise
reorganization.
– Management usually stays in control.
 Implications

• Company must demonstrate in its

reorganization plan that it is
“worth more alive than dead.”

Otherwise, judge will order

liquidation under Chapter 7.
 If the company is liquidated,
here’s the payment priority
1. Secured creditors from sales of
secured assets.
2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock
 Implications
• In a liquidation, unsecured creditors
generally get zero. This makes them
more willing to participate in
reorganization even though their
claims are greatly scaled back.
• Various groups of creditors vote on the
reorganization plan. If both the
majority of the creditors and the judge
approve, company “emerges” from
bankruptcy with lower debts, reduced
interest charges, and a chance for
success.