INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Chapter 7

Bonds and Their Valuation

Key Features of Bonds

Bond Valuation
Measuring Yield
Assessing Risk

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

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.

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Bond Markets

• Primarily traded in the over-the-counter

(OTC) market.
• Most bonds are owned by and traded
among large financial institutions.
• The Wall Street Journal reports key
developments in the Treasury, corporate,
and municipal markets.

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Key Features of a Bond

• Par value: face amount of the bond, which

is paid at maturity (assume P1,000).
• Coupon interest rate: stated interest rate
(generally fixed) paid by the issuer. Multiply by
par value 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”).
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Effect of a Call Provision

• Allows issuer to refund the bond issue if

rates decline (helps the issuer, but hurts the
investor).
• Bond investors require higher yields on
callable bonds.
• In many cases, callable bonds include a
deferred call provision and a declining call
premium.

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

What is 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.

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

The Value of Financial Assets

0 1 2 N
r% ...
Value CF1 CF2 CFN

CF1 CF2 CFN

Value   
1  r 1 1  r 2 1  r N

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

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.

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

What is the opportunity cost of debt capital?

• The discount rate (ri) is the opportunity cost

of capital, and is the rate that could be
earned on alternative investments of equal
risk.

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

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Bond value

A 12-year bond has a 9 percent annual

coupon, a yield to maturity of 8
percent, and a face value of P1,000.
What is the price of the bond?

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Bond value

You intend to purchase a 10-year,

P1,000 face value bond that pays
interest of P60 every 6 months. If your
nominal annual required rate of return
is 10 percent with semiannual
compounding, how much should you
be willing to pay for this bond?

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Bond value

A P1,000 par value bond pays interest

of P35 each quarter and will mature in
10 years. If your nominal annual
required rate of return is 12 percent
with quarterly compounding, how
much should you be willing to pay for
this bond?

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

What is the YTM on the following bond?

• 10-year; 9% annual coupon; P1,000 par value; selling

for P887.
• Must find the rd that solves this model.

INT INT M
VB   
1  rd 1 1  rd N 1  rd N
90 90 1,000
$887   
1  rd 1 1  rd 10 1  rd 10

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Bond value

Palmer Products has outstanding

bonds with an annual 8 percent
coupon. The bonds have a par value
of P1,000 and a price of P865. The
bonds will mature in 11 years. What is
the yield to maturity on the bonds?

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Bond value

A 20-year bond with a par value of

P1,000 has a 9 percent annual
coupon. The bond currently sells for
P925.

If the bond’s yield to maturity remains

at its current rate, what will be the
price of the bond 5 years from now?
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Bond value

One of the basic relationships in interest rate theory

is that, other things held constant, for a given
change in the required rate of return, the ____ the
time to maturity, the _____ the change in price.

a. longer; smaller.
b. shorter; larger.
c. longer; greater.
d. Statements b and c are correct
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Bond value

Which of the following statements is most

correct?
a. All else equal, if a bond’s yield to maturity
increases, its price will fall.
b. All else equal, if a bond’s yield to maturity
increases, its current yield will fall.
c. If a bond’s yield to maturity exceeds the coupon
rate, the bond will sell at a premium over par.
d. All of the statements above are correct.
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