1

Chapter 7
Bonds and Their Valuation
Bond's Definition:
A long-term debt contract under which a borrower agrees to make
payments of interest and principal, on a specific dates, to the holders
of the bond.

Treasury Bonds:
Bonds issued by the federal government, sometimes referred to as
government bonds.

Corporate Bonds:
Bonds issued by corporations.

Municipal Bonds:
Bonds issued by state and local governments.

Foreign Bonds:
Bonds issued by either foreign governments or foreign corporations.

Bond's Characteristics:
1. Par Value:
The pare value is the stated face value of the bond. The pare value
represents the amount of money the firm borrows and promises
to repay at the maturity date. Par value (Face amount) assumed to
be $1,000.

2. Coupon Interest Rate:

It is the stated annual rate of interest on a bond. Coupon interest
rate could be:
A. Fixed Rate Bond, the coupon interest is fixed when the
bond is issued and remains in force during the life of the
bond.
B. Floating Rate Bond, A bond whose interest rate
fluctuates with shifts in the general level of interest rates.

Dr. Hassan Mounir El-Sady Chapter-7

 2

The floating rate bond works as follows:

1. The coupon rate is set for initial period (fixed
interval, say 6 months).
2. After the first period (6 months), the bond
interest rate is adjusted for the next period (6
months) based on some market rate (mostly the
comparable Treasury bond).
3. Therefore floating rate will hedge investors
against any increases in interest rates and issuers
against any decreases in interest rate in the
future.
C. Zero Coupon Bond, A bond that pays no annual interest
but it is sold at a discount below par. It provides
compensation to investors in the form of capital
appreciation at maturity.

3. Coupon Payment:
Coupon payment is the specified number of dollars of interest
paid each period, generally each one year or six months.

Coupon Payment = Par Value × Coupon Interest

Rate

4. Maturity Date:
Maturity date is a specified date on which the par value of a bond
must be repaid. Time to maturity declines as the bond approaches
its maturity date.
A. Original Maturity: The number of years to maturity at the
time a bond is issued.
B. Effective Maturity: The remaining time to maturity,
therefore the effective maturity of a bond declines each
year after it has been issued.

5. Convertibility:
Convertible bond is a bond that is exchangeable, at the option
of the holder, for common stock of the issuing firm at a fixed
price.
➢ Convertible bond has a lower coupon rate than
nonconvertible bond,
➢ Convertible bond offers the investors the chance to
participate in the dividends when dividends are higher
than the coupon rate.

Dr. Hassan Mounir El-Sady Chapter-7

 3

6. Call Provisions:
It is a provision in a bond contract that gives the issuer the right
to redeem the bonds under specified terms prior to the normal
maturity date.
A. The call provision states that the company must pay the
bondholders an amount greater than the par value (call
premium) if they are called.
B. If the bond is called within the first year, the call premium
is set equal to one year's interest; and the call premium
declines at a constant rate each year thereafter.
C. Deferred Call (Call Protection), when bonds can not be
called until several years after they were issued (generally
5-10 years).
D. Callable bonds have a higher coupon rate than non-
callable bonds to compensate the investor for the risk of
being called when the market interest rate is below the
bond coupon interest rate.
7. Sinking Funds:
Sinking fund provision is a provision in a bond contract that
requires the issuer to retire a portion of the bond issue each year.
➢ 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.
➢ But not good for investors if rates decline after issuance

Sinking funds are generally handled in 2 ways

1. Call x% at par per year for sinking fund purposes.
2. Buy bonds on open market.
Company would call if kd is below the coupon rate and
bond sells at a premium. Use open market purchase if
kd is above coupon rate and bond sells at a discount.

Types of Corporate Bonds

Dr. Hassan Mounir El-Sady Chapter-7

 4

1. Income Bond:
A bond that pays interest only if the interest is earned.
2. Indexed (Purchasing Power) Bond:
A bond that has interest payments based on an inflation index
so as to protect the holder from inflation.

3. Mortgage Bonds:
Bonds backed by fixed assets. There are two types of mortgage
bonds:
i. First Mortgage Bonds. They are senior in priority to
claims of second mortgage bonds.
ii. Second Mortgage Bonds.

Mortgage bonds are subject to an indenture, legal agreement

between the issuer of the bond and the bondholders.

4. Debenture Bonds:
A long-term bond that is not secured by a mortgage on a specific
property.

5. Subordinated Debentures Bonds:

A bond having a claim on assets only after the senior debt has
been paid off in the event of liquidation.

Bond Valuation

Dr. Hassan Mounir El-Sady Chapter-7

 5

The value of any financial asset a bond or stock is simply the present value of the cash
flows the asset is expected to produce.

0 1 2 3 4 N
Kd=% ……………
Bond's Value INT INT INT INT INT
M
Here
Kd = The bond’s market rate of interest.
➢ This is the discount rate that is used to calculate the present value of
the bond’s cash flows.
➢ The discount rate (kd) is the opportunity cost of capital, i.e., the rate
that could be earned on alternative investments of equal risk.

kd = k* + IP + LP + MRP + DRP.

N = The number of years before the bond matures = 15. Note that N de clines
each year after the bond has been issued, so a bond that had a maturity of
15 years when it was issued (original maturity = 15) will have N = 14 after
one year, N = 13 after two years, and so on.
INT = Dollars of interest paid each year
= Coupon rate × Par value
M = The par, or maturity, value of the bond $1,000. This amount must be paid
off at maturity.

Example (1):
What’s the value of a 10-year, 10% coupon bond if kd = 10%?

0 Kd=10%
1 2 3 4 N
……………
Bond's Value 100 100 100 100 100
+1,000
The bond consists of a 10-year, 10% annuity of $100each
year plus a $1,000 lump sum at t = 10:
Bond's Value = INT × PVIFA10,10% + M × PVIF10,10%
= 100 × 6.1446 + 1,000 × 0.38554
= 614.46 + 385.54 = $1,000
Financial Calculator Solution:

INPUTS 10 10 ?? 100 1,000

N I/YR PV PMT FV
OUTPU -1,000
TS
What would happen if expected inflation rose by 3%, causing k d = 13%?

Dr. Hassan Mounir El-Sady Chapter-7

 6

INPUTS 10 13 ?? 100 1,000

N I/YR PV PMT FV
OUTPU -837.21
TS
➢ When kd rises, above the coupon rate, the bond’s value falls
below par, so it sells at a discount.

What would happen if inflation fell, and k d declined to 7%?

INPUTS 10 7 ?? 100 1,000

N I/YR PV PMT FV
OUTPU -1,210.71
TS
➢ Price rises above par, and bond sells at a premium, if coupon > k d.

Bonds Can Be Sold At:

1. Par Value: Whenever the going rate of return, kd, is equal to the coupon rate, a
fixed-rate bond will sell at its par value.

2. Discount: Whenever the going rate of interest is above the coupon rate, a fixed-
rate bond's price will be below its par value. Such a bond is called a
discount bond.

3. Premium: Whenever the going rate of interest is below the coupon rate, a fixed-
rate bond's price will be above its par value. Such a bond is called a
premium bond.
➢ Thus, an increase in interest rates will cause the prices of
outstanding bonds to fall, whereas a decrease in rates will cause
bond prices to rise.
➢ The market value of a bond will always approach its par value as
its maturity date approaches.
➢ Therefore, bondholders may suffer capital losses or make capital
gains, depending on whether interest rates rise or fall after the bond
was purchased.

Semiannual Bonds

Dr. Hassan Mounir El-Sady Chapter-7

 7

To evaluate semiannual payments bonds, we must modify the valuation models as

follow:
1. Multiply years by 2 to get periods = 2n.
2. Divide nominal rate by 2 to get periodic rate = kd/2.
3. Divide annual INT by 2 to get PMT = INT/2.

INPUTS 2×n kd÷ 2 OK INT/2 OK

N I/YR PV PMT FV
OUTPUT
S
Example (2):
Find the value of 10-year, 10% coupon, semiannual bond if kd = 13%.

2×10 13÷2 100÷2

INPUTS 20 6.5 ?? 50 1000
N I/YR PV PMT FV
OUTPUT -834.72
S
Example (3):
You could buy, for $1,000, either a 10%, 10-year, annual payment bond or
an equally risky 10%, 10-year semiannual bond. Which would you prefer?

➢ The semiannual bond’s EFF% is:

m 2
 i   0.10 
EFF % = 1 + Nom  − 1 = 1 +  − 1 = 10.25%.
 m   2 
➢ 10.25% > 10% EFF% on annual bond, so buy semiannual bond.

Example (4):
Using the information given in example (3), if $1,000 is the proper price for
the semiannual bond, what is the proper price for the annual payment bond?

➢ Semiannual bond has kNom = 10%, with EFF% = 10.25%. Should earn same
EFF% on annual payment bond, so:

INPUTS 10 10.25 ?? 100 1000

N I/YR PV PMT FV
OUTPUT -984.80
S
At a price of $984.80, the annual and semiannual bonds would be in
equilibrium, because investors would earn EFF% = 10.25% on either bond.
Changes in Bond Value over Time

Dr. Hassan Mounir El-Sady Chapter-7

 8

Observe:
➢ At maturity, the value of any bond must equal to its par value ($1,000).

➢ The value of a premium bond would decrease to its par value ($1,000).

➢ The value of a discount bond would increase to its par value ($1,000).

➢ A par bond stays at $1,000 if kd (Discount Factor) remains constant.

Example (5):
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%?

Bond Value ($)

1,372
1,211 kd = 7%.

kd = 10%.
1,000 M

837 kd = 13%.
775

30 25 20 15 10 5 0
Years remaining to Maturity

Bond Yields

1. Yield-To-Maturity "YTM"

Dr. Hassan Mounir El-Sady Chapter-7

 9

YTM is the rate of return earned on a bond held to maturity. Also called
“promised yield.”

Example (6):
What’s the YTM on a 10-year, 9% annual coupon, $1,000 par value bond
that sells for $887?

INPUTS 10 -887 90 1,000

N I/YR PV PMT FV
OUTPU YTM = 10.91%
TS
➢ If coupon rate < kd, bond is sold at discount (discount bond).
➢ If coupon rate = kd, bond is sold at par (par bond).
➢ If coupon rate > kd, bond is sold at premium (premium bond).
➢ If kd rises, price falls.

Example (7):
Find YTM if price were $1,134.20.

INPUTS 10 -1,134.2 90 1,000

N I/YR PV PMT FV
OUTPU YTM = 7.08%
TS
➢ Sells at a premium. Because coupon = 9% > kd = 7.08%,
bond’s value > par.

Observe:
➢ If the bond is traded in the market at a price less than its par value ➔
YTM > coupon rate.
➢ If the bond is traded in the market at a price greater than its par value
➔ YTM < coupon rate.
➢ If the bond is traded in the market at a price equal to its par value ➔
YTM = coupon rate.
2. Yield To Call "YTC":
The rate of return earned on a bond if it is called before its maturity date.

Dr. Hassan Mounir El-Sady Chapter-7

 10

N
INT Call Price
Yield To Call (YTC) =  +
t =1 (1 +K d ) (1 +K d )
t N

Example (8):
What’s the YTC on a 10-year, 9% annual coupon, $1,000 par value bond if
it is called after 2 years at a call price of $1,100, the bond is currently traded
at $1,120?

2 -1120 90 1,100
INPUTS
N I/YR PV PMT FV
OUTPU YTC = 7.1738%
TS

Example (9):
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 4 years at $1,050.
What’s the bond’s nominal yield to call (YTC)?

INPUTS 8 -1135.9 50 1,050

N I/YR PV PMT FV
OUTPU YTC = 3.568% × 2 = 7.136%
TS

Could also calculate Effective Annual Rate (EAR) to call:

EAR = EFF% = (1.03568)2 – 1 = 7.26%.

3. Current Yield "CY":

The annual interest payment on a bond dividend by the bond's current price.

Dr. Hassan Mounir El-Sady Chapter-7

 11

Annual Coupon PMT

Current Yield (CY) =
Current Price

Example (10):
Find current yield and capital gains yield for a 9%, 10-year bond when the
bond sells for $887 and YTM = 10.91%.
$90
Current yield =
$887
= 0.1015 = 10.15%.

YTM = Current yield + Capital gains yield.

Cap gains yield = YTM – Current yield

= 10.91% – 10.15%
= 0.76%.

Bonds' Risk

1. Interest Rate Risk:

The risk of a decline in a bond's price due to an increase in interest rates.
• If Interest Rate ↑ Bond Value ↓
• If Interest Rate ↓ Bond Value ↑

2. Default Risk:
The risk that the issuer of the bond will not pay interest or principal at the stated
time and in the stated amount. Therefore, the investor will receive less return than
the promised return on the bond.

3. Reinvestment Rate Risk:

The risk that a decline in interest rate will lead to a decline in income from a bond
portfolio, because retired bonds will be replaced by other bonds at a lower interest
rate.

In other words, reinvestment risk is the risk that CFs will have to be reinvested in
the future at lower rates, reducing income.

Example (11):
Suppose you just won $500,000 playing the lottery. You’ll invest the money
and live off the interest. You buy a 1-year bond with a YTM of 10%.

➢ Year 1 income = $50,000. At year-end get back $500,000 to reinvest.

Dr. Hassan Mounir El-Sady Chapter-7

 12

➢ If rates fall to 3%, income will drop from $50,000 to $15,000.

➢ If you bought 30-year bonds, income would have remained constant.

Observe:
• Long-term bonds: High interest rate risk, low reinvestment rate
risk.
• Short-term bonds: Low interest rate risk, high reinvestment rate
risk.
• Nothing is riskless!
• Low coupon bonds have less reinvestment rate risk but more price
risk than high coupon bonds.

Bond Rating
Investment Grade Junk Bonds
Moody's Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC D

Investment Grade Bonds:

• Bonds rated triple-B or higher.
• Banks and institutional investors are permitted by law to hold only
investment grade bonds.

Junk Bonds:
• A high risk (high yield) bonds with grade less than triple-B.

Bankruptcy
 Two main chapters of Federal Bankruptcy Act:
➢ Chapter 11, Reorganization
➢ Chapter 7, Liquidation

Dr. Hassan Mounir El-Sady Chapter-7

 13

 Typically, company wants Chapter 11, creditors may prefer Chapter 7.

 If company can’t meet its obligations, it files under Chapter 11. That
stops creditors from foreclosing, taking assets, and shutting down the
business.

 Company has 120 days to file a reorganization plan.

➢ Court appoints a “trustee” to supervise reorganization.
➢ Management usually stays in control.

 Company must demonstrate in its reorganization plan that it is “worth

more alive than dead.” Otherwise, judge will order liquidation under
Chapter 7.

 If the company is liquidated, here’s the payment priority:

4. Secured creditors from sales of secured assets.
5. Trustee’s costs.
6. Wages, subject to limits
7. Taxes
8. Unfunded pension liabilities
9. Unsecured creditors
10. Preferred stock
11. Common stock.

 In liquidation, unsecured creditors generally get zero. This makes them

more willing to participate in reorganization even though their claims
are greatly scaled back.
 Various groups of creditors vote on the reorganization plan. If both the
majority of the creditors and the judge approve, company “emerges”
from bankruptcy with lower debts, reduced interest charges, and a
chance for success.

Dr. Hassan Mounir El-Sady Chapter-7