Financial Management - Bond Valuation

UNIT 4
Bond Valuation

Source: www. http://credit-‐help.biz/bank/6986
Overview
When companies require funding to meet a specific need (for example, investment in projects)
they may issue various types of securities to meet this need. Usually, these securities include
bonds (i.e. long-term debt), preferred stock, and common stock. In this Unit, we will discuss
different types of bonds and their characteristics, and examine both preferred and common
stock in Unit 5.
Generally, the interest on long-term debt remains constant over a period of time and it is for this
reason that bonds are at times referred to as fixed-income securities. In addition, bond holders
usually receive relatively stable distributions of interest payments over time and have a fixed
claim on the assets of the firm in the event of bankruptcy.
The purpose of this Unit is twofold: 1) to provide you with important and useful information on
bonds in general and 2) to provide you with a useful paradigm of the use of the time value
concepts, thereby reinforcing the topics we covered in Unit 3.
MGMT2023 Financial Management_UNIT 4 – VERSION 1 1

Unit 4 Learning Objectives
By the end of this unit you should be able to:

1. Outline the characteristics of different kinds of bonds
2. Discuss the advantages and disadvantages of bonds.
3. Estimate the value of a bond.
4. Explain the relationship between the price of a bond, coupon rate, yield and time.

This Unit is divided into three sessions as follows:
Session 4.1: Bonds and their characteristics
Session 4.2: Bond Valuation
Session 4.3: Bond Price relationship –Coupon Rate, yield and time.
Readings & Resources
Note to Student:
Some hyperlinks to resources may not open on clicking. If any link fails to open, please copy
and paste the link to your browser to view/download the resource.

Required Reading
Drake. P.P. & Fabozzi J.F. (2010). The Basics of Finance: An Introduction to Financial
Markets, Business Finance, and Portfolio Management. Chapter 20. Valuing Bonds.
Available at: UWILinc http://tinyurl.com/hy4wv5h
Suggested Readings
Sections 3, 4, 5, 6 and 8 of Bond Valuation Topic. Available at: http://tinyurl.com/okk5ofz


Session 4.1
Bonds And Their Characteristics
Introduction
We begin our discussion by looking at the different types of bonds and their features. Bonds are
referred to as debt securities which are claims on a specified periodic stream of income.
Actually, debt securities are often called fixed-income securities since they promise either a
fixed stream of income or a stream of income that is determined according to a specified
formula. These securities have the advantage of being relatively easy to understand because the
payment formulas are specified in advance.
Types Of Bonds
In Unit 1, we established that firms issue bonds to raise additional capital to fund investment
projects which are traded in the capital markets. For example, if a firm wishes to raise more
funds than would be covered by any one debt financing institution, it could do so by issuing
bonds in the capital markets. Investors have choices when they are investing in bonds and they
can make their choice from the three classes of bonds listed below:
1. Corporate Bonds
a. Debentures
b. Subordinated Debentures
c. Mortgage Bonds
2. International Bonds
a. Foreign bonds
b. Eurobonds
3. Treasury Bonds


Corporate Bonds
These are bonds (debts) issued by corporations to finance capital investment and operating cash
flow. In the United States, there is a very strong market for such bonds. This situation was
highlighted in November 2008, when the United States government invested in a large number
of corporate bonds to bail out ailing financial companies.
Corporate bonds can have long maturity dates (for example, 30 years) but at the same time they
are exposed to default risk. This means that, if the issuer (the corporation) finds itself in
financial difficulties, it may be unable to make the promised interest and principal payments.
There are variations of corporate bonds namely (1) debentures, (2) subordinated debentures,
and (3) mortgage bonds, which carry different levels of default risk. The default risk depends on
the issuing company’s characteristics and on the terms of the specific bond. Default risk is often
referred to as ‘credit risk’; the larger the default risk, the higher the interest rate investors
demand.
a. Debentures
Debentures are a type of corporate bond which are backed by security, for example, property.
This means that, if the issuer goes into liquidation, the assets are sold to pay the bondholders.
Since the debentures are more secured, the rate of interest is lower.
However, the term debenture may also be used to describe any bond. We should also bear in
mind that corporate bonds may be any unsecured long-term debt. Because these bonds are
unsecured, the earning ability of the issuing corporation is of great concern to the bondholder.
As a result, these unsecured bonds are viewed as being more risky than secured bonds and,
therefore, they must provide investors with a higher yield than secured bonds. Generally, firms
issuing debentures usually provide some protection to the holder of the debenture by agreeing
not to issue more secured long-term debt that would further tie up the firm’s assets. To the
issuing firm, the major advantage of debentures is that no property has to be secured by them.
This allows the firm to issue debt and still preserve some future borrowing power.
b. Subordinated Debentures
A subordinated debenture is another type of corporate bond. Usually, several firms have more
than one issue of debentures outstanding and in cases of insolvency, the firm may specify a
hierarchy in which some debentures are given subordinated standing. The claims of the
subordinated debentures are honoured only after the claims of secured debt and
unsubordinated debentures have been satisfied.
c. Mortgage Bonds
Mortgage bonds are bonds secured by a lien on real property where the value of the real
property is greater than the mortgage bonds issued. This provides the mortgage bondholders
with a margin of safety in the event that the market value of the secured property should
decline.
In the United States, foreclosure is a common occurrence. In this situation, the trustees, who
represent the bondholders and act on their behalf, have the power to sell the secured property


and use the proceeds to pay the bondholders. The bond trustee, usually a banking institution or
trust company, oversees the relationship between the bondholder and the issuing firm,
protecting the bondholder and seeing that the terms of the indenture are carried out. In the
event that the proceeds from this sale do not cover the bonds, the bondholders become general
creditors, similar to debenture bondholders, for the unpaid portion of the debt.
International Bonds
a. Foreign Bonds
These are corporate bonds, issued in the country of denomination by a firm usually based
outside that country. For example, a Japanese firm might issue a yen bond in the United States.
If the bonds are denominated in a currency other than that of the investor’s home currency, then
an additional risk exists on the bond. For example, if you purchase a corporate bond
denominated in the yen, even if the company does not default, you will still lose your money if
the Japanese yen falls relative to the dollar.
b. Eurobonds
In contrast to foreign bonds, Eurobonds are issued in the currency of one country but sold in
other national markets. For example, London is known as the largest market for Eurodollar
bonds and the Eurodollar market has Eurodollar bonds being sold outside Europe, for example
in the United States. We must bear in mind that the Eurodollar market is not within the United
States jurisdiction and therefore, Eurobonds are not regulated by the United States government.
This is also true for any other bond, for example, Eurosterling bonds which are denominated in
the British pound.
Treasury Bonds
Treasury bonds are also referred to as government bonds with no default risk. These types of
bonds are issued by governments and have no default risk because it is reasonable to assume
that governments will make promised payments. Ultimately, the prices of this type of bond will
decrease especially when interest rates start to increase.
Features of Bonds
We should recall that a bond is a security that is issued in connection with a borrowing
arrangement. It is customary for the borrower to issue a bond to the lender for some amount
known as cash. In the arrangement, the issuer is obligated to make specified payments to the
bondholder on specified dates.
Now, let us discuss the major characteristics of bonds in the following order: coupon rate, par
value, maturity, call provision, indenture and sinking fund.


Coupon Rate
The coupon rate of the bond serves to determine the stated annual interest rate the borrower
(issuer) agrees to pay the lender per period over the duration of the bond. When the annual
coupon payment is divided by the par value of a bond, the result is the coupon rate. To
illustrate: if Horton Luggage Co. issues a bond with a par value of $10,000, a maturity of 5 years
and a coupon rate of 10%, then it is contracted to pay $1,000 (face value × coupon rate) each
year for the five consecutive years to the bond-holder and $10,000 at the end of the five year
period. We can find the coupon rate of 10% ($1,000 / $10,000) on a bond which is generally
fixed upon issue and remains constant throughout the life of the bond.
Par Value
The par value of a bond is the stated face value (that is, the principal) which the borrower
agrees to repay to the bondholder at the maturity date. The par value is generally a fixed
amount which the firm borrows and agrees to repay at the maturity date of the bond. To
illustrate: a bond with a par value (face value) of $20,000 and a maturity of 5 years contracts the
borrower to repay $20,000 at the end of the five-year period. However, actual amounts
contracted may be more or less than the par value depending on the difference between the
coupon rate and the current rate of interest on bonds of similar quality and maturity.
Maturity
Generally, bonds have a specified maturity date. This maturity date is a predetermined date on
which the par value becomes due to be repaid to the bondholder. Typically, maturity on bonds
is usually about 10 to 40 years, but any maturity is acceptable. When bonds reach their maturity
dates, their effective maturity also declines. Let us illustrate this in the following example: if
Horton Luggage Co. issues a 15 year bond in 2007, then one year later it will have a 14 year
maturity.
Call Provision
Most bonds, except Treasury bonds, contain a call provision within the terms of the contract.
This is a provision that gives the issuer the right to redeem the bonds under specified terms
prior to the normal maturity date. Usually, the call provision specifies that if the bonds are
redeemed before their maturity date, the issuer must pay the bondholder an amount greater
than the par value. The amount received in excess of par is known as a call premium which is
usually equal to one year’s interest. To illustrate this: Horton Luggage Co. issued a 10 year bond
with 10% annual interest and a par value of $1,000. The annual interest amount would be $100
on this bond. However, if Horton Luggage Co. calls the bond before the stated maturity date,
then the firm would pay the bondholder $1,100.
As bonds near maturity, call premiums also decline and are specified in the bond contract.
Generally, bonds are not callable until several years after issue (usually 5 to 10 years).


Indenture
An indenture is a formal contractual agreement between the issuer and the bondholder. In
general, an indenture:
• Thoroughly details the nature of the debt issue.
• Carefully specifies the manner in which the principal must be repaid.
• Identifies any restrictions placed on the organization by the lenders. These restrictions
are called covenants, and the organization must satisfy them to keep from defaulting on
its obligations. Typical restrictive covenants include the following:
o A minimum coverage ratio, or times interest earned, the organization must
maintain.
o A minimum level of working capital the organization must maintain.
o A maximum amount of dividends the firm can pay on its preferred and common
stock.
o
Sinking Fund
Generally, some bonds include a sinking fund provision that facilitates the orderly retirement of
the bond issue. Quite often investors require that the issuer of the bond gradually reduces the
outstanding balance over its life instead of having the entire principal amount come due on the
stated maturity date in the contract. The usual method of providing for a gradual retirement is a
sinking fund, so that a certain amount of money is put aside annually, or ‘sunk’ into a sinking
fund account. Consequently, a sinking fund creates a significant cash drain on the firm.
However, in most cases, the issuer can handle the sinking fund as follows:
1. The firm can redeem a certain percentage of the bonds each year. For example, the firm
might call 8 percent of the total original amount of the issue at a price of $1,000 per
bond.
2. Alternatively, the firm can purchase the required bonds on the open market.
Advantages and Disadvantages of Bonds

Bonds have some advantages over stock, which include low volatility, high liquidity, legal
protection and a variety of term structures. They are also subject to risks such as interest rate
risk, prepayment risk, credit risk, reinvestment risk and liquidity risk.
You can read more on those individual advantages and disadvantages in the following link.
http://tinyurl.com/grg5h6k


Session 4.1 Summary
In this Session, we focused on three major classes of bonds: corporate, international and
treasury. We ended the session by discussing their characteristics, advantages and
disadvantages of bonds.


Session 4.2
Bond Valuation
Introduction
In Session 4.1, we looked at three major classes of bonds and their characteristics. In this
Session, we will use the time value of money concepts discussed in Unit 3 and apply them to
estimating the value of bonds.
In this Session, we examine how to calculate the value of a bond, and then proceed to calculate
bond yields. We close the Session with an examination of changes in bond values as the
required returns or coupon rates changes.
You should ensure that, before attempting any calculations in this Session, you fully understand
the time value of money concepts we discussed in Unit 3.
Calculating The Value Of A Bond

A Bondholder receives two cash flows from a bond if it is held to maturity – interest and the
bond’s par or face value. For valuation purposes, the interest is an annuity and the face value
is a single payment received at a specified future date. Therefore, the value of the bond is the
present value of the future interest to be received and the par or maturity value of the bond. The
organization issuing the bond must meet the interest and principal payments as they come due
or the bond will go into default.
Yield Measures
There are three commonly quoted yield measures used by dealers in the capital markets. We
will now discuss those three measures as follows: Yield to maturity, Yield to call and Current
Yield.

Yield To Maturity
In practice, when an investor is considering purchasing a bond, the investor is not quoted a
promised rate of return. As an alternative, the investor would use the bond price, maturity date,
and coupon payments to infer the return offered by the bond over its life.


The yield to maturity (YTM) of a bond is defined as the interest rate that makes the present
value of a bond’s payment equal to its price. This interest rate is often viewed as a measure of
the average rate of return that it will earn on the bond if it is held to maturity.
In order to calculate the yield to maturity, we should solve the bond price equation for the
interest rate given the bond’s price. For example, if the current price of a bond, Vb, the uniform
annual interest payments, INT, and the maturity value, or principal, M, are known, the yield to
maturity of a bond having a finite maturity date can be calculated by solving Equation 5.1
presented earlier for rd:
Vb = INT/ (1 + rd)1 + INT/ (1 + rd)2 + … + INT/ (1 + rd)n + M/ (1 + rd)n
Finding rd = YTM by trial and error would be a tedious and time consuming procedure, but it
can be easily calculated with the use of a financial calculator. For this course, it is highly
recommended that you use the financial calculator to calculate the YTM. However, in the
event you do not have one a formula called the Approximation Method may be used to find the
YTM. The disadvantage of this method is that it is time consuming and can lead to errors.

F-P
+C
Semi - annual Yield to Maturity = n
F+P
2
YTM = 2 × semi - annual YTM
YTM = (1 + semi - annual YTM) 2 − 1

Where:
F = Face Value = Par Value = $1,000
P = Bond Price
C = the semi-annual coupon interest
n = number of semi-annual periods left to maturity
Yield To Call
Typically, the yield to maturity is calculated on the assumption that the bond would be held
until maturity. What if the bond is callable, however, and may be retired prior to the maturity
date? How should we measure the average rate of return for bonds subject to call provisions?
We should recall that in Session 4.1 some bond contracts contain call provisions. For example, if
an investor purchased a bond with a call provision in its contract and the company called it,
then the investor would not have the option of holding the bond until maturity. As a result, the
yield to maturity would not be earned. When interest rates fall below a bond’s coupon rate,


then it is likely that the issuing company would call the bond, and investors will estimate its
expected rate of return as the yield to call (YTC) rather than as the yield to maturity.
To calculate yield to call (YTC), we would use the equation below.
Price of a callable bond = INT /(1+ rd )t t =1 n Σ+ call price/(1+ r d )n
Where:
n - is the number of years until the company can call the bond. The call price is the price the
company must pay in order to call the bond (it is often set equal to the par value plus one year’s
interest)
rd - is the YTC.
Let’s explore an example. Suppose the 8 percent coupon, 30-year maturity bond sells for $1,150
and is callable in 10 years at a call price of $1,100. Its yield to maturity and yield to call would be
calculated using the following inputs on your financial calculator.
Step 1
Simply enter N = 10 in your financial calculator. N is the call date of the bond.
Step 2
Enter the present value (PV) = -$1,150.00. This is the selling price of the bond.
Step 3
To find PMT multiply the par value of the bond ($1,000) by its coupon rate.
PMT = $1,000 × 0.08 = $80
Now we have found the PMT, simply enter PMT = $80
Step 4
Enter the future value (FV) = $1,100 and then press CPT on the financial calculator followed by
I/Y key.
The answer, 6.5 percent will appear.
Current Yield
The current yield of a bond is the annual interest payment divided by the bond’s current price.
For example, suppose ABC’s bonds with a 10 percent coupon were currently selling at $985, the
bond’s current yield would be 10.15 percent ($100/$985).
Unlike the YTM, the current yield does not represent the rate of return that investors should
expect on the bond. The current yield provides information regarding the amount of cash
income that a bond will generate in a given year, but since it does not take account of capital
gains or losses that will be realized if the bond is held until maturity (or call), it does not


provide an accurate measure of the bond’s total expected return.
You can read more about current yield on Page 524 of Chapter 20 of Drake and Fabozzi.
LEARNING ACTIVITY 4.1
Now try out the following questions as practice.
1. The following table shows bonds which pay interest annually. Calculate the Yield to
Maturity (YTM) for each bond.
Bond Par Coupon Years to Current Value

Value Rate maturity
A 1,000 9% 8 $820
B 1,000 12 16 1000
C 500 12 12 560
D 1000 15 10 1,120
E 1000 5 3 900
1. Calculate the value of a bond maturing in 6 years, with a $1,000 par value and a coupon
interest rate of 10% (5% paid semi-annually) if the required return on similar-risk bonds is
14% annual interest (7% paid semi-annually).

Session 3.2 Summary

This Session focused on the process of valuing bonds and estimating the rates of returns on
bonds. We saw that, in order to measure the bondholder’s expected rate of return, we find the
discount rate that equates the present value of the future cash flows with the current market
price of the bond. We also looked at computing the current yields when the annual interest
payment and the price of the bond are given.


Session 4.3
Bond Price Relationships – Coupon

Rate, Yield and Time To Maturity
Introduction
Hope that you have understood how to find the price of a plain vanilla bond. If you are still
haven’t grasp the concept, kindly return to session 4.2 before moving along. Remember to
engage with your tutor for further assistance.
Now for the final session in this Unit. You would agree, there are certain external forces that
constantly change the value of a bond in the marketplace. Since these forces are not controlled
by bond issuers or investors, it is important to understand the impact of forces such as required
return, time to maturity and coupon rate on the value of the bond. We will explain this in this
right now.
Required Return and Bond Price

When the required return on a bond differs from the bond’s coupon interest rate, the bond’s
value will differ from par. When the required return is greater than the coupon interest rate,
the bond value will be less than its par. Therefore, we say that the bond will be selling at a
discount. When the required return is less than the coupon, the bond value will be greater than
par value. In this case, the bond will be selling at a premium.
The relationship between coupon rate, required yield, and price can be summarized as follows:
If
If Coupon rate < Required yield then Price < Par (discount bond)
If Coupon rate = required yield then Price = Par (par bond)
If Coupon rate > required rate then Price > Par (premium bond)
Future Value of Uneven Cash Flow

Now, let us consider uneven or irregular cash flows based on the information in the previous
section. Using the future value concept to calculate uneven cash flows, we compound the cash
flows rather than discount them. We discounted those cash flows to find the present value, but
now we need to compound them to find the future value.


View the following video, which will explain the difference between nominal and
effective annual rates of interest. Available at:
https://youtu.be/qVfVQXkT-RU
Time To Maturity and Bond Price

Whenever the required return of a bond is different from its coupon interest rate, the amount of
time to maturity affects the bond value. Constant required returns allow the bond’s value to
approach par as the bond moves closer to maturity.
The change in the value of a bond due to changing required returns is affected by time. A
change in the bond’s required return that has 10 years to maturity will have a greater impact on
the bond’s value than a change in required return on a bond with only 1 year left to maturity.
See graph below.

KEY POINT
The point is that the longer the maturity of a bond, the more its price will change in
response to a given change in interest rates; this is called interest rate risk. However,
bonds with shorter maturities expose investors to high reinvestment rate risk, which is the
risk that income from a bond portfolio will decline because cash flows received from
bonds will be rolled over at lower interest rates.


Source: http://www.tvmcalcs.com/index.php/calculators/apps/excel_bond_valuation
Reading Resource & Activity
1. Drake. P.P. & Fabozzi J.F. (2010). The Basics of Finance: An Introduction to Financial
Markets, Business Finance, and Portfolio Management. Chapter 20. Valuing Bonds.
(Pages 519 to 522) Available at: UWILinc http://tinyurl.com/hy4wv5h
2. Having read the relevant pages prescribed above, answer the following questions:
a. “If interest rates in the economy rise after a bond has been issued, what will
happen to the bond’s price and it’s YTM?
b. Does the length of time to maturity affect the extent to which a given change in
interest rates will affect the bond’s price?
3. What relationship exists between the coupon interest rate and YTM and the par value
and market value of a bond? Explain.
Post your responses to the discussion forum for feedback from your tutor.


Session 4.3 Summary
We have concluded this session, and to recap, we made two vital points about the value of the
bond and its response to changes in the yield or interest rates and changes in the time to
maturity. Firstly, the increase in the interest rate relative to the coupon rate will cause the bond
price to fall while the decrease in the interest rate will do the opposite. Therefore, there is an
inverse relationship between those two variables. Secondly we highlighted the fact that the
longer the maturity of a bond the more volatile it is and subject to changes in its value.
However as it nears the maturity the bond will trade at par.
Unit 4 Summary
In this Unit, we examined bonds, their features, and the advantages and disadvantages of bonds
as a means of financing. In our discussion on bond valuation, we saw that, if firms are viewed
as going concerns, then the value of their securities can be conceptualized as the value of the
future expected cash flows. Thus, finding the value of a bond involves discounting the stream
of expected future cash flows at the investors required rate of return as the discount rate. We
discussed three commonly used yield measures namely, yield to call, yield to maturity and
current yield. Finally, the relationship between bond price, required return and time to
maturity was explained.


References

Gitman, J. L. & Zutter, J. C. (2011). Principles of Managerial Finance. (13 Edition).th
Chapter 6. Interest Rates and Bond Valuation (Pages 231 – 249).


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UNIT 4

MGMT2023 Financial Management_UNIT 4 – VERSION 1 1

By the end of this unit you should be able to:

Readings & Resources

Bonds And Their Characteristics

Advantages and Disadvantages of Bonds

Calculating The Value Of A Bond

LEARNING ACTIVITY 4.1

Now try out the following questions as practice.

Bond Par Coupon Years to Current Value

Session 3.2 Summary

Bond Price Relationships – Coupon

Required Return and Bond Price

Future Value of Uneven Cash Flow

Time To Maturity and Bond Price

Reading Resource & Activity

Chapter 6. Interest Rates and Bond Valuation (Pages 231 – 249).

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