Bond Valuations

Firm borrow money by issuing or selling bonds. A bond is an interest-only loan. The

interests payments either annually or semi-annually are called coupons. The amount

that a firm repays at the end of the loan is called face value or par value, which is

usually $1,000 for corporate bonds. The number of years it takes to pay the face or par

value is called maturity. Also, there are callable or non-callable bonds.

There are two types of bonds: Pure Discount Bond and Level Coupon Bond

1. Pure Discount Bond is called zeroes, deep discount bonds or original issue

discount bonds (OIDs). It has no interest payment. In this case, the Bond price

(Bo) = the present value of face value or par value. Examples of this type of

bonds are treasury bills, treasury strips. With treasury strips, when a firm buys a

coupon-bearing treasury issue, the coupon payments are “stripped” away from

the principal amount and then the firm sells each component to investors

separately.

2. Level Coupon Bond is the typical government or corporate bonds. It has a

semi-annual coupon payments and principal. So, the Bond price (Bo) = present

value of coupon + present value of face value.

So, Bo =

C = $ amount from coupon or interest %

t = number of periods from remaining maturity

FV = $1,000
 r = discount rate or interest rate or YTM (Yield To Maturity) if expressed as an

annual rate.

YTM is the expected return on a bond that makes a bond market price equal the

present value of its promised future cash flows.

An example:

A bond with 7% coupon, semi-annual payment , 20 years remaining maturity and

interest in the market is 10%. Find the bond price.

7% of $1,000 = $70 (annual). The semi-annual will be $70 / 2 = $35

0 10/2% 1 semi- 2 semi- … 20 x 2

$70/ 2 $70/2 $70/2

One can either use the formula:

OR

Use the calculator: N = 20 x 2 = 40; I% = 10/2% = 5%; PMT = $70/2 = 35; FV = $1,000;

PV= ? = -742.61

One of the bond concepts is market interest rate and bond price. This concept

presents that when bond price is greater than a 1,000, coupon is greater than YTM, we

have a Premium bond. When bond price is less than a 1,000, coupon is less than

YTM, we have a Discount bond. When bond price is equal to 1,000, coupon is equal to

YTM, we have a Par bond.

Another concept is Bond Interest Rate Risks which are the changes in bond prices as

a result of fluctuating interest rates. With everything else equal, the longer it takes for a
bond to reach maturity, the greater the interest rates risk and the lower the coupon rate,

the greater the interest rate risk.

With price changes, YTM = coupon.

The formula for the percent change is [Ending value – Beginning value] ⁒ Beginning

value.

For example, if a bond price changes from 1,000 to 685 = (685 -1,000)/ 1,000 = -315 /

1,000 = -31.5%.

Public Issue of Bonds

• The procedure of issuing bonds is that the board of directors approve it, then

SEC reviews the registration statement. After it has been accepted, it is then

effective to be sold 20 days later.

• A bond indenture is a written agreement between the issuer and a trust company

representing the creditors.

o An indenture includes:

1. Terms of a bond: face value, coupon, and maturity

2. Security: states if it a secured debt or unsecured debt

3. Seniority: states who takes claim in the order of senior, junior, and

subordinated debenture

4. Sinking fund arrangement: an arrangement for the orderly

retirement of long-term debt. The corporation is to make regular

payments into a sinking fund

5. Call provision: allows the company to call or repurchase part or all

of the bond issue at a specified price before maturity.

 ▪ The different types of call are:

• Call premium – the company pays more than 1,000

• Deferred call provision – the firm will not call for

certain number of years

• “Make-whole” call - the firm will get a market price

of the bond at the time of call.

▪ These provisions that are placed in bonds allow the holder to

redeem the bond at face value at the coupon payment date.

6. Protective covenants: ae indenture conditions that limit the

actions of a firm. There are two types:

▪ Negative covenants – include debt limitation, dividend

limitation, merger limitation

▪ Positive covenants – presets a working capital level,

provide periodic financial statement report.

More Bond concepts are:

1. YTM : Current yield + Capital gains yield

o Current yield = Annual coupon payment ⁒ Current price

o Capital gains yield = Change in price ⁒ Beginning price

Expected total return = YTM = Expected Current yield + Expected Capital

gains yield

2. Bonds and Yield To Call (YTC)

• A firm should expect to earn YTC on premium bonds and YTM on par and

discount bonds.