Session6.Bond Valuation

Bonds and Their Valuation
 Bond markets
 Key features of bonds
 Bond pricing
 Bond ratings
 Bond yields and risks
SMU Classification: Restricted
Determinants of Intrinsic Value: The Cost of Debt
Net operating Required investments

−
profit after taxes in operating capital
Free cash flow

=
(FCF)
FCF1 FCF2 FCF∞

Value = + + ... +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates Firm’s debt/equity mix

Cost of debt
Market risk aversion Cost of equity Firm’s business risk
1
What is a bond?
 A long-term debt instrument in which a borrower agrees

to make payments of principal and interest, on specific
dates, to the holders of the bond.
 Issuers of bonds
 Uses of bonds
 Bond certificate
 Sample coupon bond
Key Features of a Bond
 Bond indenture
 Par value
 Coupon interest rate – convert into dollars
 Maturity date – determine years to maturity
 Bond ratings and default risk
 Callable vs puttable bonds
 Yield to maturity – also called “promised yield”
 Pecking order of claims
2
Bond Indenture
 A legal and binding contract between a bond issuer and

the bondholders. The indenture specifies all the
important features of a bond, such as its maturity date,
timing of interest payments, method of interest
calculation, callable/convertible features if applicable and
so on. The indenture also contains all the terms and
conditions applicable to the bond issue. Other critical
information included in the indenture are the financial
covenants that govern the issuer and the formulas for
calculating whether the issuer is within the covenants.
(Source: Investopedia)
Bond Ratings and Bond Spreads
Long-term Bonds Yield (%) Spread (%)

10-Year T-bond 2.18
AAA 3.37 1.19
AA 3.38 1.20
A 4.11 1.93
BBB 6.24 4.06
BB 6.28 4.10
B 7.02 4.84
CCC 9.98 7.80
Source: Fitch Ratings
3
Factors That Affect Default Risk and

Bond Ratings
 Financial ratios
 Debt ratios, coverage ratios, profitability ratios, current
ratios
 Provisions in the bond contract
 Secured versus unsecured debt
 Senior versus subordinated debt
 Guarantee provisions
 Sinking fund provisions
 Debt maturity
 Call provisions
Singapore Corporate Bonds
Issuer Amt ($m) Coupon Maturity Price Int Freq

Neptune 400 4.25 2017-04-26 100.75 2
SBS 150 1.8 2017-09-12 100 2
OLAM 350 5.8 2019-07-17 102 2
MapleTree 160 3.6 2020-08-24 100.625 2
HDB 800 2.185 2022-04-25 100.66 2
UOB 1200 3.15 2022-07-11 99.95 2
CapitalMalls 250 3.7 2022-08-29 100.045 2
StarHub 220 3.08 2022-09-12 99.75 2
DBS Bank 1000 3.1 2023-02-14 100.136 2
NTUC 600 3.65 2027-08-23 102 2
Keppel 300 4 2042-09-07 99.5 2
Source: http://www.singapore-stock-analysis.com/corporate-bonds.html and http://tradehaven.me/2012/09/10/why-not-singapore-corporate-bonds/
4
International Government Bonds
Curr Issuer Coupon Maturity Price

DKK Denmark 4.000 2017-11-15 112.617
EUR Germany 2.000 2024-04-15 105.565
EUR Netherlands 2.000 2024-07-15 105.320
EUR Netherlands 1.250 2019-01-15 103.935
EUR France 0.000 2015-06-25 99.959
EUR Austria 1.650 2024-10-21 101.680
EUR Finland 1.875 2017-04-15 104.822
EUR Portugal 6.200 2016-02-15 108.237
SGD Singapore 2.750 2023-07-01 103.680
Source: http://www.investing.com/rates-bonds/world-government-bonds
Call Provision
 Issuer can refund if rates decline. That helps the

issuer but hurts the investor.
 Therefore, borrowers are willing to pay more,
and lenders require more, on callable bonds.
 Most bonds have a deferred call and a declining
call premium.
10
5
Sinking Fund
 Provision to pay off a loan over its life rather

than all at maturity.
 Similar to amortization on a term loan.
 Reduces risk to investor, shortens average
maturity.
11
Handling of Sinking Funds: 2 Ways
 Call x% at par per year for sinking

fund purposes.
 Call if rd is below the coupon rate and bond sells at
a premium.
 Buy bonds on open market.
 Use open market purchase if rd is above coupon
rate and bond sells at a discount.
12
6
General Valuation Model
0 1 2 n
r% ...
Value CF1 CF2 CFn
CF1 CF2 CFn

Value    ... 
(1 r)1 (1 r)2 (1 r)n
13
Value of a 10-year, 10% coupon, rd = 10%.

Assume FV = $1,000
0 1 2 n
r ...
VB = ? 100 100 100 + 1,000
$100 $100 $1,000

VB   ...  
(1.10) 1 (1.10) 10 (1.10) 10
VB  $90.91  ...  $38.55  $385.54
VB  $1,000
14
7
The bond consists of a 10-year, 10%

annuity of $100/year plus a $1,000 lump
sum at t = 10:
PV annuity = $ 614.46
PV maturity value = 385.54
Value of bond = $1,000.00
INPUTS
10 10 100 1000
N I/YR PV PMT FV
OUTPUT -1,000
15
What would happen if expected inflation

rose by 3%, causing r = 13%?
INPUTS 10 13 100 1000

N I/YR PV PMT FV
OUTPUT -837.21
When rd rises above the coupon rate, the bond’s

value falls below par, so it sells at a discount.
16
8
What would happen if inflation fell, and rd

declined to 7%?
INPUTS 10 7 100 1000

N I/YR PV PMT FV
OUTPUT -1,210.71
If coupon rate > rd, price rises above par,

and bond sells at a premium.
17
The Yield-to-Maturity (YTM or rd)
 YTM is the rate of return earned on a bond held

to maturity. Also called “promised yield.”
 It assumes the bond will not default.
 If coupon rate < rd, bond sells at a discount.
 If coupon rate = rd, bond sells at its par value.
 If coupon rate > rd, bond sells at a premium.
18
9
Bond Value ($) vs. Years remaining to

Maturity
 Suppose the bond was issued 20 years ago

and now has 10 years to maturity. What
would happen to its value over time if the
required rate of return remained at 10%, or at
13%, or at 7%?
19

Maturity
1,372 rd = 7%.
1,211
rd = 10%.
1,000 M
837
rd = 13%.
775
30 25 20 15 10 5 0
20
10

Maturity
 At maturity, the value of any bond must equal

its par value.
 The value of a premium bond would decrease
to $1,000.
 The value of a discount bond would increase
to $1,000.
 A par bond stays at $1,000 if rd remains
constant.
21
Past-year Exam Question:

Bond Yields and Prices
You are considering two bonds. Bond A has a 9% annual
coupon while Bond B has a 6% annual coupon. Both bonds have
a 7% yield to maturity, and the YTM is expected to remain
constant. Which of the following statements is CORRECT?
a. The price of Bond B will decrease over time, but the price of
Bond A will increase over time.
b. The prices of both bonds will remain unchanged.
c. The price of Bond A will decrease over time, but the price of
Bond B will increase over time.
d. The prices of both bonds will increase by 7% per year.
e. The prices of both bonds will increase over time, but the price
of Bond A will increase at a faster rate.
22
11
YTM on a 10-year, 9% annual coupon,

$1,000 par value bond selling for $887
0 1 9 10
rd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find rd
23
Find rd
INT INT M
VB = + ... + +
(1 + rd) 1 (1 + rd)N (1 + rd)N
90 1,000
887 = + ... + 90 +
(1 + rd)1 (1 + rd)10 (1 + rd)10
INPUTS 10 -887 90 1000

N I/YR PV PMT FV
OUTPUT 10.91
24
12
Find YTM if price were $1,134.20.
INPUTS 10 -1134.2 90 1000

N I/YR PV PMT FV
OUTPUT 7.08
Sells at a premium. Because

coupon = 9% > rd = 7.08%,
bond’s value > par.
25
Definitions
Annual coupon pmt

Current yield = Current price
Capital gains yield = Change in price

Beginning price
Exp total Exp Exp cap

= YTM = +
return Curr yld gains yld
26
13
9% coupon, 10-year bond, P = $887,

and YTM = 10.91%
$90
Current yield = $887
= 0.1015 = 10.15%.
27
YTM = Current yield + Capital gains yield.
Cap gains yield = YTM - Current yield

= 10.91% - 10.15%
= 0.76%.
 P0 = $887; P1 = $893.78
 Cap gains yield = (893.78 – 887)/887

= 0.76%
28
14
Semiannual Bonds
1. Multiply years by 2 to get periods = 2N.

2. Divide nominal rate by 2 to get periodic
rate = rd/2.
3. Divide annual INT by 2 to get PMT =
INT/2.
INPUTS 2N rd/2 OK INT/2 OK

N I/YR PV PMT FV
OUTPUT
29
Value of 10-year, 10% coupon,

semiannual bond if rd = 13%.
2(10) 13/2 100/2

INPUTS 20 6.5 50 1000
N I/YR PV PMT FV
OUTPUT -834.72
30
15
Callable Bonds and Yield to Call
 A 10-year, 10% semiannual coupon,

$1,000 par value bond is selling for
$1,135.90 with an 8% yield to maturity.
It can be called after 5 years at $1,050.
 Call Price
31
Nominal Yield-to-Call (YTC)
INPUTS 10 -1135.9 50 1050

N I/YR PV PMT FV
OUTPUT 3.765 x 2 = 7.53%
32
16
If you bought this bond, would you be

more likely to earn YTM or YTC?
 In general, if a bond sells at a premium, then

coupon > rd (market interest rates have fallen),
so a call is likely.
 So, expect to earn:
 YTC on premium bonds.
 YTM on par & discount bonds.
33
Interest rate (or price) risk for

1-year and 10-year 10% bonds
 Interest rate risk is the concern that rising rd will cause
the value of a bond to fall.
rd 1-year Change 10-year Change

5% $1,048 $1,386
+4.8% +38.6%
10% 1,000 1,000
15% 956 –4.4% 749 –25.1%
The 10-year bond is more sensitive to interest rate

changes, and hence has more interest rate risk.
34
17
Assume two 10-year bonds with different coupon

rates, one at 6%, the other at 10%. Which of
these two have more interest rate risk?
rd 6% coupon Change 10% coupon Change

5% $1,077 $1,386
+42.8% +38.6%
10% 754 1,000
15% 548 –27.3% 749 –25.1%
The 6% (lower) coupon bond is more sensitive to

interest rate changes, and hence has more interest rate
risk.
35
Bond Theorems
1. Relationship between interest rate and price.

 Interest rates and bond prices are inversely related to
each other.
2. Short vs. long maturity
 All else remaining the same, long term bonds are more
price sensitive to a given change in interest rates than
short term bonds.
3. Low vs. high coupons
 For a given maturity, all else remaining the same, lower
coupon bonds are more price sensitive to a given
change in interest rates than higher coupon bonds.
36
18
Past-year Exam Question:

Bond Theorems
Which of the following bonds would have the greatest
percentage increase in value if all interest rates in the
economy fall by 1%?
a. 10-year, zero coupon bond.
b. 20-year, 10% coupon bond.
c. 20-year, 5% coupon bond.
d. 1-year, 10% coupon bond.
e. 20-year, zero coupon bond.
37
Reinvestment Rate Risk vs. Price Risk
 Reinvestment rate risk is the concern that

interest rates (rd) might fall, and future CFs
would have to be reinvested at lower rates,
hence reducing income.
 Price risk is the concern that bond prices
would fall when interest rates (rd) rise.
38
19
The Term Structure of Interest Rates

(Yield Curve)
Interest  An upward-sloping yield
Rate (%)
curve.
15 Maturity risk premium
 Upward slope due to an
increase in expected
10 Inflation premium
inflation and increasing
maturity risk premium.
Real risk-free rate

Years to
0 Maturity
1 10 20
39
Term Structure Yield Curve
 Term structure – relationship between interest rates (or

yields) and maturities.
 The yield curve is a graph of the term structure.
 If interest rates are expected to increase, L-T rates will be
higher than S-T rates, and vice-versa.
 Thus, the yield curve can slope up, down, or even bow.
 US: https://www.treasury.gov/resource-center/data-chart-
center/interest-rates/Pages/TextView.aspx?data=yield
 SG: https://secure.sgs.gov.sg/fdanet/BenchmarkPricesAndYields.aspx
40
20
Mini Case: Temasek’s Bond Issue
 Temasek raised US$1.75 billion in inaugural

bond issue in 2005
 Price: 99.403
 Coupon: 4.5% semiannual
 Maturity: 10 years
 Spread: 44 basis points above equivalent US
Treasuries
 Determine the YTM of the bond (4.575%).
41
Summary
Questions and Answers
42
21

Session6.Bond Valuation

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Session6.Bond Valuation

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Bonds and Their Valuation

SMU Classification: Restricted

Determinants of Intrinsic Value: The Cost of Debt

Net operating Required investments

Free cash flow

FCF1 FCF2 FCF∞

Market interest rates Firm’s debt/equity mix

 A long-term debt instrument in which a borrower agrees

SMU Classification: Restricted

Key Features of a Bond

 A legal and binding contract between a bond issuer and

SMU Classification: Restricted

Bond Ratings and Bond Spreads

Long-term Bonds Yield (%) Spread (%)

Factors That Affect Default Risk and

SMU Classification: Restricted

Singapore Corporate Bonds

Issuer Amt ($m) Coupon Maturity Price Int Freq

International Government Bonds

Curr Issuer Coupon Maturity Price

SMU Classification: Restricted

 Issuer can refund if rates decline. That helps the

 Provision to pay off a loan over its life rather

SMU Classification: Restricted

Handling of Sinking Funds: 2 Ways

 Call x% at par per year for sinking

General Valuation Model

CF1 CF2 CFn

SMU Classification: Restricted

Value of a 10-year, 10% coupon, rd = 10%.

$100 $100 $1,000

The bond consists of a 10-year, 10%

SMU Classification: Restricted

What would happen if expected inflation

INPUTS 10 13 100 1000

When rd rises above the coupon rate, the bond’s

What would happen if inflation fell, and rd

INPUTS 10 7 100 1000

If coupon rate > rd, price rises above par,

SMU Classification: Restricted

The Yield-to-Maturity (YTM or rd)

 YTM is the rate of return earned on a bond held

Bond Value ($) vs. Years remaining to

 Suppose the bond was issued 20 years ago

SMU Classification: Restricted

Bond Value ($) vs. Years remaining to

Bond Value ($) vs. Years remaining to

 At maturity, the value of any bond must equal

SMU Classification: Restricted

Past-year Exam Question:

YTM on a 10-year, 9% annual coupon,

SMU Classification: Restricted

INPUTS 10 -887 90 1000

Find YTM if price were $1,134.20.

INPUTS 10 -1134.2 90 1000

Sells at a premium. Because

SMU Classification: Restricted

Annual coupon pmt

Capital gains yield = Change in price

Exp total Exp Exp cap

9% coupon, 10-year bond, P = $887,

SMU Classification: Restricted

YTM = Current yield + Capital gains yield.