Bond Valuation Prof .

Neeraj Kapoor
Click to edit Master subtitle style
Submitted By : Jitesh Talesara Sec B : 12222 FYPGDM ISB&M Pune

4/26/12

 Bonds and Bond Valuation More on Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields

4/26/12

Bond Valuation
Learning Module Click to edit Master subtitle style

4/26/12 33

Definitions
Par or Face Value The amount of money that is paid to the bondholders at

maturity. For most bonds this amount is $1,000. It also generally represents the amount of money borrowed by the bond issuer.

Coupon Rate The coupon rate, which is generally fixed, determines the

periodic coupon or interest payments. It is expressed as a percentage of the bond's face value. It also represents the interest cost of the bond to the issuer.
4 4 4/26/12

Definitions
Coupon Payments The coupon payments represent the periodic interest

payments from the bond issuer to the bondholder. The annual coupon payment is calculated by multiplying the coupon rate by the bond's face value. Since most bonds pay interest semiannually, generally one half of the annual coupon is paid to the bondholders every six months.

Maturity Date The maturity date represents the date on which the bond

matures, i.e., the date on which the face value is repaid. The last coupon payment is also paid on the maturity date.
4/26/12

5 5

Definitions
Original Maturity The time from when the bond was issued until its maturity

date.

Remaining Maturity The time currently remaining until the maturity date.

Call Date 6 6
For bonds which are callable, i.e., bonds which can be

4/26/12 redeemed by the issuer prior to maturity, the call date represents the earliest date at which the bond can be

Definitions
Call Price The amount of money the issuer has to pay to call a

callable bond (there is a premium for calling the bond early). When a bond first becomes callable, i.e., on the call date, the call price is often set to equal the face value plus one year's interest.

Required Return The rate of return that investors currently require on a

bond.
7 7 4/26/12

Definitions
Yield to Maturity The rate of return that an investor would earn if he

bought the bond at its current market price and held it until maturity. Alternatively, it represents the discount rate which equates the discounted value of a bond's future cash flows to its current market price.

Yield to Call The rate of return that an investor would earn if he

8 8

bought a callable bond at its current market price and held it until the call date given that the bond was called 4/26/12 on the call date.

Bond Valuation
Bonds are valued using time value of

money concepts.

Their coupon, or interest, payments are

treated like an equal cash flow stream (annuity).

Their face value is treated like a lump

sum.
9 9 4/26/12

Example

Assume Hunter buys a 10-year bond from the KLM corporation on January 1, 2003. The bond has a face value of $1000 and pays an annual 10% coupon. The current market rate of return is 12%. Calculate the price of this bond today. $100 Draw a timeline 0+ $10 $10 $10 $10 $10 $100 $10 0 $10 0 $10 0 $100 0 0 0 0 0
4/26/12

1.

10 10 ?

Example
2.

First, find the value of the coupon stream

Remember to follow the same approach you use in time value of money calculations. You can find the PV of a cash flow stream

PV = $100/(1+.12)1 + $100/(1+.12)2 + $100/ (1+.12)3 + $100/(1+.12)4 + $100/(1+.12)5 + $100/(1+.12)6 + $100/(1+.12)7 + $100/ (1+.12)8 + $100/(1+.12)9+ $100/(1+.12)10 PVA = $100 * {[1-(1+.12)-10]/.12}

Or, you can find the PV of an annuity

11 11

PV = $565.02
4/26/12

Example
3.

Find the PV of the face value

PV = CFt / (1+r)t PV = $1000/ (1+.12)10 PV = $321.97

4.

Add the two values together to get the total PV

$565.02 + $321.97 = $886.99

Alternatively, on your calculator

12 12

PMT = 100 FV = 1000 n = 10 i = 12 PV = ?

4/26/12

Realized Return
Sometimes you will be asked to find the realized

rate of return for a bond.

This is the return that the investor actually

realized from holding a bond.

Using time value of money concepts, you are

solving for the required rate of return instead of the value of the bond.

13 13

4/26/12

Example
Doug purchased a bond for $800 5-years ago and he

sold the bond today for $1200. The bond paid an annual 10% coupon. What is his realized rate of return? n [CFt / (1+r)t] t=0

PV =

$800 = [$100/(1+r) + $100/(1+r)2 + $100/(1+r)3 +

$100/(1+r)4 + $100/(1+r)5] + [$1200/(1+r)5]

You plug in numbers until you find the rate of return 4/26/12 14 that solves the equation.
14

To solve, you need use a trail and error approach.

Example
This is much easier to find using a financial calculator: n = 5

PV = -800 FV = 1200 PMT = 100 i = ?, this is the realized rate of return on this bond n=10, PV=-800, FV=1200, PMT=50, i=?=9.47%. Thus, the realized return would have been 2 * 9.47% = 18.94%.
4/26/12

Note that if the payments had been semiannual,

15 15

Bond Valuation
Bonds are valued using time value of

money concepts.

Their coupon, or interest, payments are

treated like an equal cash flow stream (annuity).

Their face value is treated like a lump

sum.
16 16 4/26/12

Interest edit and Bond Valuation Click to RatesMaster subtitle style

4/26/12 1717

Click to edit Master subtitle style

BOND VALUATION
Dr. Rana Singh Associate Professor www.ranasingh.org
4/26/12

CONTENTS
Introduction Bond Returns
coupon rate current yield spot interest rate yield to maturity yield to call

Bond Prices Bond Pricing Theorems Bond Risks

4/26/12

INTRODUCTION
Bonds are Long-term fixed income

securities. Debentures are also long-term fixed income securities. Both of these are debt securities.

The two major categories of bonds are

government bonds & corporate bonds.

There are the two main features of bonds

such as callability and convertibility.

4/26/12

BOND RETURNS
COUPON RATE:-

It is the nominal rate of interest fixed and printed on the bond certificate. It is calculated on the face value of the bond. It is the rate at which interest is payable by the issuing company to the bondholder.
4/26/12

BOND RETURNS (CONT.)

CURRENT YIELD:-

The current market price of a bond in the secondary market may differ from its face value. The current yield relates the annual interest receivable on a bond to its current market price. It can be expressed as follows:current yield=In/Po 100 Where In = Annual Interest Po = Current market price
4/26/12

BOND RETURNS (CONT.)

SPOT INTEREST RATE: Zero coupon bond is a special type of bond

which does not pay annual interests.

The return on this bond is in the form of a

discount on issue of the bond.

This type of bond is also called pure discount

bond or deep discount bond.

Spot interest rate is the annual rate of return on 4/26/12

a bond that has only one cash inflow to the

BOND RETURNS (CONT.)

YIELD TO MATURITY (YTM):-

This is the most widely used measure of return on bonds. It may be defined as the compounded rate of return an investor is expected to receive from a bond purchased at the current market price and held to maturity. It is really the internal rate of return earned from holding a bond till maturity. YTM depends upon the cash outflow for purchasing the bond, that is, the cost or 4/26/12

BOND RETURNS (CONT.)

Current market price of the bond as well as the cash inflows from the bond, namely the future interest payments and the terminal principal repayment. YTM is the discount rate that makes the present value of cash inflows from the bond equal to the cash outflow for purchasing the bond. The relation between the cash outflow, the cash inflow and the YTM of a bond can be expressed as: MP = Ct (1 + YTM)t
4/26/12

TV (1 + YTM)n

BOND RETURNS (CONT.)

Where :MP = Current market price of the bond Ct = Cash inflow from the bond throughout the holding period. the TV = Terminal cash inflow received at end of the holding period.

4/26/12

BOND PRICING THEOREMS

The relation between bond prices and changes in the market interest rates have been stated by Burton G. Malkiel in the form of five general principles. These are known as Bond pricing theorems. The five principles are: Bond prices will move inversely to market

interest changes.

Bond price variability is directly related to the

term to maturity; which means, for a given 4/26/12 change in the level of market interest rates, change in bond prices are greater for longer-

BOND PRICING THEOREMS(CONT..)

A bonds sensitivity to changes in market

interest rate increases at a diminishing rate as the time remaining until its maturity increases.

The price changes resulting from equal

absolute increases in market interest rates are not symmetrical, i.e. for any given maturity, a decrease in market interest rate causes a price rise that is larger than the price decline that results from an equal 4/26/12 increase in market interest rate.

BOND PRICING THEOREMS (CONT..)

Bond price volatility is related to the

coupon rate, which implies that the percentage change in a bonds price due to a change in the market interest rate will be smaller if its coupon rate is higher.

4/26/12

BOND RISKS
Two types of risk are associated with investment in bonds, namely default risk and interest rate risk.
DEFAULT RISK:-

Default risk refers to the possibility that a company may fail to pay the interest or principal on the stipulated dates. Poor financial performance of the company leads to such defaults.
4/26/12

BOND RISKS (CONT..)

INTEREST RATE RISK:-

The risk that an investment's value will changedue to a change in the absolute level of interest rates. Such changes usually affect securities inversely and can be reduced by diversifying or hedging. Interest rate risk affects the value ofbondsmore directly than stocks, and it is a major risk to all bondholders.As interest rates rise, bond prices fall and vice versa.
4/26/12

BOND DURATION
Duration is the weighted average measure

of a bonds life. The various time periods in which the bond generates cash flows are weighted according to the relative size of the present value of those flows. (t) (Ct) d= (1 + k)t Ct (1 + k)t
4/26/12

The formula for computing duration d is:-

BOND DURATION
Where :&

(CONT..)

Ct = Annual cash flow including interest repayment of principal. n = Holding period. k = Discount rate which is the market interest rate. t = The time period of each cash flow.

4/26/12

Definitions
Par or Face Value The amount of money that is paid to the bondholders at

maturity. For most bonds this amount is $1,000. It also generally represents the amount of money borrowed by the bond issuer.

Coupon Rate The coupon rate, which is generally fixed, determines the

periodic coupon or interest payments. It is expressed as a percentage of the bond's face value. It also represents the interest cost of the bond to the issuer.
34 34 4/26/12

Definitions
Coupon Payments The coupon payments represent the periodic interest

payments from the bond issuer to the bondholder. The annual coupon payment is calculated by multiplying the coupon rate by the bond's face value. Since most bonds pay interest semiannually, generally one half of the annual coupon is paid to the bondholders every six months.

Maturity Date The maturity date represents the date on which the bond

matures, i.e., the date on which the face value is repaid. The last coupon payment is also paid on the maturity date.
4/26/12

35 35

Definitions
Original Maturity The time from when the bond was issued until its maturity

date.

Remaining Maturity The time currently remaining until the maturity date.

Call Date 36 36
For bonds which are callable, i.e., bonds which can be

4/26/12 redeemed by the issuer prior to maturity, the call date represents the earliest date at which the bond can be

Definitions
Call Price The amount of money the issuer has to pay to call a

callable bond (there is a premium for calling the bond early). When a bond first becomes callable, i.e., on the call date, the call price is often set to equal the face value plus one year's interest.

Required Return The rate of return that investors currently require on a

bond.
37 37 4/26/12

Definitions
Yield to Maturity The rate of return that an investor would earn if he

bought the bond at its current market price and held it until maturity. Alternatively, it represents the discount rate which equates the discounted value of a bond's future cash flows to its current market price.

Yield to Call The rate of return that an investor would earn if he

38 38

bought a callable bond at its current market price and held it until the call date given that the bond was called 4/26/12 on the call date.

Chapter Outline
Bonds and Bond Valuation More on Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields

39 39

4/26/12

Bond Definitions
Bond Par value (face value) Coupon rate Coupon payment Maturity date Yield or Yield to maturity

40 40

4/26/12

Present Value of Cash Flows as Rates Change

Bond Value = PV of coupons + PV of par Bond Value = PV of annuity + PV of lump

sum

Remember, as interest rates increase

present values decrease decrease and vice versa

So, as interest rates increase, bond prices

41 41

4/26/12

Valuing a Discount Bond with Annual Coupons

Consider a bond with a coupon rate of 10% and

annual coupons. The par value is $1,000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond?
Using the formula:
B = PV of annuity + PV of lump sum B = 100[1 1/(1.11)5] / .11 + 1,000 / (1.11)5 B = 369.59 + 593.45 = 963.04

Using the calculator:

N = 5; I/Y = 11; PMT = 100; FV = 1,000
42 42

CPT PV = -963.04

4/26/12

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[1 1/(1.08)20] / .08 + 1000 / (1.08)20 B = 981.81 + 214.55 = 1196.36

Using the calculator:

N = 20; I/Y = 8; PMT = 100; FV = 1000

43 43

CPT PV = -1,196.36

4/26/12

Graphical Relationship Between Price and Yield-to-maturity (YTM)

Bond Price

Yield-to-maturity (YTM)

4444

Bond Prices: Relationship Between Coupon and Yield

If YTM = coupon rate, then par value = bond

price price

If YTM > coupon rate, then par value > bond

Why? The discount provides yield above coupon rate Price below par value, called a discount bond

If YTM < coupon rate, then par value < bond

price

Why? Higher coupon rate causes value above par Price above par value, called a premium bond

45 45

4/26/12

The Bond Pricing Equation

46 46

4/26/12

Example 7.1
Find present values based on the

payment period

How many coupon payments are there? What is the semiannual coupon payment? What is the semiannual yield? B = 70[1 1/(1.08)14] / .08 + 1,000 / (1.08)14

= 917.56
Or PMT = 70; N = 14; I/Y = 8; FV = 1,000; CPT

PV = -917.56
47 47 4/26/12

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

48 48

High coupon rate bonds have more reinvestment rate

risk than low coupon rate bonds

4/26/12

Figure 7.2

49 49

4/26/12

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 N, PV, PMT, and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign)
4/26/12

If you have a financial calculator, enter

50 50

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%

51 51

4/26/12

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 semiannual 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%
52 52 4/26/12

Table 7.1

53 53

4/26/12

Current Yield vs. Yield to Maturity

Current Yield = annual coupon / price Yield to maturity = current yield + capital gains

yield

Example: 10% coupon bond, with semiannual

coupons, face value of 1,000, 20 years to maturity, $1,197.93 price

Current yield = 100 / 1,197.93 = .0835 = 8.35% Price in one year, assuming no change in YTM =

1,193.68

Capital gain yield = (1,193.68 1,197.93) / 1,197.93 =

-.0035 = -.35%

YTM = 8.35 - .35 = 8%, which the same YTM

computed earlier

54 54

4/26/12

Bond Pricing Theorems

Bonds of similar risk (and maturity) will

be priced to yield about the same return, regardless of the coupon rate can estimate its YTM and use that to find the price of the second bond

If you know the price of one bond, you

This is a useful concept that can be

transferred to valuing assets other than bonds

4/26/12

55 55

Bond Prices with a Spreadsheet

There is a specific formula for finding

bond prices on a spreadsheet

Frequency,Basis) Frequency,Basis)

PRICE(Settlement,Maturity,Rate,Yld,Redemption, YIELD(Settlement,Maturity,Rate,Pr,Redemption, Settlement and maturity need to be actual dates The redemption and Pr need to be input as % of par

value

Click on the Excel icon for an example

56 56 4/26/12

 Debt

Differences Between Debt and Equity

Equity
Ownership interest Common stockholders Not an ownership

interest

Creditors do not have

voting rights

Interest is considered a

vote for the board of directors and other issues

cost of doing business and is tax deductible

Dividends are not

Creditors have legal

considered a cost of doing business and are not tax deductible liability of the firm and stockholders have no legal recourse if dividends are not paid go bankrupt merely due to debt since it has no

recourse if interest or principal payments are missed financial distress and bankruptcy

Dividends are not a

Excess debt can lead to

57 57

An all equity firm can not 4/26/12

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

58 58 4/26/12

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
59 59 4/26/12

Bond Characteristics and Required Returns

The coupon rate depends on the risk

characteristics of the bond when issued all else equal?

Which bonds will have the higher coupon,

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
60 60 4/26/12

 High Grade

Bond Ratings Investment Quality

Moodys Aaa and S&P AAA capacity to pay is

extremely strong strong

Moodys Aa and S&P AA capacity to pay is very

Medium Grade
Moodys A and S&P A capacity to pay is strong, but

more susceptible to changes in circumstances

Moodys Baa and S&P BBB capacity to pay is

adequate, adverse conditions will have more impact on the firms ability to pay
61 61 4/26/12

Bond Ratings - Speculative

Low Grade
Moodys 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

Moodys C and S&P C income bonds with no

interest being paid interest in arrears

Moodys D and S&P D in default with principal and

62 62 4/26/12

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

ten years

than

Municipal Securities
Debt of state and local governments Varying degrees of default risk, rated similar to corporate

debt

63 63

Interest received is tax-exempt at the federal level

4/26/12

Example 7.4
A taxable bond has a yield of 8% and a

municipal bond has a yield of 6%

you prefer?

If you are in a 40% tax bracket, which bond do

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%

64 64

4/26/12

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) are good examples of zeroes

Treasury Bills and principal-only Treasury strips

65 65

4/26/12

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

66 66 4/26/12

Other Bond Types

Disaster bonds 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
4/26/12

67 67

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 particularly on small company or municipal issues

Makes getting up-to-date prices difficult,

Treasury securities are an exception

68 68 4/26/12

Work the Web Example

Bond quotes are available online One good site is Bonds Online Click on the web surfer to go to the site
Follow the bond search, corporate links Choose a company, enter it under Express

Search Issue and see what you can find!

69 69

4/26/12

Treasury Quotations
Highlighted quote in Figure 7.4
8 Nov 21

128:07

128:08

5.31

What is the coupon rate on the bond? When does the bond mature? What is the bid price? What does this mean? What is the ask price? What does this mean? How much did the price change from the

previous day?

What is the yield based on the ask price?

70 70 4/26/12

Clean vs. Dirty Prices

Clean price: quoted price Dirty price: price actually paid = quoted price plus

accrued interest

Example: Consider T-bond in previous slide, assume

today is July 15, 2007

Number of days since last coupon = 61 Number of days in the coupon period = 184 Accrued interest = (61/184)(.04*100,000) = 1,326.09

Prices (based on ask):

Clean price = 128,250 Dirty price = 128,250 + 1,326.09 = 129,576.09

71 71

So, you would actually pay $ 129,576.09 for the 4/26/12

bond

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 includes our desired real rate of return plus an adjustment for expected inflation

The ex ante nominal rate of interest

72 72

4/26/12

The Fisher Effect

The Fisher Effect defines the relationship

between real rates, nominal rates, and inflation

R = nominal rate r = real rate h = expected inflation rate

(1 + R) = (1 + r)(1 + h), where

Approximation
R = r + h
73 73 4/26/12

Example 7.5
If we require a 10% real return and we

expect inflation to be 8%, what is the nominal rate?

R = (1.1)(1.08) 1 = .188 = 18.8% Approximation: R = 10% + 8% = 18% Because the real return and expected

inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation.
4/26/12

74 74

Term Structure of Interest Rates

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. structure

Yield curve graphical representation of the term

Normal upward-sloping, long-term yields are higher than

short-term yields

Inverted downward-sloping, long-term yields are lower

than short-term yields

75 75

4/26/12

Figure 7.6 Upward-Sloping Yield Curve

76 76

4/26/12

Figure 7.6 Downward-Sloping Yield Curve

77 77

4/26/12

Figure 7.7

78 78

4/26/12

Factors Affecting Bond Yields

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 cash flows to the bondholders will affect the required returns
4/26/12

Anything else that affects the risk of the

79 79

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?
80 80 4/26/12

End of Chapter Click to edit Master subtitle style

4/26/12 8181

Comprehensive Problem
What is the price of a $1,000 par 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? the yield rose to 7%. the YTM is 7%?

What would be the price of the bond if What is the current yield on the bond if

82 82

4/26/12

CURRENT YIELD:-

The current market price of a bond in the secondary market may differ from its face value. The current yield relates the annual interest receivable on a bond to its current market price. It can be expressed as follows:current yield=In/Po 100

4/26/12