Bond Valuation

BONDS & THEIR VALUATION
5-1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
5.1 BONDS AND BOND VALUATION
• A bond is a legally binding agreement

between a borrower and a lender that
specifies the:
• Par (face) value
• Coupon rate
• Coupon payment
• Maturity date
• The yield to maturity is the required
market interest rate on the bond
• Do not confuse the coupon rate with the
required market interest rate
5-2
BOND VALUATION
• Primary Principle:
• Value of financial securities = PV of expected future
cash flows
• Bond value is, therefore, determined by the
present value of the coupon payments plus the
present value of the par, or face, value
• Interest rates are inversely related to present
(i.e., bond) values
5-3
CONCEPTUAL CASH FLOW OF A 10
YEAR BOND
• Xanth Co. has issued a 10 year bond with an 8%
annual coupon. The cash flows from the bond
would be paid as follows:
5-4
THE BOND-PRICING EQUATION
 1 
1 -
 (1  r) T  F
Bond Value  C  
 (1  r)
T
 r
 
Notice that:
• The first term is the present value of the coupon payments (an
annuity); and,
• The second term is the present value of the bond’s par value
5-5
FREQUENCY OF COUPON PAYMENTS
• Bond terms dictate the frequency of coupon payments

• The coupon rate is expressed in annual terms
• If the rate is expressed annually and the payments
are more frequent, calculation of bond value requires:
• Dividing the annual coupon payment by the number of
compounding periods per year to arrive at the value of each
coupon payment (C);
• Dividing the annual required rate of return by the number of
compounding periods per year to arrive at the desired
periodic yield (r);
• Multiplying the remaining years of the bond’s life by the
number of compounding periods per year to arrive at the
remaining number of coupon payments (T).
5-6
BOND EXAMPLE
• Consider a U.S. government bond with a
6-3/8% coupon that expires in December 2020.
• The Par Value of the bond is $1,000.
• Coupon payments are made semi-annually (June
30 and December 31 for this particular bond).
• Since the coupon rate is 6 3/8%, the payment is
$31.875.
• On January 1, 2016 the size and timing of cash
flows are:
$ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 1,0 3 1 .8 7 5
1 / 1 / 16 6 / 30 / 16 12 / 31 / 16 6 / 30 / 20 12 / 31 / 20
5-7
BOND EXAMPLE: PREMIUM BOND
• On January 1, 2016, the required yield is 5%.
• The size and timing of the cash flows are:
$ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 1,0 3 1 .8 7 5
1 / 1 / 16 6 / 30 / 16 12 / 31 / 16 6 / 30 / 20 12 / 31 / 20
$ 31 . 875  1  $ 1, 000
PV  1 10 
 10
 $ 1, 060 . 17
. 05 2  (1 . 025 )  (1 . 025 )
5-8
BOND EXAMPLE: DISCOUNT BOND
• Now assume that the required yield is 11%.
• How does this change the bond’s price?
$ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 1,0 3 1 .8 7 5
1 / 1 / 16 6 / 30 / 16 12 / 31 / 16 6 / 30 / 20 12 / 31 / 20
$ 31 . 875  1  $ 1, 000
PV  1 10 
 10
 $ 825 . 69
. 11 2  (1 . 055 )  (1 . 055 )
5-9
YTM AND BOND VALUE
When the YTM < coupon, the bond
1300 trades at a premium.
Bond Value
1200
1100 When the YTM = coupon, the

bond trades at par.
1000
800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8% Discount Rate
When the YTM > coupon, the bond trades at a discount.
5-10
BOND CONCEPTS
• Bond prices and market interest rates move in

opposite directions.
• When coupon rate = YTM, price = par value
• When coupon rate > YTM, price > par value
(premium bond)
• When coupon rate < YTM, price < par value
(discount bond)
5-11
INTEREST RATE RISK
• Price Risk
• Change in price due to changes in interest rates
• Long-term bonds have more price risk than short-
term bonds
• Low coupon rate bonds have more price risk than
high coupon rate bonds
• Reinvestment Rate Risk
• Uncertainty concerning rates at which cash flows can be
reinvested
• Short-term bonds have more reinvestment rate risk than
long-term bonds
• High coupon rate bonds have more reinvestment rate risk
than low coupon rate bonds
5-12
MATURITY AND BOND PRICE
VOLATILITY
Bond Value
Consider two otherwise identical bonds.

The long-maturity bond will have much more
volatility with respect to changes in the
discount rate.
Par
Short Maturity Bond

Discount Rate
C
Long Maturity
Bond 5-13
COUPON RATES AND BOND PRICES
Bond Value
Consider two otherwise identical bonds.

The low-coupon bond will have more
volatility with respect to changes in the
discount rate.
Par
High Coupon Bond
C Discount Rate
Low Coupon Bond
5-14
COMPUTING YIELD TO MATURITY
• Yield to maturity is the rate implied by the

current bond price.
• Finding the YTM requires trial and error if you do
not have a financial calculator and is similar to
the process for finding r with an annuity.
• If you have a financial calculator, enter N, PV,
PMT, and FV, remembering the sign convention
(PMT and FV need to have the same sign, PV the
opposite sign).
5-15
YTM WITH ANNUAL COUPONS
• Consider a bond with a 10% annual coupon rate,

15 years to maturity, and a par value of $1,000.
The current price is $928.09.
• Will the yield be more or less than 10%?
• N = 15; PV = -928.09; FV = 1,000; PMT = 100
• CPT I/Y = 11%
5-16
YTM WITH SEMIANNUAL COUPONS
• Suppose a bond with a 10% coupon rate and

semiannual coupons has a face value of $1,000,
20 years to maturity, and is selling for $1,197.93.
• Is the YTM more or less than 10%?
• What is the semi-annual coupon payment?
• How many periods are there?
• N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT
I/Y = 4% (Is this the YTM?)
• YTM = 4% * 2 = 8%
5-17
CURRENT YIELD VS. YIELD TO
MATURITY
• Current Yield = annual coupon / price
• Yield to maturity = current yield + capital gains
yield
• Example: 10% coupon bond, with semi-annual
coupons, face value of 1,000, 20 years to
maturity, $1,197.93 price
• Current yield = 100 / 1197.93 = .0835 = 8.35%
• Price in one year, assuming no change in YTM =
1,193.68
• Capital gain yield = (1193.68 – 1197.93) / 1197.93
=
-.0035 = -.35%
• YTM = 8.35 - .35 = 8%, which is the same YTM
computed earlier
5-18
BOND PRICING THEOREMS
• Bonds of similar risk (and maturity) will be priced

to yield about the same return, regardless of the
coupon rate.
• If you know the price of one bond, you can
estimate its YTM and use that to find the price of
the second bond.
• This is a useful concept that can be transferred to
valuing assets other than bonds.
5-19
BOND PRICING WITH A SPREADSHEET
• There are specific formulas for finding bond prices

and yields on a spreadsheet.
• PRICE (Settlement, Maturity, Rate, Yld,
Redemption, Frequency, Basis)
• YIELD (Settlement, Maturity, Rate, Pr,
Redemption, Frequency, Basis)
• Settlement and maturity need to be actual
dates
• The redemption and Pr need to given as % of
par value
• Click on the Excel icon for an example.
5-20
5.2 MORE ON BOND FEATURES
• There are two kinds of securities issued by

corporations:
• Equity – Ownership Interest
• Debt – Short or Long Term Borrowing
• Bonds are classified as Debt
5-21
DEBT VERSUS EQUITY
• Debt • Equity
• Not an ownership • Ownership interest
interest • Common stockholders
• Creditors do not have vote for the board of
voting rights directors and other issues
• Interest is considered a • Dividends are not
cost of doing business considered a cost of doing
and is tax deductible business and are not tax
• Creditors have legal deductible
recourse if interest or • Dividends are not a
principal payments are liability of the firm, and
missed stockholders have no
• Excess debt can lead to legal recourse if dividends
financial distress and are not paid
bankruptcy • An all-equity firm cannot
go bankrupt
5-22
THE BOND INDENTURE
• Contract between the company and the

bondholders that includes:
• The basic terms of the bonds
• The total amount of bonds issued
• A description of property used as security, if applicable
• Sinking fund provisions
• Call provisions
• Details of protective covenants
5-23
SAMPLE BOND FEATURES
• Features of a recent Walt Disney bond issue

demonstrate the range of topics covered in the
bond indenture:
• Insert Table showing “Features of a Walt Disney

Company Bond” here
5-24
BOND CLASSIFICATIONS
• Registered vs. Bearer Forms

• Security
• Collateral – secured by financial securities
• Mortgage – secured by real property, normally land or
buildings
• Debentures – unsecured
• Notes – unsecured debt with original maturity less than
10 years
• Seniority
5-25
BOND CLASSIFICATIONS (CONT.)
• Sinking Funds
• Call Provisions:
• Deferred Call
• Call Premium
• Protective Covenants
5-26
REQUIRED YIELDS
• The coupon rate depends on the risk

characteristics of the bond when issued.
• Which bonds will have the higher coupon, all else
equal?
• Secured debt versus a debenture
• Subordinated debenture versus senior debt
• A bond with a sinking fund versus one without
• A callable bond versus a non-callable bond
5-27
5.3 BOND RATINGS –
INVESTMENT QUALITY
• High Grade
• Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
• Moody’s Aa and S&P AA – capacity to pay is very
strong
• Medium Grade
• Moody’s A and S&P A – capacity to pay is strong,
but more susceptible to changes in circumstances
• Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more
impact on the firm’s ability to pay
5-28
BOND RATINGS – SPECULATIVE
• Low Grade
• Moody’s Ba and B
• S&P BB and B
• Considered speculative with respect to
capacity to pay
• Very Low Grade
• Moody’s C
• S&P C & D
• Highly uncertain repayment and, in many
cases, already in default, with principal and
interest in arrears
5-29
5.4 SOME DIFFERENT TYPES OF
BONDS
• There are many different types of
bonds
• Some common bonds include:
• Government Bonds
• Federal
• State and Municipal
• Zero Coupon Bonds (AKA Pure Discount
Bonds)
• Floating Rate Bonds
• Each are discussed below
5-30
GOVERNMENT BONDS
• Treasury Securities
• Federal government debt
• T-bills – pure discount bonds with original
maturity less than one year
• T-notes – coupon debt with original maturity
between one and ten years
• T-bonds – coupon debt with original maturity
greater than ten years
• Municipal Securities
• Debt of state and local governments
• Varying degrees of default risk, rated similar to
corporate debt
• Interest received is tax-exempt at the federal
level
5-31
AFTER-TAX YIELDS
• A taxable bond has a yield of 8%, and a

municipal bond has a yield of 6%.
• If you are in a 40% tax bracket, which bond do you
prefer?
• 8%(1 - .4) = 4.8%
• The after-tax return on the corporate bond is 4.8%,
compared to a 6% return on the municipal
• At what tax rate would you be indifferent between the
two bonds?
• 8%(1 – T) = 6%
• T = 25%
5-32
ZERO COUPON BONDS
• Make no periodic interest payments (coupon

rate = 0%)
• The entire yield to maturity comes from the
difference between the purchase price and the
par value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount bonds,
or original issue discount bonds (OIDs)
• Treasury Bills and principal-only Treasury
STRIPS (or “strips”) are good examples of
zeroes
5-33
PURE DISCOUNT BONDS
Information needed for valuing pure discount bonds:
• Time to maturity (T) = Maturity date - today’s
date
• Face value (F)
• Discount rate (r)
$0 $0 $0 $F
0 2 T 1 T
Present value of a pure discount bond at time 0:

F
PV 
(1  r ) T
5-34
PURE DISCOUNT BONDS: EXAMPLE
Find the value of a 30-year zero-coupon bond

with a $1,000 par value and a YTM of 6%
$0 $0 $0 $ 1, 0 0 0
0 2 29 30
F $ 1, 000
PV    $ 174 . 11
(1  r ) T
(1 . 06 ) 30
5-35
FLOATING RATE BONDS
• Coupon rate floats depending on some index

value
• Examples – adjustable rate mortgages and
inflation-linked Treasuries
• There is less price risk with floating rate
bonds.
• The coupon floats, so it is less likely to differ
substantially from the yield to maturity.
• Coupons may have a “collar” – the rate
cannot go above a specified “ceiling” or below
a specified “floor”
5-36
OTHER BOND TYPES
• Income bonds
• Convertible bonds
• Put bonds
• There are many other types of provisions that can
be added to a bond, and many bonds have
several provisions – it is important to recognize
how these provisions affect required returns.
5-37
5.5 BOND MARKETS
• Primarily over-the-counter transactions with

dealers connected electronically
• Extremely large number of bond issues, but
generally low daily volume in single issues
• Makes getting up-to-date prices difficult,
particularly on small company or municipal issues
• Treasury securities are an exception
5-38
5.6 INFLATION AND INTEREST RATES
• Real rate of interest – change in purchasing power

• Nominal rate of interest – quoted rate of interest,
change in purchasing power and inflation
• The ex ante nominal rate of interest includes our
desired real rate of return plus an adjustment for
expected inflation
• Fisher notes that investors realize inflation reduces
purchasing power and insist on high returns during
inflationary times:
• “A rise in the rate of inflation causes the nominal rate to
rise just enough so that the real rate of interest is
unaffected.”
5-39
THE FISHER EFFECT
• The Fisher Effect defines the relationship between

real rates, nominal rates, and inflation
• (1 + R) = (1 + r)(1 + h), where
• R = nominal rate
• r = real rate
• h = expected inflation rate
• Approximation
• R=r+h
5-40
THE FISHER EFFECT: EXAMPLE
• If we require a 10% real return and we expect

inflation to be 8%, what is the nominal rate?
• R = (1.10)(1.08) – 1 = .188 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because the real return and expected inflation
are relatively high, there is a significant
difference between the actual Fisher Effect and
the approximation
5-41
5.7 DETERMINANTS OF BOND YIELDS
• Term structure is the relationship between time
to maturity and yields, all else equal
• It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
• Yield curve – graphical representation of the term
structure
• Normal – upward-sloping, long-term yields are higher
than short-term yields
• Inverted – downward-sloping, long-term yields are
lower than short-term yields
• Typically shown for the Treasury yield curve
5-42
FACTORS AFFECTING REQUIRED
RETURN
• Default risk premium – remember bond ratings
• Taxability premium – remember municipal versus
taxable
• Liquidity premium – bonds that have more
frequent trading will generally have lower
required returns (remember bid-ask spreads)
• Anything else that affects the risk of the cash
flows to the bondholders will affect the required
returns
5-43
QUICK QUIZ
• How do you find the value of a bond, and why

do bond prices change?
• What is a bond indenture, and what are some
of the important features?
• What are bond ratings, and why are they
important?
• How does inflation affect interest rates?
• What is the term structure of interest rates?
• What factors determine the required return
on bonds?
5-44

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BONDS & THEIR VALUATION

• A bond is a legally binding agreement

• Bond terms dictate the frequency of coupon payments

1100 When the YTM = coupon, the

• Bond prices and market interest rates move in

Consider two otherwise identical bonds.

Short Maturity Bond

Consider two otherwise identical bonds.

High Coupon Bond

• Yield to maturity is the rate implied by the

• Consider a bond with a 10% annual coupon rate,

• Suppose a bond with a 10% coupon rate and

• Bonds of similar risk (and maturity) will be priced

• There are specific formulas for finding bond prices

• There are two kinds of securities issued by

• Bonds are classified as Debt

• Contract between the company and the

• Features of a recent Walt Disney bond issue

• Insert Table showing “Features of a Walt Disney

• Registered vs. Bearer Forms

• The coupon rate depends on the risk

• A taxable bond has a yield of 8%, and a

• Make no periodic interest payments (coupon

Present value of a pure discount bond at time 0:

Find the value of a 30-year zero-coupon bond

• Coupon rate floats depending on some index

• Primarily over-the-counter transactions with

• Real rate of interest – change in purchasing power

• The Fisher Effect defines the relationship between

• If we require a 10% real return and we expect

• How do you find the value of a bond, and why

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