Bonds

CHAPTER 7
Bonds and Their Valuation
 Key features of bonds

 Bond valuation
 Measuring yield
 Assessing risk
7-1
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.
7-2
Bond markets
 Primarily traded in the over-the-counter
(OTC) market.
 Most bonds are owned by and traded among
large financial institutions.
7-3
Key Features of a Bond
 Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
 Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply by
par to get dollar payment of interest.
 Maturity date – years until the bond must be
repaid.
 Issue date – when the bond was issued.
 Yield to maturity - rate of return earned on
a bond held until maturity (also called the
“promised yield”).
7-4
Effect of a call provision
 Allows issuer to refund the bond issue
if rates decline (helps the issuer, but
hurts the investor).
 Borrowers are willing to pay more,
and lenders require more, for callable
bonds.
 Most bonds have a deferred call and a
declining call premium.
7-5
The value of financial assets
0 1 2 n
k ...
Value CF1 CF2 CFn
CF1 CF2 CFn

Value  1
 2
 ...  n
(1  k) (1  k) (1  k)
7-6
Other types (features) of bonds
 Convertible bond – may be exchanged for
common stock of the firm, at the holder’s option.
 Warrant – long-term option to buy a stated
number of shares of common stock at a specified
price.
 Putable bond – allows holder to sell the bond
back to the company prior to maturity.
 Income bond – pays interest only when interest
is earned by the firm.
 Indexed bond – interest rate paid is based upon
the rate of inflation.
7-7
What is the value of a 10-year, 10%
annual coupon bond, if kd = 10%?
0 1 2 n
k ...
VB = ? 100 100 100 + 1,000
$100 $100 $1,000

VB  1
 ...  10

(1.10) (1.10) (1.10)10
VB  $90.91  ...  $38.55  $385.54
VB  $1,000
7-8
Definitions
Annual coupon payment
Current yi eld (CY) 
Current price
Change in price
Capital gains yield (CGY) 
Beginning price
 Expected   Expected 
Expected total return  YTM      
 CY   CGY 
7-9
An example:
Current and capital gains yield
 Find the current yield and the capital
gains yield for a 10-year, 9% annual
coupon bond that sells for $887, and
has a face value of $1,000.
Current yield = $90 / $887
= 0.1015 = 10.15%
7-10
Calculating capital gains yield
YTM = Current yield + Capital gains yield
CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%
Could also find the expected price one year from

now and divide the change in price by the beginning
price, which gives the same answer.
7-11
Example 1:
 The $1,000 face value ABC bond has a
coupon rate of 6%, with interest paid
semi-annually, and matures in 5 years.
If the bond is priced to yield 8%, what
is the bond's value today?
7-12
Example 2:
 The KLM bond has a 8% coupon rate
(with interest paid semi-annually), a
maturity value of $1,000, and matures
in 5 years. If the bond is priced to yield
6%, what is the bond's current price?
7-13
Example 3:
 The HIJ bond has a current price of
$800, a maturity value of $1,000, and
matures in 5 years. If interest is paid
semi-annually and the bond is priced to
yield 8%, what is the bond's annual
coupon rate?
7-14
Example 4:
 Consider a $1,000 par value bond with
a 7 percent annual coupon. The bond
pays interest annually. There are 9
years remaining until maturity. What is
the current yield on the bond assuming
that the required return on the bond is
10 percent?
7-15
Example 5:
 Assume that you wish to purchase a 20-
year bond that has a maturity value of
$1,000 and makes semi- annual interest
payments of $40. If you require an
annual 10 percent rate of return on this
investment, what is the maximum price
you should be willing to pay for the
bond?
7-16
Example 6:
 What is the value of an Orion bond that
has a 10 percent annual coupon, pays
interest semiannually, and has 10 years
to maturity, if the annual required rate
of return is 12 percent?
7-17
Example 7:
 What is the value of a bond with 20
years left to maturity, a coupon
payment of $50 every 6 months, and a
$1,000 face value if the yield to
maturity is 8%?
7-18
Example 8:
 J&J Manufacturing just issued a bond
with a $1,000 face value and a coupon
rate of 7 percent. If the bond has a life
of 30 years, pays annual coupons, and
the yield to maturity is 9 percent what
will the bond sell for?
7-19
Types of bonds
 Mortgage bonds
 Debentures
 Subordinated debentures
 Investment-grade bonds
 Junk bonds
7-20
Factors affecting default risk and
bond ratings
 Financial performance
 Debt ratio
 TIE ratio
 Current ratio
 Bond contract provisions
 Secured vs. Unsecured debt
 Senior vs. subordinated debt
 Guarantee and sinking fund provisions
 Debt maturity
7-21
Other factors affecting default risk
 Earnings stability
 Regulatory environment
 Potential antitrust or product liabilities
 Pension liabilities
 Potential labor problems
 Accounting policies
7-22
Priority of claims in liquidation
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
7-23

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CHAPTER 7

Bonds and Their Valuation

 Key features of bonds

CF1 CF2 CFn

$100 $100 $1,000

Current yield = $90 / $887

Could also find the expected price one year from

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