BOND VALUATION

Financial Management
Key Concepts and Skills

■ Know the important bond features and bond types

■ Understand bond values and why they fluctuate
■ Understand bond ratings and what they mean
■ Understand the impact of inflation on interest rates
■ Understand the term structure of interest rates and the determinants
of bond yields
Chapter Outline

■ Bonds and Bond Valuation

■ Bond Ratings
■ Different Types of Bonds
■ Bond Markets
■ Inflation and Interest Rates
■ Determinants of bond yields
Definitions

■ Bond: long-term debt security issued by a corporation or government

to borrow money from the public.
■ Par value (face value): the principal amount of a bond that is
repaid at the maturity. Also called par value.
■ Coupon rate: the annual coupon divided by the face value of a bond.
■ Coupon: the interest payment made on a bond.
■ Maturity: the specified date on which the principal amount of a bond
is paid.
■ Yield or Yield to maturity: the rate required in the market on a
bond.
PV of Cash Flows as Rates
Change
■ Bond Value = PV of coupons + PV of par value

■ Bond Value = PV annuity + PV of lump sum

■ Remember, as interest rates increase, the PVs decrease

■ So, as interest rates increase, bond value decrease and

vice versa
Valuing a Discount Bond with
Annual Coupons
■ Consider a bond with a coupon rate of 10% and coupons
paid annually. The par value (face value) is $1000 and the
bond has 5 years to maturity. The yield to maturity is 11%.
What is the market value of the bond?

– Using the formula:

■ B = PV of annuity + PV of lump sum
■ B = $100 x [1 – 1 / (1.11)5] / 0.11 + $1000 /
(1.11)5
■ B = $369.59 + 593.45 = $963.04
Valuing a Premium Bond with
Annual Coupons
■ Suppose you are looking at a bond that has a 10% annual
coupon and a face value of $1000. There are 20 years to
maturity and the yield to maturity is 8%. What is the price of
this bond?

– Using the formula:

■ B = PV of annuity + PV of lump sum
■ B = $100 x [1 – 1 / (1.08)20] / 0.08 + $1000 /
(1.08)20
■ B = $981.81 + 214.55 = $1 196.36
Graphical Relationship Between
Price and YTM
1500
1400
1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
Bond Prices: Relationship
between Coupon and Yield
■ If YTM = coupon rate, then par value = bond price
■ If YTM > coupon rate, then par value > bond price
– Why?
– Price below par = ‘discount’ bond
■ If YTM < coupon rate, then par value < bond price
– Why?
– Price above par = ‘premium’ bond
The Bond Pricing Formula

Bond Value = Bond price

С = Coupon

r = Interest rate (YTM)

t = Time (number of periods)

FV = Face value
Example
■ Suppose, we have $1000 bond with 14% coupon
paid semi-annually. YTM is 16%. Time to maturity
is 7 years.
– How many coupon payments are there?
– What is the semiannual coupon payment?
– What is the semiannual yield?

■ B = $70 x [1 – 1 / (1.08)14] / 0.08 + $1000 /

(1.08)14 = $917.56
Example
■Find current bond price
– How many coupon payments are there?
– What is the semiannual coupon payment?
– What is the semiannual yield?

■ B = $70 x [1 – 1 / (1.08)14] / 0.08 + $1000 / (1.08)14 =

$917.56
Interest Rate Risk

■ Change in price due to changes in interest rates

– Interest rates goes up, bond price goes down!
– Long-term bonds have more interest rate risk than
short-term bonds
■ More-distant cash flows are more adversely affected by an
increase in interest rates
– Lower coupon rate bonds have more interest rate risk
than higher coupon rate bonds
■ More of the bond’s value is deferred to maturity (thus, for a
longer time) if the coupons are small
Figure 7.2
Computing YTM

■ 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 formula
YTM with Annual Coupons

■Consider a bond with a 10% annual coupon

rate, 15 years to maturity, and a face value of
$1000. The current price is $928.09.
– Will the yield be more or less than 10%?

– N = 15; PV = -928.09; FV = 1000; PMT = 100

– CPT I/Y = 11%
YTM with Semiannual Coupons

■ Suppose a bond with a 10% coupon rate and semiannual

coupons, has a face value of $1000, 20 years to maturity
and is selling for $1197.93.
– Is the YTM more or less than 10%?
– What is the semiannual coupon payment?
– How many periods are there?

– Using financial calculator: N= 40; PV = -1197.93; PMT =

50; FV = 1000; CPT I/Y = 4% (is this the YTM?)
– YTM = 4% x 2 = 8%
Spreadsheet Strategies (using
Excel)
■ There is a specific formula for finding bond prices 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
 Differences Between Debt and
Equity
 Debt  Equity
• Not an ownership interest • Ownership interest
• Creditors do not have • Common stockholders vote
voting rights to elect the board of
• Interest is considered a directors and on other
cost of doing business issues
and is tax-deductible • Dividends are not
• Creditors have legal considered a cost of doing
recourse if interest or business and are not tax
principal payments are deductible
missed • Dividends are not a liability
• Excess debt can lead to of the firm until declared.
financial distress and Stockholders have no legal
bankruptcy recourse if no dividends are
The Bond Indenture

■ Bond indenture is a contract between the

company and the bondholders and 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
Bond Classifications

■ Registered vs. Bearer Forms

■ Security
– Collateral – secured by financial securities;
– Mortgage – secured by real property, normally land or
buildings;
– Debentures – unsecured debt instruments with maturity
of 10+ years
– Notes – unsecured debt with original maturity less than
10 years
■ ‘Seniority’ of debt repayment
Bond Characteristics and
Required Returns
■ The coupon rate is usually set close to the yield, which
depends on the risk characteristics of the bond when issued
■ Which bonds will have the higher yield, all else equal?
– Secured debt or a debenture?
– Subordinated debenture or senior debt?
– A bond with a sinking fund or bond without sinking fund?
– A callable bond or a non-callable bond?
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, but
adverse conditions will have more impact on the firm’s
ability to pay
Bond Ratings - Speculative

■ Low Grade
– Moody’s Ba, B, Caa, and Ca
– S%P BB, B, CCC, CC
– Considered speculative with respect to capacity to pay. The
“B” ratings are the lowest degree of speculation.
■ Very Low Grade
– Moody’s C and S&P C – income bonds with no interest being
paid
– Moody’s D and S&P D – in default with principal and interest
in arrears
Government Bonds

■ Treasury Securities
– Federal government debt
– T-bills – pure discount bonds with original maturity of one year or
less
– 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
Example

■ 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 – 0.4) = 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%
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, or deep discount bonds
■ Treasury Bills and principal-only Treasury strips are
good examples of zeroes
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”
Other Bond Types

■ Disaster bonds
■ Income bonds
■ Convertible bonds
■ Put bond
■ 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 requires returns
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
Inflation and Interest Rates

■ Real rate of interest – change in purchasing power

or inflation-adjusted interest rate
■ Nominal rate of interest – quoted rate of interest;
Reflects change in purchasing power and not
adjusted for inflation
■ The ex ante nominal rate of interest includes our
desired real rate of return plus an adjustment for
expected inflation
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
For example

■ If real interest rate is 10% and we expect inflation of 8%, what is

nominal interest rate?
■ R = (1.1) x (1.08) – 1 = 0.188 = 18.8%
■ Approximately: R = 10% + 8% = 18%
■ As real interest rate and inflation rate is relatively high, there is s
significant difference between Fisher effect and approximate
calculation of real interest rate.
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?
Comprehensive Problem

■ What is the price of a $1000 face value bond with

a 6% coupon rate paid semiannually, if the bond
is priced to yield 5% YTM, and it has 9 years to
maturity?
■ What would be the price of the bond if the yield
rose to 7%
■ 2. Ackerman Co. has 9% coupon bonds on the
market with 10 years left to maturity. The bonds
make annual coupon payments. If the bond
currently sells for $934, what is YTM?
■ 3. Ashes Divide Corporation has bonds on the
market with 14.5 years to maturity. Bonds have
6.8% YTM and a current price is $924. The bonds
make semiannual payments. What must the
coupon rate be on these bonds?