Finance Applications and Theory 3rd

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 Chapter 07 – Valuing Bonds

CHAPTER 7 – VALUING BONDS

questions

LG1 1. What does a call provision allow issuers to do, and why would they do it?

A call provision on a bond issue allows the issuer to pay off the bond debt early at a cost of the
principal plus any call premium. Most of the time when a bond issue is called, it is because
interest rates have substantially declined in the economy. The issuer calls the existing bonds
and issues new bonds at the lower interest rate. This reduces the interest payments the issuer
must pay each year.

LG2 2. List the differences between the new TIPS and traditional Treasury bonds.

Traditional Treasury bonds have a fixed principal and constant interest payments. Because the
principal and coupon rate are fixed, interest rate changes in the economy cause the market price
of the bonds to have large fluctuations. On the other hand, the principal of a TIPS increases with
the rate of inflation. Similar to a T-bond, the TIPS has a constant coupon rate. However, since
the principal of the TIPS increases over time, the interest payment also increases over time. This
inflation rate adjustment of a TIPS’ principal every six months reduces the amount of downward
price change in the price of the bond when interest rates increase.

LG2 3. Explain how mortgage-backed securities work.

A large amount of home mortgages are purchased and pooled together. The homeowners pay
interest and principal monthly on their mortgages. Bonds are issued from the pool of mortgages,
using the mortgages as collateral. The interest payments and bond principal payments for these
mortgage-backed securities (MBS) originate from the mortgage borrowers and flow through the
pool of mortgages. As the homeowners pay off their mortgages over time, the MBS are also paid.

LG3 4. Provide the definitions of a discount bond and a premium bond. Give examples.

A discount bond is simply a bond that is selling below its par value. It would be quoted at a price
that is less than 100 percent of par, like 99.05. A premium bond is a bond selling above its par
value. Its price will be quoted as over 100 percent of par value, like 101.15. A bond becomes a
discount bond when market interest rates rise above the bond’s coupon rate. A bond becomes a
premium bond when market interest rates fall below the bond’s coupon rate.

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 Chapter 07 – Valuing Bonds

LG4 5. Describe the differences in interest payments and bond price between a 5 percent coupon bond
and a zero coupon bond.

The 5 percent coupon bond pays annual interest of 5 percent of the bond’s par value. For a
$1,000 par value bond, this would be $50 per year. This interest might be paid in two payments
of $25 each. The price of the coupon bond tends to stay near its par value. The zero coupon bond
pays no interest payments. The bondholder earns a return from the increase of the bond’s market
price over time. The bond’s price is initially much lower than its par value. When the zero
coupon bond finally matures, the par value is paid.

LG5 6. All else equal, which bond’s price is more affected by a change in interest rates, a short-term
bond or a longer-term bond? Why?

All else equal, a long-term bond experiences larger price changes when interest rates change than
a short-term bond. A bond’s price is the present value of all its cash flows. Changes in the
discount rate (the interest rate) impact present values more for cash flows that are further out in
time.

LG5 7. All else equal, which bond’s price is more affected by a change in interest rates, a bond with a
large coupon or a small coupon? Why?

The price of the bond with the small coupon will be impacted more by a change in interest rates
than the price of the large coupon bond. For a small coupon bond, the cash flows are weighted
much more toward the maturity date because of the small interest payments. The large coupon
bond has high interest payments, many of which occur soon. These higher cash flows made
earlier dampen the impact of interest rate changes because those changes in the discount rate
impact the earlier cash flows to a lesser degree than the later cash flows.

LG5 8. Explain how a bond’s interest rate can change over time even if interest rates in the economy
do not change.

Because of the yield curve, there are different interest rates that apply to each time to maturity.
So, as a bond gets closer to its maturity date, different interest rates may apply to its discounting
even when interest rates in the economy have not changed.

LG6 9. Compare and contrast the advantages and disadvantages of the current yield computation
versus yield to maturity calculations.

The current yield computation is useful because it is a very simple one. It provides a quick and
easy assessment of what the bond offers the investor in return. But it measures only the return
from the interest payments. The full return to an investor also includes the capital gain or loss the
bond will experience if it is selling as a discount or premium bond. The yield to maturity
computation is more difficult, but it incorporates the full return the bond offers to investors.

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 Chapter 07 – Valuing Bonds

LG6 10. What is the yield to call and why is it important to a bond investor?

Many bonds do not survive until their maturity date because they get paid early through a call
provision. The yield to call is the yield that would be earned if the bond is purchased at today’s
price and held until it is called by the issuer. The computation incorporates the additional call
premium that is paid with the principal.

LG6 11. What is the purpose of computing the equivalent taxable yield of a municipal bond?

Municipal bonds offer a tax advantage for the bondholder that other kinds of bonds do not offer.
Thus, their yield to maturity is not directly comparable to that of other bonds. The equivalent
taxable yield (ETY) is an adjustment to the yield to make it comparable to taxable bonds. Bond
investors can use the ETY to assess which bond will earn them a higher after-tax return.

LG6 12. Explain why high income and wealthy people are more likely to buy a municipal bond than a
corporate bond.

Individual bondholders do not owe taxes on interest payments received from municipal bonds.
This tax advantage is more valuable to individuals who are in a higher marginal tax bracket.
Because wealthy individuals are usually in a higher tax bracket, this tax advantage is more
valuable to them.

LG7 13. Why does a Treasury bond offer a lower yield than a corporate bond with the same time to
maturity? Could a corporate bond with a different time to maturity offer a lower yield? Explain.

The Treasury bond has lower credit risk than the corporate bond. Given the risk/return
relationship, lower risk is associated with lower expected return. Thus, all else equal, a Treasury
bond will offer a lower yield to maturity than a corporate bond. However, if the yield curve
slopes upward, then shorter term to maturity bonds will require a smaller interest rate than longer
term bonds. So, it is possible that a short-term corporate bond would offer a lower yield than a
long-term Treasury bond.

LG7 14. Describe the difference between a bond issued as a high-yield bond and one that has become
a “fallen angel.”

Both of these bonds would be rated as BB or below. The bond referred to as a “fallen angel”
would have been issued by a firm that was a successful, financially stable firm but one that has
recently struggled. The bondholder would have purchased the bond when it was rated investment
grade (BBB or above), but now holds a “fallen angel”, or junk bond, due to a decline in the
issuer’s financial status. The bond issued as a high-yield, or junk, bond would

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 Chapter 07 – Valuing Bonds

have been issued after the firm’s financial condition had already deteriorated. The purchaser of
this bond bought the bond initially as a junk bond.

LG8 15. What is the difference in the trading volume between Treasury bonds and corporate bonds?
Give examples and/or evidence.

There is high trading volume in Treasury bonds and low trading volume in corporate bonds.

problems

basic problems

LG1 7-1 Interest Payments Determine the interest payment for the following three bonds: 3.5
percent coupon corporate bond (paid semiannually), 4.25 percent coupon Treasury note,
and a corporate zero coupon bond maturing in ten years. (Assume a $1,000 par value.)

3.5 percent coupon corporate bond (paid semiannually): 0.5 × 0.035 × $1,000 = $17.50
4.25 percent coupon Treasury note: 0.5 × 0.0425 × $1,000 = $21.25
Corporate zero coupon bond maturing in 10 years: 0.00 × $1,000 = $0

LG1 7-2 Interest Payments Determine the interest payment for the following three bonds: 4.5percent
coupon corporate bond (paid semiannually), 5.15 percent coupon Treasury note, and a corporate
zero coupon bond maturing in 15 years. (Assume a $1,000 par value.)

4.5 percent coupon corporate bond (paid semiannually): 0.5 × 0.045 × $1,000 = $22.50
5.15 percent coupon Treasury note: 0.5 × 0.0515× $1,000 = $25.75

Corporate zero coupon bond maturing in 10 years: 0.00 × $1,000 = $0

LG1 7-3 Time to Maturity A bond issued by Ford on May 15, 1997 is scheduled to mature on May
15, 2097. If today is November 16, 2014, what is this bond’s time to maturity?

May 15, 2097 minus November 16, 2014 = 82 years and 6 months

LG1 7-4 Time to Maturity A bond issued by IBM on December 1, 1996 is scheduled to mature on
December 1, 2096. If today is December 2, 2015, what is this bond’s time to maturity?

December 1, 2096 minus December 2, 2015 = 81 years

LG1 7-5 Call Premium A 6 percent corporate coupon bond is callable in five years for a call
premium of one year of coupon payments. Assuming a par value of $1,000, what is the price
paid to the bondholder if the issuer calls the bond?

Principal + Call premium = $1,000 + 0.06 × $1,000 = $1,060

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 Chapter 07 – Valuing Bonds

LG1 7-6 Call Premium A 5.5 percent corporate coupon bond is callable in 10 years for a call
premium of one year of coupon payments. Assuming a par value of $1,000, what is the price
paid to the bondholder if the issuer calls the bond?

Principal + Call premium = $1,000 + 0.055 × $1,000 = $1,055

LG2 7-7 TIPS Interest and Par Value A 2.75 percent TIPS has an original reference CPI of 185.4.
If the current CPI is 210.7, what is the current interest payment and par value of the TIPS?

Par value = 210.7 / 185.4 × $1,000 = $1,136.46

Interest payment = 0.5 × 0.0275 × $1,136.46 = $15.63

LG2 7-8 TIPS Interest and Par Value A 3.125 percent TIPS has an original reference CPI of 180.5.
If the current CPI is 206.8, what is the current interest payment and par value of the TIPS?

Par value = 206.8 / 180.5 × $1,000 = $1,145.71

Interest payment = 0.5 × 0.03125 × $1,145.71 = $17.90

LG3 7-9 Bond Quotes Consider the following three bond quotes; a Treasury note quoted at 97:27,
and a corporate bond quoted at 103.25, and a municipal bond quoted at 101.90. If the Treasury
and corporate bonds have a par value of $1,000 and the municipal bond has a par value of
$5,000, what is the price of these three bonds in dollars?

Treasury note at 97:27: (97 + 27/32)% × $1,000 = 0.9784375 × $1,000 = $978.44

Corporate bond at 103.25: 103.25% × $1,000 = 1.0325 × $1,000 = $1,032.50
Municipal bond at 101.90: 101.90% × $5,000 = 1.019 × $5,000 = $5,095.00

LG3 7-10 Bond Quotes Consider the following three bond quotes; a Treasury bond quoted at 106:14,
a corporate bond quoted at 96.55, and a municipal bond quoted at 100.95. If the Treasury and
corporate bonds have a par value of $1,000 and the municipal bond has a par value of $5,000,
what is the price of these three bonds in dollars?

Treasury note at 106:14: (106 + 14/32)% × $1,000 = 1.064375 × $1,000 = $1,064.38

Corporate bond at 96.55: 96.55% × $1,000 = 0.9655 × $1,000 = $965.50
Municipal bond at 100.95: 100.95% × $5,000 = 1.0095 × $5,000 = $5,047.50

LG4 7-11 Zero Coupon Bond Price Calculate the price of a zero coupon bond that matures in 20
years if the market interest rate is 3.8 percent.

Use semiannual compounding:

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 Chapter 07 – Valuing Bonds

FVN $1,000
PV = = = $471.01
(1 + i )N  .038 
40

1 + 
 2 
Or N=40, I=1.9, PMT=0, FV=−1000, CPT PV == 471.01

LG4 7-12 Zero Coupon Bond Price Calculate the price of a zero coupon bond that matures in 15
years if the market interest rate is 5.75 percent.

Use semiannual compounding:

FVN $1,000
PV = = = $427.27
(1 + i )  .0575 30
N

1 + 
 2 
Or N=30, I=2.875, PMT=0, FV=−1000, CPT PV == 427.27

LG6 7-13 Current Yield What is the current yield of a 3.8 percent coupon corporate bond quoted at a
price of 102.08?

3.8% / 102.08% = 0.0372 = 3.72%

LG6 7-14 Current Yield What is the current yield of a 5.2 percent coupon corporate bond quoted at a
price of 96.78?

5.2% / 96.78% = 0.05373 = 5.37%

LG6 7-15 Taxable Equivalent Yield What is the taxable equivalent yield on a municipal bond with a
yield to maturity of 3.5 percent for an investor in the 33 percent marginal tax bracket?

Use equation 7.4:

Muni yield 3.5%

Equivalent taxable yield = = = 5.22%
1-Tax rate 1 − 0.33

LG6 7-16 Taxable Equivalent Yield What is the taxable equivalent yield on a municipal bond with a
yield to maturity of 2.9 percent for an investor in the 28 percent marginal tax bracket?

Use equation 7.4:

Muni yield 2.9%

Equivalent taxable yield = = = 4.03%
1-Tax rate 1 − 0.28

LG7 7-17 Credit Risk and Yield Rank from highest credit risk to lowest risk the following bonds,
with the same time to maturity, by their yield to maturity: Treasury bond with yield of 5.55
percent, IBM bond with yield of 7.49 percent, Trump Casino bond with yield of 8.76 percent,
and Banc One bond with a yield of 5.99 percent.
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 Chapter 07 – Valuing Bonds

Trump Casino bond with yield of 8.76 percent

IBM bond with yield of 7.49 percent
Banc One bond with yield of 5.99 percent
Treasury bond with yield of 5.55 percent

LG7 7-18 Credit Risk and Yield Rank the following bonds in order from lowest credit risk to highest
risk, all with the same time to maturity, by their yield to maturity: Treasury bond with yield of
4.65 percent, United Airline bond with yield of 9.07 percent, Bank of America bond with a yield
of 6.25 percent, and Hewlett/Packard bond with yield of 6.78 percent.

Treasury bond with yield of 4.65 percent

Bank of America bond with yield of 6.25 percent
Hewlett/Packard bond with yield of 6.78 percent
United Airline bond with yield of 9.07 percent

intermediate problems

LG2 7-19 TIPS Capital Return Consider a 3.5 percent TIPS with an issue CPI reference of 185.6. At
the beginning of this year, the CPI was 193.5 and was at 199.6 at the end of the year. What was
the capital gain of the TIPS in dollars and in percentage terms?

Gain = End of year value – Beginning of year value =

199.6 / 185.6 × $1,000 − 193.5 / 185.6 × $1,000 = $1,075.43 − $1,042.56 = $32.87
As a percentage, the gain was = $32.87 / $1,042.56 = 3.15%

LG2 7-20 TIPS Capital Return Consider a 2.25 percent TIPS with an issue CPI reference of 187.2.
At the beginning of this year, the CPI was 197.1 and was at 203.8 at the end of the year. What
was the capital gain of the TIPS in dollars and in percentage terms?

Gain = End of year value – Beginning of year value =

203.8 / 187.2 × $1,000 − 197.1 / 187.2 × $1,000 = $1,088.68 − $1,052.88 = $35.80
As a percentage, the gain was = $35.80 / $1,052.88 = 3.40%

LG4 7-21 Compute Bond Price Compute the price of a 3.8 percent coupon bond with 15 years left to
maturity and a market interest rate of 6.8 percent. (Assume interest payments are semiannual.) Is
this a discount or premium bond?

 1 
1 − (1 + 0.034 )30  $1,000
Bond Price = $19.00   + = $353 .869 + $366 .762 = $720 .63
  (1 + 0.034 )
30
0.034
 
or TVM calculator: N = 30, I = 3.4, PMT = 19.00, FV = 1000; CPT PV = -720.63
Since the bond’s price is less than $1,000, it is a discount bond.

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 Chapter 07 – Valuing Bonds

LG4 7-22 Compute Bond Price Compute the price of a 5.6 percent coupon bond with 10 years left to
maturity and a market interest rate of 7.0 percent. (Assume interest payments are semiannual.) Is
this a discount or premium bond?

 1 
1 − (1 + 0.035)20  $1,000
Bond Price = $28.00   + = $397.95 + $502.56 = $900.51
  (1 + 0.035)
20
0.035
 
 

or TVM calculator: N = 20, I = 3.5, PMT = 28, FV = 1000; CPT PV = -900.51

Since the bond’s price is less than $1,000, it is a discount bond.

LG4 7-23 Compute Bond Price Calculate the price of a 5.2 percent coupon bond with 18 years left to
maturity and a market interest rate of 4.6 percent. (Assume interest payments are semiannual.) Is
this a discount or premium bond?

 1 
1 − (1 + 0.023)36  1,000
Bond Price = $26.00   + = $631.87 + $441.04 = $1,072.91
  (1 + 0.023)
36
0.023
 
 
or TVM calculator: N = 36, I = 2.3, PMT = 26, FV = 1000; CPT PV = -1,072.91
Since the bond’s price is greater than $1,000, it is a premium bond.

LG4 7-24 Compute Bond Price Calculate the price of a 5.7 percent coupon bond with 22 years left to
maturity and a market interest rate of 6.5 percent. (Assume interest payments are semiannual.) Is
this a discount or premium bond?

 1 
1 − (1 + 0.0325 )44  $1,000
Bond Price = $28.50   + = $662 .24 + $244 .81 = $907 .05
  (1 + 0.0325 )
44
0.0325
 

or TVM calculator: N = 44, I = 3.25, PMT = 28.50, FV = 1000; CPT PV = -907.05

Since the bond’s price is less than $1,000, it is a discount bond.

LG5 7-25 Bond Prices and Interest Rate Changes A 5.75 percent coupon bond with 10 years left to
maturity is priced to offer a 6.5 percent yield to maturity. You believe that in one year, the yield
to maturity will be 6.0 percent. What is the change in price the bond will experience in dollars?

Compute the current bond price:

 1 
1 − (1 + 0.0325)20  $1,000
Bond Price = $28.75   + = $418.01 + $527.47 = $945.48
  (1 + 0.0325)
20
0.0325
 
 

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 Chapter 07 – Valuing Bonds

or TVM calculator: N = 20, I = 3.25, PMT = 28.75, FV = 1000; CPT PV = -945.48

Now compute the price in one year:

 1 
1 − (1 + 0.029 )18  $1,000
Bond Price = $28.75   + = $398 .777 + $597 .755 = $996 .53
  (1 + 0.029 )
18
0.029
 

or TVM calculator: N = 18, I = 3.0 PMT = 28.75, FV = 1000; CPT PV = -$982.81

So, the dollar change in price is:

$996.53 − $945.48 = $37.33

LG5 7-26 Bond Prices and Interest Rate Changes A 6.5 percent coupon bond with 14 years left to
maturity is priced to offer a 7.2 percent yield to maturity. You believe that in one year, the yield
to maturity will be 6.8 percent. What is the change in price the bond will experience in dollars?

Compute the current bond price:

 1 
1 − (1 + 0.036)28  $1,000
Bond Price = $32.50   + = $567.42 + $371.47 = $938.89
  (1 + 0.036)
28
0.036
 
 

or TVM calculator: N = 28, I = 3.6, PMT = 32.50, FV = 1000; CPT PV = -938.89

Now compute the price in one year:

 1 
1 − (1 + 0.034)26  $1,000
Bond Price = $32.50   + = $555.14 + $419.24 = $974.38
  (1 + 0.034)
26
0.034
 
 

or TVM calculator: N = 26, I = 3.4, PMT = 32.50, FV = 1000; CPT PV = -974.38

So, the dollar change in price is:

$974.38 − $938.89 = $35.49

LG6 7-27 Yield to Maturity A 5.65 percent coupon bond with 18 years left to maturity is offered for
sale at $1,035.25. What yield to maturity is the bond offering? (Assume interest payments are
semiannual.)

TVM calculator: N = 36, PV = -1,035.25, PMT = 28.25, FV = 1000; CPT I = 2.671% YTM =
2.671% × 2 = 5.34%

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 Chapter 07 – Valuing Bonds

LG6 7-28 Yield to Maturity A 4.30 percent coupon bond with 14 years left to maturity is offered for
sale at $943.22. What yield to maturity is the bond offering? (Assume interest payments are
semiannual.)

TVM calculator: N = 28, PV = -943.22, PMT = 21.5, FV = 1000; CPT I = 2.432% YTM =
2.432% × 2 = 4.86%

LG6 7-29 Yield to Call A 6.75 percent coupon bond with 26 years left to maturity can be called in six
years. The call premium is one year of coupon payments. It is offered for sale at $1,135.25.
What is the yield to call of the bond? (Assume interest payments are semiannual.)

TVM calculator: N = 12, PV = -1,135.25, PMT = 33.75, FV = 1067.50; CPT I = 2.541%

YTC = 2.541% × 2 = 5.08%

LG6 7-30 Yield to Call A 5.25 percent coupon bond with 14 years left to maturity can be called in
four years. The call premium is one year of coupon payments. It is offered for sale at $1,075.50.
What is the yield to call of the bond? (Assume interest payments are semiannual.)

TVM calculator: N = 8, PV = -1,075.50, PMT = 26.25, FV = 1,052.50; CPT I = 2.193% YTC =

2.193% × 2 = 4.39%

LG6 7-31 Comparing Bond Yields A client in the 39 percent marginal tax bracket is comparing a
municipal bond that offers a 4.5 percent yield to maturity and a similar-risk corporate bond that
offers a 6.45 percent yield. Which bond will give the client more profit after taxes?

First determine the ETY:

Muni yield 4.5%

Equivalent taxable yield = = = 7.38%
1-Tax rate 1 − 0.39

Since 7.38 percent is greater than 6.45 percent, the client should take the municipal bond.

LG6 7-32 Comparing Bond Yields A client in the 28 percent marginal tax bracket is comparing a
municipal bond that offers a 4.5 percent yield to maturity and a similar-risk corporate bond that
offers a 6.45 percent yield. Which bond will give the client more profit after taxes?

First determine the ETY:

Muni yield 4.5%

Equivalent taxable yield = = = 6.25%
1-Tax rate 1 − 0.28

Since 6.25 percent is less than 6.45 percent, the client should take the corporate bond.

advanced problems

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 Chapter 07 – Valuing Bonds

LG2 7-33 TIPS Total Return Reconsider the 3.5 percent TIPS discussed in problem 7-19. It was
issued with CPI reference of 185.6. The bond is purchased at the beginning of the year (after the
interest payment), when the CPI was 193.5. For the interest payment in the middle of the year,
the CPI was 195.1. Now, at the end of the year, the CPI is 199.6 and the interest payment has
been made. What is the total return of the TIPS in dollars and in percentage terms for the year?

Capital gain = End of year value – Beginning of year value =

199.6 / 185.6 × $1,000 – 193.5 / 185.6 × $1,000 = $1,075.43 − $1,042.56 = $32.87
The mid-year interest payment was: 0.5 × 0.035 × 195.1 / 185.6 × $1,000 = $18.40
The end-of-year interest payment was: 0.5 × 0.035 × 199.6 / 185.6 × $1,000 = $18.82
Total dollar return = $32.87 + $18.40 + $18.82 = $70.09
As a percentage, the return was = $70.09 / $1,042.56 = 6.72%

LG2 7-34 TIPS Total Return Reconsider the 2.25 percent TIPS discussed in problem 7-20. It was
issued with CPI reference of 187.2. The bond is purchased at the beginning of the year (after the
interest payment), when the CPI was 197.1. For the interest payment in the middle of the year,
the CPI was 200.1. Now, at the end of the year, the CPI is 203.8 and the interest payment has
been made. What is the total return of the TIPS in dollars and in percentage terms for the year?

Gain = End of year value – Beginning of year value =

203.8 / 187.2 × $1,000 − 197.1 / 187.2 × $1,000 = $1,088.68 − $1,052.88 = $35.80
The mid-year interest payment was: 0.5 × 0.0225× 200.1 / 187.2 × $1,000 = $12.03
The end-of-year interest payment was: 0.5 × 0.0225× 203.8 / 187.2 × $1,000 = $12.25
Total dollar return = $35.80 + $12.03 + $12.25 = $60.08
As a percentage, the return was = $60.08 / $1,052.88 = 5.71%

LG5 7-35 Bond Prices and Interest Rate Changes A 6.25 percent coupon bond with 22 years left to
maturity is priced to offer a 5.5 percent yield to maturity. You believe that in one year, the yield
to maturity will be 6.0 percent. If this occurs, what would be the total return of the bond in
dollars and percent? (Assume interest payments are semiannual.)

Compute the current bond price:

 1 
1 − (1 + 0.0275)44  $1,000
Bond Price = $31.25   + = $791.92 + $303.11 = $1,095.03
  (1 + 0.0275)
44
0.0275
 
 

or TVM calculator: N = 44, I = 2.75, PMT = 31.25, FV = 1,000; CPT PV = -1,095.03

Now compute the price in one year:

 1 
1 − (1 + 0.03)42  $1,000
Bond Price = $31.25   + = $740.67 + $288.96 = $1,029.63
  (1 + 0.03)
42
0.03
 
 

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 Chapter 07 – Valuing Bonds

or TVM calculator: N = 42, I = 3.0, PMT = 31.25, FV = 1,000; CPT PV = -1,029.63

Total return = Dollar change in price + Interest payments:

$1,029.63 − $1,095.03 + $62.50 = -$2.90
The percentage return is: -$2.90 / $1,095.03 = -0.26%

LG5 7-36 Bond Prices and Interest Rate Changes A 7.5 percent coupon bond with 13 years left to
maturity is priced to offer a 6.25 percent yield to maturity. You believe that in one year, the yield
to maturity will be 7.0 percent. If this occurs, what would be the total return of the bond in
dollars and percentage terms? (Assume interest payments are semiannual.)

Compute the current bond price:

 1 
1 − (1 + 0.03125)26  $1,000
Bond Price = $37.50   + = $660.84 + $449.30 = $1,110.14
  (1 + 0.03125)
26
0.03125
 
 

or TVM calculator: N = 26, I = 3.125, PMT = 37.50, FV = 1000; CPT PV = -1,110.14

Now compute the price in one year:

 1 
1 − (1 + 0.035)24  $1,000
Bond Price = $37.50   + = $602.19 + $437.96 = $1,040.15
  (1 + 0.035)
24
0.035
 
 

or TVM calculator: N = 24, I = 3.5, PMT = 37.50, FV = 1000; CPT PV = -1,040.15

Total return = Dollar change in price + Interest payments:

$1,040.15 − $1,110.14 + $75.00 = $5.01

The percentage return is: $5.01 / $1,110.14 = 0.45%

LG6 7-37 Yields of a Bond A 2.50 percent coupon municipal bond has 12 years left to maturity and
has a price quote of 98.45. The bond can be called in four years. The call premium is one year of
coupon payments. Compute and discuss the bond’s current yield, yield to maturity, taxable
equivalent yield (for an investor in the 35 percent marginal tax bracket), and yield to call.
(Assume interest payments are semiannual and a par value of $5,000.)

Current yield = (0.025 × $5,000) / (0.9845 × $5,000) = 2.50% / 98.45% = 2.54%

TVM calculator: N = 24, PV = -4,922.50, PMT = 62.50, FV = 5000; CPT I = 1.3258%

YTM = 1.3258% × 2 = 2.65%

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 Chapter 07 – Valuing Bonds

Muni yield 2.65%

Equivalent taxable yield = = = 4.08%
1-Tax rate 1 − 0.35

TVM calculator: N = 8, PV = -4,922.50, PMT = 62.50, FV = 5125; CPT I = 1.753%

YTC = 1.753% × 2 = 3.51%
The current yield is higher than the coupon rate because this is currently a discount bond. This is
also shown by the YTM, which is greater than the coupon rate. The YTC is comparatively high,
but it is currently unlikely that the bond will be called early since interest rates have risen.

LG6 7-38 Yields of a Bond A 3.85 percent coupon municipal bond has 18 years left to maturity and
has a price quote of 103.20. The bond can be called in eight years. The call premium is one year
of coupon payments. Compute and discuss the bond’s current yield, yield to maturity, taxable
equivalent yield (for an investor in the 35 percent marginal tax bracket), and yield to call.
(Assume interest payments are semiannual and a par value of $5,000.)

Current yield = (0.0385 × $5,000) / (1.0320 × $5,000) = 3.85% / 103.20% = 3.73%

TVM calculator: N = 36, PV = -5,160, PMT = 96.25, FV = 5000; CPT I = 1.803%
YTM = 1.803% × 2 = 3.61%

Muni yield 3.61%

Equivalent taxable yield = = = 5.55%
1-Tax rate 1 − 0.35

TVM calculator: N = 16, PV = -5,160, PMT = 96.25, FV = 5192.50; CPT I = 1.90%

YTC = 1.90% × 2 = 3.80%

The current yield is lower than the coupon rate because this is currently a premium bond. This is
also shown by the YTM , which is lower than the coupon rate. The YTC is comparatively high,
but it is currently unlikely that the bond will be called early since interest rates are only a little
lower than the coupon rate and the call premium would have to be paid.

LG7 7-39 Bond Ratings and Prices A corporate bond with a 6.5 percent coupon has 15 years left to
maturity. It has had a credit rating of BBB and a yield to maturity of 7.2 percent. The firm has
recently gotten into some trouble and the rating agency is downgrading the bonds to BB. The
new appropriate discount rate will be 8.5 percent. What will be the change in the bond’s price in
dollars and percentage terms? (Assume interest payments are semiannual.)

Compute the current bond price:

 1 
1 − (1 + 0.036)30  $1,000
Bond price = $32.50   + = $590.3223 + $346.1046 = $936.43
  (1 + 0.036)
30
0.036
 
 
or TVM calculator: N = 30, I = 3.6, PMT = 32.50, FV = 1000; CPT PV = -936.43

Now compute the price after the rating change:

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 Chapter 07 – Valuing Bonds

 1 
1 − (1 + 0.0425)30  $1,000
Bond price = $32.50   + = $545.32 + $286.89 = $832.21
  (1 + 0.0425)
30
0.0425
 
 

or TVM calculator: N = 30, I = 4.25, PMT = 32.50, FV = 1000; CPT PV = -832.21

So, the dollar change in price is:

$832.21 − $936.43 = -$104.22
The percentage return is: -$104.22 / $936.43 = -11.13%

LG7 7-40 Bond Ratings and Prices A corporate bond with a 6.75 percent coupon has 10 years left
to maturity. It has had a credit rating of BB and a yield to maturity of 8.2 percent. The firm has
recently become more financially stable and the rating agency is upgrading the bonds to BBB.
The new appropriate discount rate will be 7.1 percent. What will be the change in the bond’s
price in dollars and percentage terms? (Assume interest payments are semiannual.)

Compute the current bond price:

 1 
1 − (1 + 0.041)20  $1,000
Bond price = $33.75   + = $454.64 + $447.70 = $902.34
  (1 + 0.041)
20
0.041
 
 

or TVM calculator: N = 20, I = 4.1, PMT = 33.75, FV = 1000; CPT PV = -902.34

Now compute the price after the rating change:

 1 
1 − (1 + 0.0355)20  $1,000
Bond price = $33.75   + = $477.51 + $497.73 = $975.24
  (1 + 0.0355)
20
0.0355
 
 
or TVM calculator: N = 20, I = 3.55 PMT = 33.75, FV = 1000; CPT PV = -975.24

So, the dollar change in price is:

$975.24 − $902.34 = $72.90
The percentage return is: $72.90 / $902.34 = 8.08%

7-41 Spreadsheet Problem Say that in June of 2014, a company issued bonds that are
scheduled to mature in June of 2017. The coupon rate is 5.75 percent and is paid semiannually.
The bond issue was rated AAA.
a. Build a spreadsheet that shows how much money the firm pays for each interest rate payment
and when those payments will occur if the bond issue sells 50,000 bonds.
b. If the bond issue rating would have been BBB, then the coupon rate would have been 6.30
percent. Show the interest payments with this rating. Explain why bond ratings are important to
firms issuing capital debt.

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Education.
Chapter 07 – Valuing Bonds

c. Consider that interest rates in the economy increased in the first half of 2012. If the firm
would have issued the bonds in January of 2012, then the coupon rate would have only been 5.40
percent. How much extra money per year is the firm paying because it issued the bonds in June
instead of January?

The spreadsheet might look like:

a. b. c.
Coupon Rate= 5.75% 6.30% 5.40%
Par Value = $1,000 $1,000 $1,000
Number of Bonds = 50,000 50,000 50,000

Interest payments Interest payments Interest payments

Jun-12 $ 0 $ 0 $1,350,000
Dec-12 1,350,000
Jun-13 1,350,000
Dec-13 1,350,000
Jun-14 1,350,000
Dec-14 1,437,500 1,575,000 1,350,000
Jun-15 1,437,500 1,575,000 1,350,000
Dec-15 1,437,500 1,575,000 1,350,000
Jun-16 1,437,500 1,575,000 1,350,000
Dec 16 1,437,500 1,575,000 1,350,000
June 17 1,437,500 1,575,000 1,350,000
1

B. The better the bond rating, the lower the interest rate a firm will have to pay. In this example,
the firm saves $275,000 each year in interest payments with the higher bond rating.

C. The firm is paying $175,000 per year more in interest because it issued its bonds after the
rates increased.

research it!
Bond Information Online

Information on the bond market is widely available in papers like The Wall Street Journal and
Barron’s. Bond information can also be found online at financial websites like
finance.yahoo.com and http://www.finra.org. The bond credit rating agencies also
maintainwebsites with their own bond market news.
You can follow the bond market easily at places like Yahoo! Finance . Click on the Bond
link in the menu to go to their Bond Center. Bond yields for various maturity Treasury securities
are shown for today and for previous days. The Bond Composite Rates link shows similar
comparisons for municipal and corporate bonds too.
Bond calculators are also available for free on the Web. Compare a bond price result from
your calculator or the price equation with the online bond calculator result at Investopedia.
(www.investopedia.com/calculator/BondPrice.aspx)

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Chapter 07 – Valuing Bonds

SOLUTION: All answers will be different. Here is an example answer:

An example done on the website…

 1 
1 − (1 + 0.02)6  $1,000
Bond price = $17.50   + = $98.03 + $887.97 = $986.00
  (1 + 0.02)
6
0.02
 
 

or TVM calculator: N = 6, I = 2, PMT = 17.50, FV = 1000; CPT PV = -986.00

All computations are the same.

integrated mini-case: Corporate Bond Credit Risk Changes and Bond Prices

Land’o’Toys is a profitable, medium-sized, retail company. Several years ago, it issued a 6.5
percent coupon bond, which pays interest semiannually. The bond will mature in 10 years and is
currently priced in the market as $1,037.19. The average yields to maturity for 10-year corporate
bonds are reported in the following table by bond rating.

Bond Rating Yield (%) Bond Rating Yield (%)

AAA 5.4 BB 7.3
AA 5.7 B 8.2
A 6.0 CCC 9.2
BBB 6.5 CC 10.5
C 12.0
D 14.5

Periodically, one company will purchase another by buying all of the target firm’s stock. The
bonds of the target firm continue to exist. The debt obligation is assumed by the new firm. The
credit risk of the bonds often changes because of this type of an event.
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 Chapter 07 – Valuing Bonds

Suppose that the firm Treasure Toys makes an announcement that they are purchasing
Land’o’Toys. Due to Treasure Toy’s projected financial structure after the purchase, Standard &
Poor’s states that the bond rating for Land’o’Toys bonds will change to BB.

a. Compute the yield to maturity of Land’o’Toys bonds before the purchase announcement
and use it to determine the likely bond rating.
b. Assume the bond’s price changes to reflect the new credit rating. What is the new price?
Did the price increase or decrease?
c. What is the dollar change and percentage change in the bond price?
d. How do the bond investors feel about the announcement?

SOLUTION:
a. TVM calculator: N = 20, PV = -1,037.19, PMT = 32.50, FV = 1000 CPT I = 3.00%
YTM = 3.00% × 2 = 6.00%
This bond is likely rated as an “A.”
b. The new YTM will likely be 7.3 percent annually, so the price will change to:
TVM calculator: N = 20, I = 3.65, PMT = 32.50, FV = 1000; CPT PV = -943.91
The price decreased because the bond got riskier.
c. The price change would be $943.91 − $1,037.19 = -$93.28
The change as a percentage would be -$93.28 / $1,037.19 = -8.99%
d. In a firm buyout, the stockholders of the target firm generally earn a nice profit. However, the
bond holders of the target firm can be unhappy if the new combined firm has a worse bond
rating, like in this case.

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