HOA SEN UNIVERSITY

FACULTY OF ECONOMICS AND

COMMERCE

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CORPORATE FINANCE

CHAPTER 3
BONDS VALUATION

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 Chapter 3: BONDS VALUATION
• Main Contents:
1. The Bond Market
2. Interest rates and Bond prices
3. Current Yield and Yield to Maturity
4. Bond rates of return
5. The yield curve
6. Corporate bonds and the risk of default

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 I. BOND MARKET

Governments and corporations (issuer) borrow money by selling bonds to investors

Bond issuer make interest payment and then the debt payment

Interest rate can be either fixed or floating

Bonds have different maturities

Bonds: security that obligates the issuer to make specified payments to the bondholder

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 I. BOND MARKET (cont’d)
Bond characteristics

DEFINITION OF A BOND
•A bond is security that obligates the issuer to make
specified payments to the bondholders.
It is a legally binding agreement between a borrower and
a lender that specifies the:
– Par (face) value (called principal)
– Coupon rate
– Coupon payment
– Maturity Date

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 I. BOND MARKET (cont’d)
Bond characteristics

Par (face) value (called principal): Payment at

the maturity of the bond.
Coupon: The periodic interest payments paid to
the bondholder
Coupon rate: The periodic interest payments are
computed as a fixed percentage of bond’s face
value
Maturity: the length of time until the principal is
scheduled to be repaid.
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 I. BOND MARKET (cont’d)
Bond characteristics

• The yield to maturity is the required market interest rate

on the bond. It is discount rate used to estimate bond
price.
• Current yield: a bond’s coupon payment divided by its
closing price
• Bond quote is last price at which a bond trade, express as
a percentage of par value and converted to a point scale
• Bid price: the price a dealer is willing to pay for a
security
• Asked price: the price a dealer is willing to take for a
security
• Bid-ask spread: the difference between the bid price and
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the asked price
 I. BOND MARKET (cont’d)
Bond characteristics
In Nov 15th, 2013, the U.S. government issued of a Treasury
bond. It auctioned off 1.25% coupon bonds maturing in
2018. The bonds have a face value of $1,000. Each year until
the bond matures, the bondholder receives an interest
payment of 1.25% of the face value, or $12.50.
What is face value, coupon rate, Maturity Date, Coupon
payment?
How much is bond quoted?
How much does it cost to buy it?

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 I. BOND MARKET (cont’d)
Bond characteristics

Face value = $1,000

Coupon rate = 1.25%
Maturity Date: 2018
Coupon payment = $1,000 x 1.25% = $1.25
Table: Sample Treasury bond quotes in November 2015

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 I. BOND MARKET (cont’d)
Bond characteristics

Anyone buying the 1.25% bond would need to

pay the asked price, which is $100.164. This
means that the price is 100.164% of face value
(bond quote). Bond is quoted $100.164
Therefore, each bond costs $1,001.64.

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 I. BOND MARKET (cont’d)
Bond characteristics

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 I. BOND MARKET (cont’d)
The asked price of the 1.625s is 97.3203. So one
bond would cost $973.203 (=97.3203% x $1,000).
A bond is selling for $1,106.25 would be quoted at
110.625 (=$1,106.25/$1,000).
The bid price of the 3s of 2044 is 98.5859. So you
would receive $985.859

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 I. BOND MARKET (cont’d)
Bond characteristics

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 I. BOND MARKET (cont’d)
Bond characteristics
a. The asked price in 2028 is 130.4531% of face value, or
$1,304.531.
b. The bid price is 130.3906% of face value, or $1,303.906.
c. The annual coupon is 5.25% of face value, or $52.50, a year.
d. The yield to maturity, based on the asked price, is given as
2.493%

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 I. BOND MARKET (cont’d)
WARNING
The coupon rate IS NOT the discount rate used
in the Present Value calculations.

The coupon rate merely tells us what cash flow

the bond will produce.

Since the coupon rate is listed as a %, this

misconception is quite common.

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 I. BOND MARKET (cont’d)
HOW TO VALUE A BOND
•Primary Principle:
– Value of financial securities = PV of expected future
cash flows

•Bond value is, therefore, determined by the present value

of the coupon payments and par value.

•Interest rates are inversely related to present (i.e., bond)

values.

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 I. BOND MARKET (cont’d)
Bond characteristics (cont’d)

You plan to hold bond until maturity, what is cash flow of the bond ?

Coupon payment Face value

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Cash flows to an investor in the 1.25% coupon bond maturing in 2018
 I. BOND MARKET (cont’d)
Bond characteristics

Face value (principal or par value)

Coupon

Last payment: coupon + face value

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 I. BOND MARKET (cont’d)
Pure Discount Bonds
•Make no periodic interest payments (coupon rate =
0%)
•The entire yield to maturity comes from the difference
between the purchase price and the par value.
•Cannot sell for more than par value
•Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
•Treasury Bills and principal-only Treasury strips are
good examples of zeroes.

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 I. BOND MARKET (cont’d)
Consols
•Not all bonds have a final maturity.
•British consols pay a set amount (i.e., coupon)
every period forever.
•These are examples of a perpetuity.

C
PV 
R
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 II. INTEREST RATE AND BOND
PRICES
The value of the bond is the present value of the cash flows

…discount the cash flow by the current interest rate

 1 
1 - (1  R) T  FV
Bond Value  C   T
 R  (1  R )

 

C: coupon payment Face value

Annuity factor

Discount factor: 1/(1+r)t

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II. INTEREST RATE AND BOND PRICES (cont’d)
What is price of a bond in 2015 if holding it until maturity?
•The coupon rate: 1.25%
•The face value: $1,000
•The coupon rate: 1.194%

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Cash flows to an investor in the 1.25% coupon bond maturing in 2018
II. INTEREST RATE AND BOND PRICES
(cont’d)

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 II. INTEREST RATE AND BOND PRICES
(cont’d)
Semi-annual coupon payment

•The coupon rate: 1.25%

•The face value: $1,000
•The interest rate: 1.194%

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II. INTEREST RATE AND BOND PRICES (cont’d)
Coupon payment = $12.50/2 = $6.25
6-month rate is 1.194/2 = 0.597%

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II. INTEREST RATE AND BOND PRICES (cont’d)

Please calculate the price of the bond, known that the interest rate is 2.16%

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II. INTEREST RATE AND BOND PRICES (cont’d)
•The coupon rate: 5%

•The face value: $1,000

•The interest rate: 2.16%

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II. INTEREST RATE AND BOND PRICES (cont’d)

How bond prices vary with interest rate

•The coupon rate: 5%

•What is the price of this bond … ?
•The face value: $1,000
…if interest rate is 5%, 8% and 2.16%
•The coupon paid annually •What is the conclusion withdrawn ?

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II. INTEREST RATE AND BOND PRICES (cont’d)
How bond prices vary with interest rate (cont’d)

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II. INTEREST RATE AND BOND PRICES (cont’d)

How bond prices vary with interest rate (cont’d)

r > Coupon Interest Rate P0 < par value

= DISCOUNT

r < Coupon Interest Rate P0 > par value

= PREMIUM

r = Coupon Interest Rate P0 = par value

=P 0= PAR VALUE

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II. INTEREST RATE AND BOND PRICES (cont’d)

Interest rate risk

•Bond exhibit interest rate risk

why?

•Bond prices fluctuate as interest rate changes

•Price of long-term bonds has the greater effect from the change of interest rate
than that of short-term bonds

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 II. INTEREST RATE AND BOND PRICES (cont’d)
Interest rate risk (cont’d)

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 III. CURRENT YIELD AND YIELD TO MATURITY

• Simple yield (coupon rate): Annual interest payment

simple yield = Coupon / Face value
as a percentage of face value
• Current yield: a ratio of bond’s annual coupon
payment to the bond’s market price. It only focus on
current income and ignore the future fluctuation of
bond price current yield = Coupon / bond price

• Yield to maturity: the discount rate used in the bond

pricing formula. This equals the rate of return earned
by a bondholder 33
 III. CURRENT YIELD AND YIELD TO MATURITY
•Buy a 3-year bond with the face value of $1,000 and a coupon rate of 10%
•Cash flow of the bond if bond priced at face value

•Cash flow of the bond if price of the 3-year bond rises to $1,200

•Cash flow of the bond if price of the 3-year bond decrease to $800

  Cash paid to you in year  

You pay 1 2 3 Rate of return
$800 $100 $100 $1,100 ? 34
 III. CURRENT YIELD AND YIELD TO MATURITY

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Note: in financial calculator, PV is positive, FV and Pmt are negative
 III. CURRENT YIELD AND YIELD TO MATURITY
•Buy a 3-year bond with the face value of $1,000 and a coupon rate of 10%
Market price at 3 years
$800 $1,000 $1,200
Coupon yield 10% 10% 10%
Current yield =100/800 = 12.5% 10% =100/1,200 = 8.3%
Yield to Maturity 19,4% 10% 2,9%

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 III. CURRENT YIELD AND YIELD TO MATURITY
•Buy a 3-year bond with the face value of $1,000 and a coupon rate of 10%
Market price at 3 years
$800 $1,000 $1,200
Coupon yield 10% 10% 10%
Current yield =100/800 = 12.5% 10% =100/1,200 = 8.3%
Yield to Maturity 19,4% 10% 2,9%

•Current yield only focus on current income and ignore the future fluctuation of bond price

If buy a bond at a premium: return on bond (yield to maturity) is less than its current yield.

If buy a bond at a discount:return on bond (yield to maturity) is greater than its current yield

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 III. CURRENT YIELD AND YIELD TO MATURITY
(cont’d)

•We need a Return that reflect fully both coupon payment and the change in a
bond’s value over its life

Yield to Maturity

…the discount rate of the bond’s payment to calculate the bond price

? If I buy a bond today and hold it to maturity, my return will be …

Yield to maturity is the discount rate that …the yield to maturity

equates a present value of interest payments
and principal repayment with its price

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III. CURRENT YIELD AND YIELD TO MATURITY (cont’d)

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III. CURRENT YIELD AND YIELD TO MATURITY (cont’d)
Use financial calculator Annual coupons Semiannual coupons

Settlement date 11/15/2015 11/15/2015

Maturity date 11/15/2019 11/15/2019
Annual coupon rate 14% 14%
Bond price 120 120
Redemption value (% of 100 100
face value
Coupon payments per year 1 2

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III. CURRENT YIELD AND YIELD TO MATURITY (cont’d)
Annual coupons Semiannual coupons

Settlement date 11/15/2015 11/15/2015

Maturity date 11/15/2018 11/15/2018
Annual coupon rate 14% 14%
Bond price 120 120
Redemption value (% of 100 100
face value
Coupon payments per year 1 2

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 III. CURRENT YIELD AND YIELD TO MATURITY
(cont’d)

•Example 1
If you buy a 3-year bond at $1,136.16, face value is $1,000; the coupon rate is 10%.
What is the yield to maturity of the bonds ?

•Example 2
If you buy a 3-year bond at $1,136.16, face value is $1,000; the coupon rate is 10%.
The coupon will be paid semi-annually
What is the yield to maturity of the bonds ?

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III. CURRENT YIELD AND YIELD TO MATURITY
(cont’d)

Annual payment Semiannual payment

n 3 3x2=6
PV $1,136.16 $1,136.16
FV $1,000 $1,000
PMT $ 100 $ 100/2 = $50

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III. CURRENT YIELD AND YIELD TO MATURITY (cont’d)
Annual coupons Semiannual coupons

Settlement date 11/15/2015 11/15/2015

Maturity date 11/15/2018 11/15/2018
Annual coupon rate 10% 10%
Bond price 113.616 113.616
Redemption value (% of face value) 100 100

Coupon payments per year 1 2

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 IV. RATE OF RETURN

•The rate of return is measured by the yield to maturity

…but it just right in the interim

Interest rate rises The price of bond falls Your return will be reduced

Interest rate falls The price of bond rises Your return will be increased

The rate of return cannot be kept unchanged

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 IV. RATE OF RETURN (cont’d)
•Rate of return:

coupon income  price change

Rate of return 
investment
Example:
5.5% coupon bond with maturity 2008 currently has 3 years left until
maturity and sell today for 1,056.03. Its yield to maturity is 3.5%.
Suppose that by the end of this year, interest rates have fallen and the
bond’s yield to maturity is now only 2.0%. What will the bond rate of
return?

The value of the bond = 55$/1.020 + $1,055/(1.020)2 = $1,067.95

Rate of return =(55 + 1,067.95 – 1,056.03)/1,056.03 = 6.34%

YTM at the start of the year is 3.5%. However, because interest rates fell46
during the year, the bond price rose and this increase the rate of return
IV. RATE OF RETURN (cont’d)

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 IV. RATE OF RETURN (cont’d)
•Relation between Yield to maturity and Rate of return

Interest rate The price of bond falls Rate of return < Yield to maturity
(yield to maturity) rises

Interest rate The price of bond rises Rate of return > Yield to maturity
(yield to maturity) falls

Interest rate The price of bond

Rate of return = Yield to maturity
(yield to maturity) changes with time
unchanged

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 V. THE YIELD CURVE

•Yield curve – graph of the relationship between time to maturity and yield to
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maturity
 V. THE YIELD CURVE (cont’d)
Nominal and Real Rates of Interest

•Nominal interest rate – the cash flow of coupon rate.

•Real interest rate – the cash flow of coupon rate extracted the inflation rate

1  nominal interest rate

1  Real interest rate 
1  inflation rate

•Treasury Inflation Protected Securities (TIPS): fixed real cash flow, adjusted nominal
cash flow by the CPI

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 V. THE YIELD CURVE (cont’d)
Nominal and Real Rates of Interest (cont’d)

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 VI. CORPORATE BONDS AND
THE RISK OF DEFAULT
Variations in Corporate bonds

Zero coupon bonds

•Coupon rate can be changed over time according

Floating Rate bonds
with current market interest rate

•A bond can be exchanged for a specific number of

Convertible bonds
common shares

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 VI. CORPORATE BONDS AND
THE RISK OF DEFAULT
Default risk (credit risk) •The risk that a bond issuer may default on its obligation

•Additional yield on an bond that investors require for

Default premium
bearing credit risk

Default premium = promised yield on the corporate bond – yield of US treasury bond

Investment grade •Bonds rated Baa or above (Moody’s)

Junk bonds •Bonds rated Ba or below (Moody’s)

•Speculative grade, high-yield 53
QUIZ
1. A 30-year treasury bond is issued with face value of $1,000, paying interest of
$60 per year. If market interest rates increase shortly after the T-bond is issued
what happens to the bond’s:
a.Coupon rate?
b.Price?
c.Yield to maturity?
d.Current yield?

2. One bond has a coupon rate of 8%, another a coupon rate of 12%. Both bond
have 10-year maturities and sell at a yield to maturity of 10%. If their yields to
maturity next year are still 10%, what is the rate of return on each bond? Does
the higher coupon bond give a higher rate of return?

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Thank you for your attention !

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