Corporate Finance (B02030) Ton Duc Thang University

Module 3
VALUING BONDS

Bonds and Bond Valuation

A bond is a debt security that obligates the borrower or issuer to make specified payments (periodic
interest payments and return of principal) to the lender or investor.

Bond Features. A level-coupon bond promises regular interest payments (called coupon interest
payment or coupon) either annually or semi-annually, as well as a specified principal payment
(called face value, par value or maturity value) at the maturity date.

The coupon interest rate, or coupon rate, indicates the annual coupon interest payment to the
holder of the bond; the coupon interest rate times the face value of the bond is equal to the coupon
payment. Meanwhile, the yield to maturity is the required market rate or rate that makes the
discounted cash flows from a bond equal to the bond’s market price. The maturity date is the date of
the principal payment to the owner of the bond, and is also the date of the last coupon payment.

Example: On 1 January 2017, Beck Corporation wants to borrow $1,000 for 30 years and issues
corporate bonds. Beck will pay 12% interest every year for 30 years. The interest rate on similar debt
issued by similar corporations is 11%. At the end of 30 years which is 31 December 2046, Beck will
repay the $1,000.

The face value of the bond is $1,000. The coupon rate is 12%. The coupon is 12% x $1,000 = $120.
The yield to maturity is 11%. The maturity date is 31 December 2046.

Bond Values. The cash flows from a bond are the coupons and the face value. The value of a bond
(market price) is the present value of the expected cash flows discounted at the market rate of
interest or yield to maturity. The bond pricing equation takes the following form:

Bond price or value = PV of coupons + PV of par = PV of annuity + PV of lump sum = [C x PVIFA(r,t)]

+ [F x PVIF(r,t)]

where C is the coupon payment, t is the number of time periods to the maturity date, r is the yield to
maturity rate, and F is the face value.

Example: Wilhite, Co. issues $1,000 par bonds with 20 years to maturity. The annual coupon is $110.
Similar bonds have a yield to maturity of 11%.

Bond price = PV of coupons + PV of face value

Bond price = $110[1 – 1/(1.11)20] / 0.11 + $1,000 / (1.11)20 = $875.97 + $124.03 = $1,000

Example: Assume instead that the yield to maturity on bonds similar to that of Wilhite Co. is 13%
instead of 11%. What is the bond price?

Bond price = 110[1 – 1/(1.13)20] / 0.13 + 1,000/(1.13)20 = 772.72 + 86.78 = 859.50

The difference between this price $859.50 and the par value of $1000 is $140.50. This is equal to the
present value of the difference between bonds with coupon rates of 13% ($130) and Wilhite’s coupon
($110). (Check: $20[1 – 1/(1.13)20] / 0.13 = $140.50)
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Example: Consider the Wilhite bond in the previous examples. Suppose that the yield on bonds of
similar risk and maturity is 9% instead of 11%. What will the bonds sell for?

Bond price = 110[1 – 1/(1.09)20] / .09 + 1,000/(1.09)20 = 1,004.14 + 178.43 = 1,182.57

When a bond sells for more than its face value, it is said to be selling at a premium and is referred to
as a premium bond; a bond which sells for less than face value is selling at a discount and is called
a discount bond. When the market rate of interest is equal to the bond’s coupon rate, the bond’s
market value is equal to its face value and is said to be a par bond.

When coupon rate = YTM, price = par value (par bonds).

When coupon rate > YTM, price > par value (premium bond).
When coupon rate < YTM, price < par value (discount bond).

The value of the bond decreases when the market rate of interest increases. Similarly, a
decrease in the market rate of interest increases the value of the bond. If the coupon rate and
the yield are the same, the price should equal face value.

Finding the Yield to Maturity. An understanding of the relationship between interest rates and bond
values is essential in determining the yield to maturity for a given bond. The yield to maturity is the
discount rate which equates the present value of the future cash flows and the current market price.

Example: 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%? (Clue: par value >
bond price) Answer: 11%. Excel formula: =RATE(15,100,-928.09,1000).

Interest Rate Risk

Bond price changes attributable to changes in market interest rates constitute interest rate risk. All
else equal, the longer the time to maturity, the greater the interest rate risk.

Bond Ratings

Firms often pay to have a credit rating assigned to their bonds. Moody’s Investors Services, and
Standard & Poor’s Corporation (S&P) are the two largest rating agencies. Bonds are rated according
to the likelihood of default and the protection afforded bondholders in the event of default. The
highest ratings (AAA, AA for S&P, Aaa, Aa for Moody’s) indicate a very low probability of default.
Bonds rated at least BBB (S&P) or Baa (Moody’s) are considered investment grade, while lower-
rated bonds are referred to as low-grade, high-yield, or junk bonds.

Some Different Types of Bonds

Government Bonds. A national government can borrow by issuing treasury bills and bonds.
Treasury bills are discount instruments with maturities of up to one year while bonds can have
maturities ranging from 2 to 30 years. Treasury bills and bonds have no default risk.

Zero Coupon Bonds. A zero-coupon bond pays no annual coupon interest. Principal and all
interest are paid at maturity, and the bond is issued at a price below face value. The difference
between the face value and the original issue price bond constitutes the interest paid.

Floating-Rate Bonds. The coupon payments on a floating-rate bond are adjusted as interest rates
change. Most ‘floaters’ have a ‘put’ provision which gives the holder the option to redeem the bond at
face value; the put provision takes effect following a specified period after issuance. Most floaters
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also have a floor-and-ceiling provision, specifying minimum and maximum coupon rates over the
bond’s life.

Other Types of Bonds. As with most securities, the number of features and variants found in bonds
is limited only by investment bankers’ and financial officers’ imaginations. An income bond is a bond
in which the coupon payment is made only if income is sufficient, so it is not necessarily in default
when a payment is omitted. Convertible bonds can be exchanged for a specified number of the
issuing firm’s common stock at the bondholder’s option. Put bonds can be sold back to the issuer at
a specified price, again at the bondholder’s option.

Inflation and Interest Rates

Real versus Nominal Returns. Suppose the rate of return on an investment is 10% and the rate of
inflation is 5%. If one invests $1 at the 10% rate of return, he will have $1.10 at the end of one year;
this is a nominal amount, because it is measured in actual dollars. It does not reflect the change in
one’s purchasing power, however. If an item costs $1 at the beginning of the year, then $1 will buy
one item. If during the year the cost of the item increases by 5% due to inflation, $1.10 will buy
($1.10/$1.05) = 1.048 units of the same item. Consequently, one’s purchasing power has increased
by only 4.8%, rather than by the 10% earned on the investment.

The Fisher Effect. In the above example, the nominal rate of return is 10%, but the real rate of return
is only 4.8%; the real rate indicates the actual change in purchasing power. The Fisher Effect is a
theoretical relationship between nominal returns, real returns and the expected inflation rate. Let R be
the nominal rate, r the real rate and h the expected inflation rate; then, (1 + R) = (1 + r)(1 + h).

Example: 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%

Determinants of Bond Yields

The Term Structure of Interest Rates. Bond yields reflect the required rates of return existing in the
economy at a point in time. The term structure of interest rates is the relationship between nominal
short- and long-term interest rates for debt issues which have no default risk. The nominal rates
reflected in the term structure (or in its graphical representation, the yield curve) impound (a) the real
rate of interest, (b) an inflation premium, and (c) an interest rate risk premium.

Bond Yields and the Yield Curve. The required return on corporate bonds includes not only the
three components mentioned above, but also premiums for default risk (the portion of a nominal rate
that represents compensation for the possibility of default), taxability (the portion of a nominal rate
that represents compensation for unfavorable tax status), and illiquidity (the portion of a nominal
rate that represents compensation for lack of liquidity).
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Spot Rate and Forward Rate. Spot rate is the actual interest rate today while the forward rate is
the interest rate, fixed today, on a loan made in the future at a fixed time. If we are given spot rates, r1
and r2, we can always determine the forward rate for year 2, f2, such that (1 x r2)2 = (1 x r1) x (1 x f2) or
f2 = (1 x r2)2 / (1 x r1) – 1.

Example: If the one-year spot rate is 7 percent and the two-year spot rate is 12 percent, what is
forward rate for year 2? (1.122) / 1.07 – 1 = 17.23%

We can rearrange this equation to find the general formula: fn = (1 + YTMn)n / (1 + YTMn-1)n-1 - 1

Example: Calculate the forward rates for years 1 through 5 from the following zero-coupon yields:

Maturity 1 2 3 4
YTM 5.00% 6.00% 6.00% 5.75%

f1 = YTM = 5.00%

f2 = 1.062 / 1.05 – 1 = 7.01%

f3 = 1.063 / 1.062 – 1 = 6.00%

f4 = 1.05754 / 1.063 – 1 = 5.00%

Exercises

1. Microhard has issued a bond with the following characteristics:

Par: $1,000
Time to maturity: 15 years
Coupon rate: 7 percent
Semiannual payments
Calculate the price of this bond if the YTM is:
a. 7 percent $1,000.00
b. 9 percent $837.11
c. 5 percent $1,209.30

2. A 10-year German government bond (bund) has a face value of €100 and a coupon rate of 5%
paid annually. Assume that the interest rate (in euros) is equal to 6% per year. What is the bond’s
PV? €92.64

3. A 10-year U.S. Treasury bond with a face value of $10,000 pays a coupon of 5.5% (2.75% of face
value every six months). The semiannually compounded interest rate is 5.2% (a six-month
discount rate of 5.2/2 = 2.6%). What is the present value of the bond? $10,231.64

4. Even though most corporate bonds in the United States make coupon payments semiannually,
bonds issued elsewhere often have annual coupon payments. Suppose a German company
issues a bond with a par value of €1,000, 19 years to maturity, and a coupon rate of 4.5 percent
paid annually. If the yield to maturity is 3.9 percent, what is the current price of the bond?
€1,079.48

5. The prices of several bonds with face values of $1000 are summarized in the following table:

Bond A B C D
Price $972.50 $1040.75 $1150.00 $1000.00

For each bond, state whether it trades at a discount, at par, or at a premium.

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6. Suppose a seven-year, $1,000 bond with an 8% coupon rate and semiannual coupons is trading
with a yield to maturity of 6.75%.
a. Is this bond currently trading at a discount, at par, or at a premium? Explain. At a premium.
b. If the yield to maturity of the bond rises to 7% (APR with semiannual compounding), what
price will the bond trade for? $1,054.60

*7. A Japanese company has a bond outstanding that sells for 92 percent of its ¥100,000 par value.
The bond has a coupon rate of 2.8 percent paid annually and matures in 21 years. What is the
yield to maturity of this bond? 3.34% =RATE(21,28,-920,1000)

*8. Watters Umbrella Corp. issued 15-year bonds 2 years ago at a coupon rate of 6.4 percent. The
bonds make semiannual payments. If these bonds currently sell for 105 percent of par value,
what is the YTM? 2.923% x 2 = 5.85%, =RATE(13*2,64/2,-1050,1000)*2

*9. Hawk Enterprises has bonds on the market making annual payments, with 16 years to maturity,
and selling for $870. At this price, the bonds yield 7.5 percent. What must the coupon rate be on
the bonds? 6.08% =PMT(7.5%,16,-870,1000)/1000

*10.Rhiannon Corporation has bonds on the market with 11.5 years to maturity, a YTM of 7.6
percent, and a current price of $1,060. The bonds make semiannual payments. What must the
coupon rate be on these bonds? 8.39% =PMT(7.6%/2,11.5*2,-1060,1000)*2/1000

11. Andrew Industries is contemplating issuing a 30-year bond with a coupon rate of 7% (annual
coupon payments) and a face value of $1000. Andrew believes it can get a rating of A from
Standard and Poor’s. However, due to recent financial difficulties at the company, Standard and
Poor’s is warning that it may downgrade Andrew Industries bonds to BBB. Yields on A-rated,
long-term bonds are currently 6.5%, and yields on BBB-rated bonds are 6.9%.
a. What is the price of the bond if Andrew maintains the A rating for the bond issue? $1,065.29
b. What will the price of the bond be if it is downgraded? $1,012.53

12. HMK Enterprises would like to raise $10 million to invest in capital expenditures. The company
plans to issue five-year bonds with a face value of $1000 and a coupon rate of 6.5% (annual
payments). The following table summarizes the yield to maturity for five-year (annual pay) coupon
corporate bonds of various ratings:

Rating AAA AA A BBB BB

YTM 6.20% 6.30% 6.50% 6.90% 7.50%

a. Assuming the bonds will be rated AA, what will the price of the bonds be? $1,008.36
b. What must the rating of the bonds be for them to sell at par? A-rated
*c. Suppose that when the bonds are issued, the price of each bond is $959.54. What is the likely
rating of the bonds? Are they junk bonds? 7.5% =RATE(5,65,-959.54,1000), BB-rated (junk
bonds)

13. What is the price of a 15-year, zero coupon bond paying $1,000 at maturity if the YTM is:
a. 5 percent? $476.74
b. 10 percent? $231.38
c. 15 percent? $114.22
(Note: Even though there are no coupon payments, the periods are semiannual.)

14. If Treasury bills are currently paying 4.5 percent and the inflation rate is 2.1 percent, what is the
real rate of interest? 2.35%

15. Suppose the real rate is 2.4 percent and the inflation rate is 3.1 percent. What rate would you
expect to see on a Treasury bill? 5.57%

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16. An investment offers a 14 percent total return over the coming year. Alan Wingspan thinks the
total real return on this investment will be only 10 percent. What does Alan believe the inflation
rate will be over the next year? 3.64%

17. Say you own an asset that had a total return last year of 12.5 percent. If the inflation rate last year
was 5.3 percent, what was your real return? 6.84%

18. Assume the following set of rates:

Year 1 2 3 4
Spot Rate 5% 6% 7% 6%

What are the forward rates over each of the four years? f1 = 5%; f2 = 7.01%; f3 = 9.03%; f4 =
3.06%