BOND VALUATION AND
INTEREST RATES
CHAPTER 8
Chapter outline
• Introduction
• What is a bond?
• Characteristics of bonds
• How to value a bond
• The different types of bonds
• Bond markets and bond ratings
• What determines bond yields?
• The influence of interest and inflation rates
on bonds
• Conclusions
Learning outcomes
By the end of this chapter, you should be
able to:
• Explain what a bond is and the main
characteristics of a bond.
• Calculate the value of a bond.
• Describe the various types of bonds, bond
markets and bond ratings.
• Examine what determines bond yields.
• Explain the relationship between bonds,
interest rates and the inflation rate.
Introduction
• A bond is a form of debt financing
• Used by governments and the corporate
sector, usually to finance expansion
• Determine a bond’s current value by
calculating the present value of all the
future cash flows
What is a bond?
• Companies or governments in need of
bonds can borrow money from the public
on a long-term basis
• The public buys the bond from the
borrower (bond issuer) and becomes the
lender (bond holder)
• The bond issuer is obliged to pay interest
(coupons) to the lender at fixed intervals
What is a bond?
• At the end of the life of the bond (maturity),
the bond issuer has to repay the principal
amount (par/nominal amount) to the bond
holder
• Bond issuer generally uses to funds from
the bond issue to finance long-term
investments/current expenditure
Characteristics of a bond
• Nominal amount
– Amount borrowed and repaid at the end of the life of the
bond
• Coupon rate
– Fixed interest rate that the issuer pays the bond holder
every period
• Coupon
– Amount that the issuer pays the bond holder every period
• Maturity
– Time left until the bond reaches the end of its term and the
nominal value has to be repaid
• Yield-to-maturity (YTM)
– Interest rate required on bonds
– Not fixed but fluctuates
Characteristics of a bond
• Bonds = interest-only loans
• Annuity = makes fixed payments for a
specific period of time
• Therefore, a bond = an annuity
Characteristics of a bond
• If YTM > coupon rate
– Investors in the market receive a higher interest
rate than bond investors
– To attract investors they should be compensated
by selling the bond at a cheaper price (trading at
a discount)
• If coupon rate > YTM
– Bond investors will receive a higher interest rate
than investors in the market
– They will have to pay for the privilege by selling
the bond at a more expensive price (trading at a
premium)
Bond values and interest rates
How to value a bond
• Calculating the value of a bond = 5
variables
– Nominal value of the bond – usually to the
value of R1 000 (or US$100)
– Coupon rate – fixed percentage (an interest
payment)
– Time to maturity
– YTM – current interest rate in the markets (not
fixed interest rate)
– PV of the bond – amount investors will pay for
the investment
• With any 4 variables, the 5th can be
calculated
How to value a bond
• Using a financial calculator
• PV of an annuity: Calculating all the future
cash flows and adding them together
How to value a bond
• Bond = 2 parts
– Annuity part (coupon payments)
– Nominal value (paid at maturity)
– Calculated separately and added together
– Bond PV = PV of annuity + PV of nominal value
Semi-annual payments
• South African bonds are mostly semi-
annual
• Make 2 payments a year (every 6 months)
• Therefore, 3 things needs to happen:
– The maturity has to double (maturity x 2)
– The coupon rate has to be halved
– (coupon rate ÷ 2)
– The yield-to-maturity has to be halved (YTM ÷ 2)
Semi-annual payments
• The reason for this is that instead of
receiving for instance 10% per year in
coupons for a 10 year period, the company:
– Makes 2 payments a year of 5% each
– There are 2 payments a year for 10 years,
therefore 20 periods
– The YTM also has to be halved
Example 8.1
Example 8.1
Example 8.2
Example 8.3
Example 8.3
Example 8.4
Example 8.4
Example 8.5
Example 8.5
The different types of bonds
• Government bonds
– Treasury bills: maturity of less than 1 year
– Treasury notes: maturity between 1 and 10
years
– Treasury bonds: maturity longer than 10 years
• Municipal bonds
– Municipalities support debt with property taxes
• Corporate bonds
– Higher yields – higher risk (lower than
governments)
– Companies are classified according to:
• Specific industry
• Credit rating
The different types of bonds
• Convertible bonds
– Gives the owner the right to convert the nominal
amount to ordinary shares
The different types of bonds
• Junk bonds
– High-yield bonds
– Highly risky and speculative
– Higher return
• Zero-coupon bonds
– No coupon payments
– Offered at a considerable discount to par
Example 8.8
Conclusion
• A bond is a debt instrument issued either by a
government or a corporation in need of funds. The
bond pays interest on the nominal amount (coupon
payments). The loan has a fixed maturity and
when it reaches maturity, the nominal amount is
repaid.
• A bond consists of the following variables:
– Nominal value
– Coupon rate
– Coupon
– YTM
– Maturity
– Price of the bond
Conclusion (cont.)
• When the YTM (the interest rate in the market) and
the coupon rate differ, the price of the bond will
also differ from the nominal value of the bond.
When the interest rate in the market goes up, the
price of the bond goes down to compensate the
investor for earning a lower coupon rate (trading at
a discount).
• When the YTM is lower then the coupon rate, the
price of the bond will increase relative to the
nominal value. The price of the bond will be more
because the bond will pay a higher coupon rate
than in the market and, therefore, the investor has
to pay more for that privilege.
Conclusion (cont.)
• If the YTM and the coupon rate are equal, then the
price of the bond will equal the nominal value.
• When calculating the price of a bond, the PV of the
lump sum paid out at maturity (the nominal value)
will have to be calculated and added to the PV of
all the future cash flows (the coupon payments).
• A bond that makes semi-annual payments makes
two payments a year – once ever six months. This
means that the coupon rate has to be divided by
two, and the coupon payment and maturity will
have to be multiplied by two.
Conclusion (cont.)
• There are various types of bonds, namely
government, municipal, corporate, convertible,
zero-coupon, extendable, retractable, foreign
currency, junk and inflation-linked bonds.
• The New York Stock Exchange is the biggest bond
exchange in the world; South Africa’s BESA is a
leader in emerging economies. Mostly, the bond
market is an OTC market.
• Moody’s, Standard & Poor’s and Fitch are the
three main credit-rating agencies.
Conclusion (cont.)
• Bonds are rated in order to indicate to investors
the level of risk of payment default.
• The bond coupon rate is dependent on the real
interest rate implicit in the coupon, the expected
inflation rate, the time left to maturity, and the
interest rate risk, default risk and liquidity risk.
• The difference between real and nominal interest
rates is that the real interest rate has been
adjusted for inflation, where the nominal rate has
not been adjusted for inflation.
Conclusion (cont.)
• The Fisher Effect illustrates the relationship
between the nominal rate, real rate and inflation
rate.
