Bond Valuation

MGFB Principles of Finance

Jincheng Tong
University of Toronto

January 27, 2024

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Why Is This Important?

- Bonds = debt

- Bonds are an important component of an investment portfolio

- Issuing bonds is the most common form of raising funds by corporations and governments

- Understanding bonds may help to understand how well an individual company or the
overall economy is doing

- Bond market contains valuable information about where the economy is heading

- People anticipate that 2024 might be a great year for Bond investors

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Upward Trend in Government Borrowing

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Downward Trend in Government Borrowing Cost

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Total US Bond Market Capitalization

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Outline

1. What’s a bond and how to value it?

- zero-coupon bonds

- coupon bonds

2. Yield measures
- Current yield

- Yield-to-maturity (YTM)

3. Holding period returns

4. Term structure and yield curves

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1. What’s a bond and how to value it?

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Definition of a Bond

- A bond is a legally binding agreement between a borrower (bond issuer) and a lender
(bondholder) according to which borrower agrees to make interest and principal payments
on designated dates
- It’s debt!!

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Definition of a Bond
- A bond specifies:
- Face (or par) value, $F , paid to the bondholder at maturity

- Coupon rate, c, which is the interest payable over the life of the bond
- Coupon rate determines coupon payment per period, $C = (F · c )/(number of payment
periods in a year)

- Fixed rate, e.g., 5% annually

- Floating rate, e.g., 1-year Treasury bill rate + 100 basis points

- Maturity, T

0 1 2 T −2 T −1 T
...
$C $C $C $C $C + $F

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How to Value Bonds

Value of Bond = PV of expected future cash flows

- We will apply the same principal as in time-value of money

- Identify future cash flows

- Size (how much) and

- Timing (when)

- Discount future cash flows at a discount rate appropriate to the risk presented by the
bond
- Risk of the issuer (Standard & Poor’s, Moody’s, Fitch ratings)

- Collateralized or non-collateralized

- Seniority type
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Zero-Coupon Bond
Zero-coupon (or pure discount) bonds make no interest payments (c = 0)
Information needed for valuing pure discount bonds:
- Time to maturity (T ) = Maturity date - today’s date

- Face value (F )

- Discount rate (r )
F
P=
(1 + r )T
- Find the present value of a 20-year zero-coupon bond with a $1,000 face value and a
discount rate of 6% (annual compounding)
$1, 000
P= = $311.805
(1 + 0.06)20

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Level-Coupon Bond

Level-coupon bonds make periodic coupon payments (c > 0%)

Information needed to value level-coupon bonds:
- Coupon payment dates and time to maturity (T )

- Coupon payment (C ) per period and Face value (F )

- Discount rate (r )
Value of a Level-coupon bond = PV of coupon annuity + PV of face value

 
C 1 F
P= 1− T
+
r (1 + r ) (1 + r )T

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Level-Coupon Bond: Example

- Rogers Communications issued $ 1000 with a 8% annual coupon rate with maturity 12
years. Coupons are paid semi-annually. You require 10% (compounded semi-annually)
return on investments with similar level of risk.

- What is the maximum price you are willing to pay for this bond?

Coupon: 40 = 1, 000 × (0.08/2)

 
40 1 1000
Value: P = × 1− 24
+ = $862.01
0.05 1.05 1.0524

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2. Yield Measures

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Yield Measures

- How can we measure the profitability of a traded bond?

- Coupon payments

- Capital gain or losses when the bond is sold, matures or it is called

- Income generated by reinvesting the coupon payments

- How can we compare different bonds traded in the market with similar credit risk?

- We will consider three measures:

- Current Yield

- Yield to Maturity

- Holding Period Return

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Current Yield

Current Yield = Annual Coupon / Market Price

- Example: 5-year 10% coupon bond with $100 of par value trading at $93. What is the
current yield?

Current Yield = 10/93 = 10.7%

- The current yield is an incomplete measure of bond profitability, it is rather a measure of

coupon profitability
- Time value of money is ignored

- Principal value is ignored

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Yield to Maturity

Yield to maturity (YTM) or simply “yield” is the measure of per period return (also called
internal rate of return, IRR) that the holder is earning from holding a bond to maturity
- YTM is the discount rate y that makes the present value of a bond cash flow equal to its
price
T
C F
P= ∑ (1 + y )t + (1 + y )T
t =1

- YTM is the yield an investor would earn if he or she:

- purchases the bond at the current market price

- holds the bond to maturity

- reinvests all of the coupons paid by the bond at the YTM

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Yield to Maturity
- For zero-coupon bonds,

 1/T
F
y= −1
P

- For level-coupon bonds, there is no closed-form algebraic solution to the equation for
YTM

- In Excel, use the RATE function

- Useful approximation:

C + (F − P )/T
y≈
(F + P )/2

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Yield to Maturity: Example
What is the YTM on a 8% semi-annual coupon bond with 12 years to maturity that is selling
for $927.52?
Using the RATE or IRR function in Excel,

Semi-annual YTM = RATE (24, 40, −927.52, 1000) = 4.5%

⇒ YTM = 4.5% × 2 = 9%

Using the approximation,

40 + (1000 − 927.52)/24
Semi-annual YTM = = 0.0446
(1000 + 927.52)/2
⇒ YTM = 0.0446 × 2 = 0.0892 = 8.92%

Remember to express YTMs as annual rates, not semi-annual rates.

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Mini Case Study: Wework INC

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What we’ver learnt so far

- Bonds belong to fixed income securities: their payments are fixed over time

- For borrowers, fixed periodical payments are fine as long as business is growing
- risky when business conditions deteriorate

- Inverse relations between YTM and Bond Prices

- As the demand for bonds fall, prices drop and yield rises

- The failure of Wework Inc is a great example to showcase the importance of managing a
firm’s financial leverage

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Wework – Flexible Coworking Spaces Provider

Wework: providing shared

workspaces(coworking spaces)

Primarily for startups, freelancers, and

small businesses

Flexibility: small business no longer need

to worry about long-term leases

WeWork rents buildings from property

owners at one price and then rents them
out to clients at higher prices (adding
. more features such as cafes etc.)
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Wework – Strong Initial Growth

Fast-growing revenue at the

beginning: almost doubling
revenue per year until the
Pandemic

Work-from-home clearly
adversely impacts the company’s
core business model

Slow recovery of commerical real

. estate market post pandemic

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Wework – Debt Increases over Time

As sales were expected to grow in 2021,

Wework took on more debt to finance its
growth

Total outstanding debt increased by $ 1

Billion since its IPO

Too much debt when growth slows down

.
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Wework – Debt Price Decline with Looming Default Risk

- Wework could very likely miss debt payments! Cheaper does not always mean better
- Investors worried about default risks – prices of Wework bond fell
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Wework – Jump Yield Jump with Looming Default Risk

- When bond prices fall, yields increase

- Investors discount risky debt of Wework even further 26 / 37
3. Holding Period Return

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Holding Period Return

- Recall the sources of bond return

1. coupon payments
2. capital gain or losses when the bond is sold, matures or it is called
3. income generated by reinvesting the coupon payments

- The current yield only considers 1.

- The yield to maturity considers both 1. and 2. but fails to take into account that coupon
payments can be reinvested at a different rate than the yield to maturity

- Holding period return accounts for this possibility

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Holding Period Return

1. Determine the sale price at the end of the planned holding period.
2. Calculate the future value of the coupon payments assuming they grow at the
reinvestment rate.
3. Sum 1 and 2. This is the total future value received from the bond investment.
4. Calculate the annualized holding period return (HPR) as

 1/t
Total Future Value
HPR = −1
Purchase Price

where t is the length of the holding period measured in years.

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Holding Period Return: Example
Consider a semi-annual coupon bond maturing in 3 years. The face value of this bond is
$1,000. The coupon rate is 8%.
- Calculate the price of this bond if the YTM is 8.7% (semi-annual compounding).
 
40 1 1, 000
P0 = 1− + = $981.85
0.0435 1.04356 1.04356
- Suppose you hold the bond for two years and sell it just after receiving a coupon
payment. The YTM is now 7.5%. Calculate the sale price.
40 1, 040
P2 = + = $1, 004.73
1 + 0.0375 (1 + 0.0375)2

- If you have reinvested the intermediate coupon payments at 7.5% (semi-annual

compounding). What is your annualized HPR?
FV (coupons) = 40 · 1.03753 + 40 · 1.03752 + 40 · 1.0375 + 40 = $169.23
1/2
HPR = [(169.23 + 1, 004.73)/981.85] − 1 = 9.35%.
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4. Term Structure and Yield Curves

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The Term Structure of Interest Rates
- So far, we have assumed interest rates are constant

- In reality, interest rates vary with the length of the horizon we consider

- For each period, we should use a different discount rate

- Thus, the value of a bond should be

C1 C2 C +F
P= + 2
+ ... + T
1 + r1 (1 + r2 ) (1 + rT )T

- These rates are given by the term-structure of interest rates, or the yield curve. They are
known as the spot rates

- Term structure is the relation between interest rates and maturities

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Term Structure and YTM: Example
- Consider a level-coupon bond with the face value of $1,000, annual coupons with the
coupon rate of 8%, and T = 3

- The 1-, 2-, 3-year spot rates are r1 = 5%, r2 = 6%, r3 = 7%

- Determine the YTM

The bond price is

80 80 1, 080
P = $1, 029 = + +
1.05 1.062 1.073

The YTM of the bond today

80 80 1, 080
P = $1, 029 = + 2
+
(1 + y ) (1 + y ) (1 + y )3

We find that y = 6.9%

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Determining the Yield Curve
- To determine the term structure, you need to find r1 , r2 , ..., rT

- If there are zero-coupon bonds the term structure is easy to obtain

- The market price of a zero-coupon bond with maturity T gives us the interest rate for
this maturity
 1/T
F F
P= T
−→ rT = −1
(1 + rT ) P

- These interest rates are zero coupon yields (hence the term “yield curve”)

- Suppose zero-coupon bonds with maturities of 1, 2, and 3 years and $1,000 face value sell
for $950, $920, $880. Determine the yield curve.
r1 = (1, 000/950)1/1 − 1 = 5.26%
r2 = (1, 000/920)1/2 − 1 = 4.26%
r3 = (1, 000/880)1/3 − 1 = 4.35%
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Typical Shapes of the Yield Curve
Yield

rising (normal)

flat

falling (inverted)

Time to maturity (years)

Usually, the term structure (yield curve) is rising: r1 < r2 < ... < rT

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Inverted Yield Curve and Recessions

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Summary
- Value of a bond = PV of coupons + PV of face value

- The value of a zero-coupon bond is

F
P=
(1 + r )T
- The value of a coupon bond is the sum of the PV of the annuity of coupon payments plus
the PV of the face value at maturity
 
C 1 F
P= 1− T
+
r (1 + r ) (1 + r )T
- Yield to maturity (YTM) of a bond is the rate that discounts the payments on the bond
to the purchase price

- Bond prices and YTM move in opposite directions

- Holding period return (HPR) accounts for a reinvestment rate that is different from YTM
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