Bond Valuation

Accounting and Finance Class

Instructure : Usman Arief
Bond Definitions

• Bond

• Par value (face value)

• Coupon rate

• Coupon payment

• Maturity date

• Yield or Yield to maturity

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

• As interest rates increase, present values decrease

• So, as interest rates increase, bond prices

decrease and vice versa

7-3
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
• CPT PV = -963.04

7-4
Valuing a Premium Bond with Annual
Coupons
• Suppose you are reviewing 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
• CPT PV = -1,196.36

7-5
 Graphical Relationship Between Price and
Yield-to-maturity (YTM)

1500
1400
Bond Price, in dollars 1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%

Yield-to-Maturity Yield-to-maturity
(YTM) (YTM)

Bond characteristics:
10 year maturity, 8% coupon rate, $1,000 par value 7-6
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? 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

7-7
The Bond Pricing Equation

 1 
1 -
 (1 + r) t  FV
Bond Value = C  +
 (1 + r)
t
 r
 

7-8
Copyright © 2016 by McGraw-Hill Education. All rights reserved
 Example 7.1

• If an ordinary bond has a coupon rate of

14 percent, then the owner will get a total
of $140 per year, but this $140 will come in  1 
 1 - (1 + r) t  FV
two payments of $70 each. The yield to Bond Value = C  +
 (1 + r)
t
maturity is quoted at 16 percent. The bond  r
 
matures in seven years. If Par Value is
$1000. Calculate the bond value?

7-9
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

7-10
Long-term VS Short-term bond

7-11
Computing Yield to Maturity
• Yield to Maturity (YTM) 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)

7-12
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%

7-13
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%

7-14
Table 7.1

7-15
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 is the same YTM computed
earlier

7-16
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

7-17
Bond Prices with a Spreadsheet
• 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 be input as % of
par value

• Click on the Excel icon for an example

7-18
Differences Between
Debt and Equity
• Debt • Equity
▪ Not an ownership interest ▪ Ownership interest
▪ Creditors do not have voting ▪ Common stockholders vote
rights for the board of directors
▪ Interest is considered a cost and other issues
of doing business and is tax ▪ Dividends are not
deductible considered a cost of doing
▪ Creditors have legal business and are not tax
recourse if interest or deductible
principal payments are ▪ Dividends are not a liability
missed of the firm, and stockholders
▪ Excess debt can lead to have no legal recourse if
financial distress and dividends are not paid
bankruptcy ▪ An all equity firm can not go
bankrupt merely due to debt
since it has no debt

7-19
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

7-20
Bond Classifications

• Registered vs. Bearer Forms

• Security
▪ Collateral – secured by financial securities
▪ Mortgage – secured by real property, normally land or
buildings
▪ Debentures – unsecured with 10 years or more maturity
▪ Notes – unsecured debt with original maturity less than
10 years

• Seniority

7-21
Bond Characteristics and Required
Returns
• 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

7-22
Bond Ratings –
Investment Quality
• High Grade
▪ Moody’s Aaa, S&P and Fitch AAA – capacity to pay is
extremely strong
▪ Moody’s Aa, S&P and Fitch AA – capacity to pay is very
strong

• Medium Grade
▪ Moody’s A, S&P and Fitch A – capacity to pay is strong,
but more susceptible to changes in circumstances
▪ Moody’s Baa, S&P and Fitch BBB – capacity to pay is
adequate, adverse conditions will have more impact on
the firm’s ability to pay

7-23
Bond Ratings –
Speculative Grade
• Low Grade
▪ Moody’s Ba and B
▪ S&P and Fitch BB and B
▪ Considered possible that the capacity to pay will
degenerate.

• Very Low Grade

▪ Moody’s C (and below) and S&P and Fitch C (and
below)
• income bonds with no interest being paid, or
• in default with principal and interest in arrears

7-24
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
7-25
Example 7.4

• 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%

7-26
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 are good
examples of zeroes

7-27
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”

7-28
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
7-29
Sukuk

• Sukuk are bonds have been created to meet a

demand for assets that comply with Shariah, or
Islamic law

• Shariah does not permit the charging or paying of

interest

• Sukuk are typically bought and held to maturity, and

are extremely illiquid

7-30
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

7-31
Work the Web Example
• Bond quotes are available online

• One good site is FINRA’s Market Data Center

• Click on the web surfer to go to the site

▪ Choose a company, enter it in the Issuer Name bar,
choose Corporate, and see what you can find!

7-32
Treasury Quotations
• Highlighted quote in Figure 7.4
Maturity Coupon Bid Asked Chg Asked yield
2/15/2036 4.50 136.5469 136.6094 -1.7109 2.30

▪ 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?

7-33
Clean vs. Dirty Prices
• Clean price: quoted price

• Dirty price: price actually paid = quoted price plus accrued

interest

• Example: Consider a T-bond with a 4% semiannual yield and a

clean price of $1,282.50:
▪ Number of days since last coupon = 61
▪ Number of days in the coupon period = 184
▪ Accrued interest = (61/184)(.04*1000) = $13.26
▪ Dirty price = $1,282.50 + $13.26 = $1,295.76

• So, you would actually pay $ 1,295.76 for the bond

7-34
Inflation and Interest Rates
• Real rate of interest – change in purchasing
power

• Nominal rate of interest – quoted rate of

interest, change in actual number of dollars

• The ex ante nominal rate of interest includes

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

7-35
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

7-36
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.

7-37
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.

• 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

7-38
Figure 7.6 – Upward-Sloping Yield Curve

7-39
Figure 7.6 – Downward-Sloping
Yield Curve

7-40
Figure 7.7

7-41
Factors Affecting
Bond Yields

• Real rate of interest

• Expected future inflation premium

• Interest rate risk premium

• Default risk premium

• Taxability premium

• Liquidity premium
7-42
 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% and it has 9
years to maturity?

• What would be the price of the bond if the yield rose to 7%?

• What is the current yield on the bond if the YTM is 7%?

7-43