Lecture 4

Valuing Bonds
 Objectives
• Understand the main features of a bond (par value, coupon rate, current yield,
and yield to maturity).
• Estimate the value of a bond
• Understand the interest rate risk
• Understand why investors pay attention to bond ratings
• When a corporation needs external financing, it can borrow money:
- it can borrow from a bank
- If it needs to make a long-term investment, it may instead issue
bonds,

• A bond is a debt security held by individual and institutional investors

 A bond is a part of the debt of the corporation  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
• Companies are not the only bond issuers. State and local
governments also raise money by selling bonds.
 Bond Characteristics
• A bond has:
- a face value (also called the principal or par value ) - face amount of the bond,
which is paid to the bondholders at maturity. It also generally represents the
amount of money borrowed by the bond issuer.
- An interest payment (also called the bond’s coupon rate)
 Coupon = coupon rate * face value
- A maturity (the time until the bond matures). At maturity, the face value is paid
back.
• A yield to maturity (the return to investors if they buy the bond at the asked price
and hold it to maturity)
 Bond value
• The value of the bond is the present value of the cash flows this bond will generate.
• To find this value, you need to discount each future payment by the current interest rate.

• We suppose that the cost of opportunity is 3.5%

• Bond prices are usually expressed as a percentage of their face value  this bond is worth 120.556% of face
value
• The bond is like a package of two investments: the first provides a level stream of
coupon payments of $72.50 a year for each of 3 years; the second consists of the
final repayment of the $1,000 face value.
• Therefore, you can use the annuity formula to value the coupon payments and then
add on the present value of the final payment of face value
Example
 How Bond Prices Vary with Interest Rates?
• As interest rates change, so do bond prices.
• For example, suppose that investors demanded an interest rate of 7.25% on the previous bond

when the interest rate = the coupon rate, the bond sells for its face value
when the interest rate > the coupon rate, the bond sells at a discount (< face value)

when the interest rate < the coupon rate, the bond sells at a premium (> face value)
• When the interest rate rises, the present value of the payments to be received by
the bondholder falls and bond prices fall.
• Conversely, a decline in the interest rate increases the present value of those
payments and results in a higher price.

• A warning! People sometimes confuse the interest, or coupon, payment on the

bond with the interest rate —that is, the return that investors require.
• The $72.50 coupon payments on our bond are fixed when the bond is issued.
• The coupon rate, 7.25%, measures the coupon payment ($72.50) as a percentage
of the bond’s face value ($1,000) and is therefore also fixed.
• However, the interest rate changes from day to day. These changes affect the
present value of the coupon payments but not the payments themselves.
 Example
• Suppose that the market interest rate is 8% and then drops overnight to 4%.
• Calculate the present values of the 7.25%, 3-year bond and of the 7.25%, 30-year bond both
before and after this change in interest rates.
 Yield to Maturity

• Suppose you are considering the purchase of a 3-year bond with a coupon rate of 10%. Your investment
adviser quotes a price for the bond. How do you calculate the rate of return the bond offers?
 Calculating the YTM
• Solve the equation  Internal rate of return
• Approximation:
 Corporate Bonds and the Risk of Default

• The risk that a bond issuer may default on its obligations is called default risk (or
credit risk ).
• Companies need to compensate for this default risk by promising a higher rate of
interest on their bonds.
• The difference between the promised yield on a corporate bond and the yield on
a U.S. Treasury bond with the same coupon and maturity is called the default
premium.
• The greater the chance that the company will get into trouble, the higher the
default premium demanded by investors.
• The safety of most corporate bonds can be judged from bond ratings provided by
Moody’s, Standard & Poor’s, or other bond rating firms
Applications