Chapter 7

Bonds and Their Valuation

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 Outline

 Sources of Capital
 What is bond and Why Bonds
 Key Features of Bonds
 Bond Valuation
 Measuring Yield
 Assessing Risk

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 Sources of capital

There are many different sources of capital—each with

its own requirements and investment goals. They fall
into two main categories:

•Debt financing, which essentially means you borrow

money and repay it with interest
•Equity financing, where money is invested in your
business in exchange for part ownership.

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 Debt Financing

 Private sources of debt financing:

Commercial banks, credit unions, consumer finance
companies, commercial finance companies, trade
credit, insurance companies, factor companies, and
leasing companies.

 Public sources of debt financing:

Financing include a number of loan programs provided
by the state and federal governments to support small
businesses.
Note: Firms can also rely on internal source of debt
financing. Example Bonds and Commercial Papers 7-4
 What is a bond?

 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.

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 Classifications of bonds
1. Treasury bonds, sometimes referred to as government
bonds, are issued by the federal government. It is
reasonable to assume that the federal government will make
good on its promised payments, so these bonds have almost
no default risk.

2. Corporate bonds, are issued by corporations. Unlike

Treasury bonds, corporate bonds are exposed to default risk
—if the issuing company gets into trouble, it may be unable
to make the promised interest and principal payments.
Different corporate bonds have different levels of default
risk, depending on the issuing company’s characteristics and
the terms of the specific bond. Default risk is often referred
to as “credit risk,”. 7-6
 Classifications of bonds

3. Municipal bonds, or “munis,” are issued by state and

local governments. Like corporate bonds, munis have
default risk. However, munis offer one major advantage:
The interest earned on most municipal bonds is exempt
from federal taxes and also from state taxes if the holder is
a resident of the issuing state.
4. Foreign bonds are issued by foreign governments or
foreign corporations. Foreign corporate bonds are, of
course, exposed to default risk, and so are some foreign
government bonds. An additional risk exists if the bonds are
denominated in a currency other than that of the investor’s
home currency.
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 Why Bonds?
Borrowing from a bank is perhaps the approach that comes to
mind first for many corporations who need money. This leads to
the question, “Why would a corporation issue bonds instead of
just borrowing from a bank?”
•Bonds release firms from the restrictions that are often attached
to bank loans. or example, that lenders often require companies
to agree to a variety of limitations, such as not issuing more debt
or not making corporate acquisitions until their loans are repaid
in full. Such restrictions can hamper a company’s ability to do
business and limit its operational options and issuing bonds
enables companies to raise money with no such strings attached.
•The interest rate companies pay bond investors is often less
than the interest rate they would be required to pay to obtain a
bank loan.
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 Bond Markets

 Primarily traded in the over-the-counter (OTC) market.

 Most bonds are owned by and traded among large
financial institutions.

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 Key Features of a Bond

• Par value: face amount of the bond, which

is paid at maturity (assume $1,000).
• Coupon interest rate: stated interest rate (generally
fixed) paid by the issuer. Multiply by par value to
get dollar payment of interest.
• Maturity date: years until the bond must be repaid.
• Issue date: when the bond was issued.
• Yield to maturity: rate of return earned on
a bond held until maturity (also called the
“promised yield”).

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 Call Provisions and Effect of a Call Provision

• Allows issuer to refund the bond issue if rates

decline (helps the issuer but hurts the investor).
• Borrowers are willing to pay more, and lenders
require more, for callable bonds.
• Most bonds have a deferred call.

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 What is a sinking fund?

• Provision to pay off a loan over its life rather than

all at maturity.
• Similar to amortization on a term loan.
• Reduces risk to investor, shortens.
• But not good for investors if rates decline after
issuance.

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 How are sinking funds executed?

• Call x% of the issue at par, for sinking fund

purposes.
– Likely to be used if r is below the coupon rate and
d
the bond sells at a premium.
• Buy bonds in the open market.
– Likely to be used if r is above the coupon rate and
d
the bond sells at a discount.

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 Other Types (Features) of Bonds

• Convertible bond: may be exchanged for common

stock of the firm, at the holder’s option.
• Warrant: long-term option to buy a stated number
of shares of common stock at a specified price.
• Putable bond allows holder to sell the bond back to
the company prior to maturity.
• Income bond: pays interest only when interest is
earned by the firm.
• Indexed bond: interest rate paid is based upon the
rate of inflation.

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 The Value of Financial Assets

0 1 2 N
r% ...
Value CF1 CF2 CFN

CF1 CF2 CFN

Value   
1  r  1  r 
1 2
1  r N

The Value of Bond

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 What is the opportunity cost of debt capital?

• The discount rate (ri or rd or i ) is the opportunity

cost of capital and is the rate that could be earned
on alternative investments of equal risk.

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MicroDrive issued a 15-year bond with an annual coupon rate
of 10% and a par value of $1,000. What is the value of its bond?

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MicroDrive issued a 15-year bond with an annual coupon rate of 10% and a
par value of $1,000. What is the value of its bond if the market interest rate
is 10%?

Value of bond =
1000

Present
Value of
Annuity
Formula.

Note: Market
interest rate is
(ri or rd or i )
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What is the value of a 15-year, 10% annual coupon bond, Par
value $ 1000, if market interest rate (rd or i or ri )= 15%?

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What is the value of a 15-year, 10% annual coupon bond, Par
value $ 1000, if market interest rate (rd or i or ri )= 8%?

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Premium Bond and Discount Bond

• Discount bond: Whenever the going rate of interest

rises above the coupon rate, a fixed-rate bond price will
fall below its par value; this type of bond is called
discount bond.

• Premium bond: Whenever the going rate of interest

rises above the coupon rate, a fixed-rate bond price will
fall below its par value; this type of bond is called
discount bond.
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 Yield to Maturity (YTM)

What rate of interest would you earn on your

investment if you bought the bond and held it to
maturity? This rate is called the bond’s yield to
maturity (YTM), and it is the interest rate generally
discussed by investors when they talk about rates of
return.

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What is the YTM on a 10-year, 9% annual coupon,
$1,000 par value bond, selling for $887?

• Must find the rd that solves this model.

Par Value=1000
INT = 1000*9%=90
Current Value of Bond = 887
YTM= rd =?

INT INT M
VB     
1  rd 1 1  rd N 1  rd N
90 90 1,000
$887   
1  rd 1
1  rd  1  rd 10
10

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 Yield to Call

Yield to call (YTC) is a financial term that refers to the return

a bondholder receives if the security is held until the call
date, before the debt instrument reaches maturity. 

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 If you bought these callable bonds, would you be
more likely to earn the YTM or YTC?

• The coupon rate = 10% compared to YTC = 7.137%.

The firm could raise money by selling new bonds
which pay 7.137%.
• Could replace bonds paying $100 per year with
bonds paying only $71.37 per year.
• Investors should expect a call, and to earn the YTC
of 7.137%.

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 When is a call more likely to occur?

• In general, if a bond sells at a premium, then (1)

coupon > rd, so (2) a call is more likely.
• So, expect to earn:
– YTC on premium bonds.
– YTM on par and discount bonds.

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 An Example:
Current Yields

• Current yield is an investment's annual income

(interest or dividends) divided by the current price
of the security
• Find the current for a 10-year, 9% annual coupon
bond that sells for $887, and has a face value of
$1,000.

$90
Current yield 
$887
 0.1015  10.15% 7-27
 Semiannual Bonds

1. Multiply years by 2: Number of periods = 2N

2. Divide nominal rate by 2: Periodic rate (I/YR) = r d/2
3. Divide annual coupon by 2: PMT = Annual coupon/2

• A bond has a 25-year maturity, an 8% annual coupon

paid semiannually, and a face value of $1,000. The
going nominal annual interest rate (rd) is 6%. What
is the bond’s price?
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Would you prefer to buy a 10-year, 10.2% annual coupon
bond or a 10-year, 10% semiannual coupon bond, all else
equal?

The semiannual bond’s effective rate is:

M 2
 rNOM   0.10 
EFF%   1    1  1    1  10.25%
 M   2 

10.25% > 10.2% (the annual bond’s effective rate), so you

would prefer the semiannual bond.

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 Concept of Price and Reinvestment Risks

• Interest rates go up and down over time, and an increase

in interest rates leads to a decline in the value of
outstanding bonds. This risk of a decline in bond values
due to rising interest rates is called interest rate risk or
price risk. To illustrate, suppose you bought some 10%
Micro Drive bonds at a price of $1,000 and then interest
rates rose in the following year to 15%. As we saw earlier,
the price of the bonds would fall to $713.78, so you
would have a loss of $286.22 per bond.
• One’s exposure to interest rate risk is higher on bonds
with long maturities than on those maturing in the near
future.

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What is price risk? Does a 1-year or 10-year bond
have more price risk?

• Price risk is the concern that rising r d will cause the

value of a bond to fall.
rd 1-year Change 10-year
Change
+ 4.8% +38.6%
5% $1,048 $1,386
– 4.4% –25.1%
10% 1,000 1,000
15% 956 749

• The 10-year bond is more sensitive to interest

rate changes, and hence has more price risk.
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 What is reinvestment risk?

• Reinvestment risk is the concern that r d will fall, and

future CFs will have to be reinvested at lower rates,
hence reducing income.

EXAMPLE: Suppose you just won $500,000 playing the

lottery. You intend to invest the money and live off
the interest.

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 Reinvestment Risk Example

• You may invest in either a 10-year bond or a series

of ten 1-year bonds. Both 10-year and 1-year
bonds currently yield 10%.
• If you choose the 1-year bond strategy:
– After Year 1, you receive $50,000 in income and have
$500,000 to reinvest. But, if 1-year rates fall to 3%,
your annual income would fall to $15,000.
• If you choose the 10-year bond strategy:
– You can lock in a 10% interest rate, and $50,000
annual income for 10 years, assuming the bond is not
callable.

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 Conclusions about Price Risk and Reinvestment Risk

Short-term Long -term

- -

Price risk Low High

Reinvestment risk High Low

• CONCLUSION: Nothing is riskless!

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 Default Risk

• If an issuer defaults, investors receive less than the

promised return. Therefore, the expected return is
less than the promised return.
• Influenced by the issuer’s financial strength and the
terms of the bond contract.

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 Other Types of Bonds

• Mortgage bonds
• Debentures
• Subordinated debentures
• Investment-grade bonds
• Junk bonds

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 Evaluating Default Risk:
Bond Ratings

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC C

• Bond ratings are designed to reflect the probability

of a bond issue going into default.

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Factors Affecting Default Risk and Bond Ratings

• Financial performance
– Debt ratio
– TIE ratio
– Current ratio
• Qualitative factors: Bond contract terms
– Secured vs. unsecured debt
– Senior vs. subordinated debt
– Guarantee and sinking fund provisions
– Debt maturity
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 Other Factors Affecting Default Risk

• Miscellaneous qualitative factors

– Earnings stability
– Regulatory environment
– Potential antitrust or product liabilities
– Pension liabilities
– Potential labor problems

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 Bankruptcy

• Two main chapters of the Federal Bankruptcy Act:

– Chapter 11, Reorganization
– Chapter 7, Liquidation
• For large organizations, reorganization occurs more
frequently than liquidation, particularly in those
instances where the business is worth more “alive
than dead.”

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 Chapter 11 Bankruptcy

• If company can’t meet its obligations …

– It files under Chapter 11 to stop creditors from
foreclosing, taking assets, and closing the business
and it has 120 days to file a reorganization plan.
– Court appoints a “trustee” to supervise
reorganization.
– Management usually stays in control.
• Company must demonstrate in its reorganization
plan that it is “worth more alive than dead.”
– If not, judge will order liquidation under Chapter 7.

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 Priority of Claims in Liquidation

1. Secured creditors from sales of secured assets

2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock

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 Reorganization

• In a liquidation, unsecured creditors generally

receive nothing. This makes them more willing to
participate in reorganization even though their
claims are greatly scaled back.
• Various groups of creditors vote on the
reorganization plan. If both the majority of the
creditors and the judge approve, the company
“emerges” from bankruptcy with lower debts,
reduced interest charges, and a chance for success.

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