How to value Bonds

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 Debt  Equity
◦ Not an ownership ◦ Ownership interest
interest ◦ Common stockholders
◦ Creditors do not have vote to elect the board
voting rights of directors and on
other issues
◦ Interest is considered a ◦ Dividends are not
cost of doing business considered a cost of
and is tax-deductible doing business and
◦ Creditors have legal are not tax deductible
recourse if interest or ◦ Dividends are not a
principal payments are liability of the firm
missed until declared.
◦ Excess debt can lead to Stockholders have no
financial distress and legal recourse if no
bankruptcy dividends are declared
◦ An all-equity firm
cannot go bankrupt

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A bond is a certificate To repay the money, the
borrower has agreed to
showing that a
make interest and
borrower owes a
principal payments on
specified sum designated dates
Kreuger Enterprises just issued 100,000 bonds for 10,000 Rand
each, where the bonds have a coupon rate of 5 % and a maturity
of two years. Interest on the bonds is to be paid yearly.

The firm must

Rand 1 billion The firm must
pay both Rand 50
pay interest of
has been million of interest
Rand 50 million
borrowed by at the end of one
and Rand 1 billion
the firm. of principal at the
year.
end of two years.
 Three Types
Pure Discount Level Coupon
Bonds Bonds (both Consols (only
(only Face Coupons = C C for ever!)
Value = F) & F)
 Bond Value = PV of coupons + PV of face value

 PV of coupons (C), measured in money units

not in %, is:
C 1 
1
r  (1  r )T 


 PV of face value (F) is:

F
(1  r )T

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 1500
1400
1300
1200
1100
Price

1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
YTM

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 If YTM = C (in %), then F= PV
 If YTM > C (in %), then F> PV
◦ Why?...
◦ Price below F => “discount” bond
 If YTM < C (%), then F< PV
◦ Why?...
◦ Price above F => “premium” bond

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 Change in price due to changes
in interest rates
◦ Interest rates up, bond price 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

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 Yield to maturity is the rate implied by
the current bond price, i.e. solve the
PV formula of a bond for r.
 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

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 Sweden issued the 24th of August 2011 a 2-year
bond with a C rate of 0.875% and C paid annually.
The par value (F) is €100 and the bond was priced at
€99.897. What is the yield to maturity (i.e. r)?
◦ Using the formula:

C  1  F
PV  1  (1  r ) T   (1  r ) T
r  
 99.897 = $0.875[1 – 1/(1+r)2] / r+ $100 / (1+r)2
 r= 0.927% (just less than 1%)

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 Consols Other Uses

•Same as •Same cash

Perpetuity flow stream as
•Use perpetuity preference
formula shares
 If the market-wide interest rate is 10%, what
is the value of a consol with a yearly interest
payment of €50?

€50
 €500
0.10
The Term Structure of Interest Rates, Spot
Rates, and Yield to Maturity
http://highered.mcgraw-
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ices.html
 Consider two zero Coupon bonds.
 Bond A is a one-year bond and bond B is a
two-year bond. Both have F of €1,000.
 The one-year interest rate, r1 = 8%. The two-
year interest rate, r2 =10%.
 These two rates of interest are examples of
spot rates
 Given the spot rates r1=8% and r2 =10%, what
should a 5% Coupon, two-year bond cost?
€50 €1,050
PV    €914.06 (A.1)
1   (1  0.10) 2

 What is the Yield (=Return) to Maturity?

€50 €1, 050

€914.06   (A.2)
1  y (1  y)2
y = 9.95 %
 The Relationship
Yield must come
between Yield and
from zero C bond
Term to Maturity

Graph of
relationship is
called the Yield
Curve
 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 C,
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

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 The forward rate is the theoretically correct (or
implied) interest rate that the market expects, it
will exist in the future (for instance next year).
 Assuming that there are 2 periods and you can
save directly for either 2 years, or for 1 year
first and then for one more year. What is the
implied interest rate next year = f2?
 (1  r2)2  (1  r1)  (1  f2) =>

(1  r2 ) 2
f2  1
  r
 If the one-year spot rate is 7 % and the two-
year spot rate is 12 %, what is f2?

2
(1.12)
f2   1  17.23%
1.07
 (1  rn )
n
fn  n 1
1
(1  rn 1)
 Assume the following set of rates:

Year Spot Rate
1 5%
2 6
3 7
4 6
 What are the forward rates over each of the
four years?
 2
(1.06)
f2   1  7.01%
1.05
3
(1.07)
f3  2
 1  9.03%
(1.06)
4
(1.06)
f4  3
 1  
(1.07)
 Three Main Theories

Liquidity
Expectations Clientele
Preference
Hypothesis Hypothesis
Hypothesis
 fn  Spot rate expected over year n

 Investors will set interest rates such

that the forward rate over the nth year
= to the one-year spot rate expected
over the nth year
 f2  Spot rate expected over year 2

 To induce investors to hold the riskier

two-year bonds, the market sets the
forward rate over the 2nd year to be
above the spot rate expected over the
2nd year.
 • There are Clienteles in the Bond Market
• Pension Funds invest only in long term bonds
Clienteles
• Other institutions invest more in short term bonds

• There is very little overlap between investors in

Overlaps different bond terms

• The dynamics of short-term bonds are different to that

of long-term bonds
Outcome • Any term structure (upward, downward, humped) can
exist