Bonds and Their Valuation

CHAPTER
11

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 11.1 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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 11.2 Types of Bonds

Debentures
Any unsecured long term debt

Subordinated debentures
A debenture that is subordinated to other debentures
in being paid in the case of solvency.

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 11.2 Types of Bonds

Mortgage Bond
A bond secured by a lien on real property

Eurobond Bon
Bonds issued in a country different from the one in
whose currency the bond is denominated. For example
a bond issued in Indonesia by an American company
that pays interest and principal to the lender in US
dollars.

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 11.2 Types of Bonds

Zero and low coupon bonds

Bonds issued at a substantial discount from
their RM1,000 par or face value that pay zero
or little interest.

Junk / high yield bond

Bond rated BB or below

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 11.3 Terminology and characteristic
of bonds
• Claims on assets and income
• Par value
• Coupon interest rate
• Maturity
• Indenture
• Current Yield
• Bond Ratings

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 11.3.1 Discussion : (1) claims on asset &
income

Bonds also have a claim on income that come

ahead of preferred stock and common stock
I) Bond holder
II)Preferred Stock holder
III)Common stock holder

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 11.3.2 Discussion : (2) Par Value

Par Value – face amount of

the bond, which is paid at
maturity (assume
RM1,000).

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 11.3.3 Discussion : (3) Coupon interest rate

Coupon interest rate – stated interest rate

(generally fixed) paid by the issuer.
Multiply by par value to get ringgit
Malaysia (RM) payment of interest.
Eg. 12% coupon interest, par value
RM1,000
Coupon payment= 12%(RM1000)
=RM120
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 11.3.4 Discussion : (4) Maturity

Maturity date – years until the bond must

be repaid.

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 11.3.5 Discussion : (5) Indenture

The legal agreement or contract between the

firm issuing the bonds and the bond trustee
who represents the bondholders. Indenture try
to protect the bondholders financial position.

BOND HOLLDER
BOND ISSUER

BOND
TRUSTEE

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 11.3.6 Discussion : (6) Current yield

The ratio of the annual interest payment to the

bond’s market price.
Example : 8%(interest rate) RM1000(par value).
What is current yield?

annual int erest payment

Current Yield 
market price of the bond
0.08(1000)
Current Yield   11 .4%
700

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 11.3.7 Discussion : (7) Bond ratings: Evaluating
default risk

Investment Grade Junk Bonds

RAM Aaa Aa A Baa Ba B Caa C
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 provisions
– Secured vs. Unsecured debt
– Debt maturity

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 11.4 Definition of value
• 11.4.1 Book Value – The value of an asset as
shown on a firm’s balance sheet. It represents the
historical cost of the asset rather than its current
market value or replacement cost.
• 11.4.2 Liquidation value -
The amount that could be realized if an
asset were sold individually and not as a
part of a going concern.

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 11.4 Definition of value
11.4.3 Market Value – The observed
value for the asset in the market place.

11.4.4 Intrinsic Value - The present value of the

asset’s expected future cash flows. This value is
the amount the investor considers to be a fair
value given the amount, timing and riskiness of
future cash flows.

11.4.5 Efficient market : Fully reflect all available

information.
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 11.6.1 BOND VALUATION

What is the value of a 5-year, 10% annual coupon

bond,RM1000 par value if rd = 10%?
0 1 2 3 4 5

100
100 100 100 100 + 1000

Coupon payment = RM1000 (10%) = RM100

PB  PV (int erest payments)  PV ( principal repayment )

Vb  100( PVIFA10%,5 years )  1000( PVIF10%,5 years )

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 11.6.2 BOND VALUATION (INTEREST PAID ANNUALLY)

Assume that investor required rate of return for a

given bond is 10%. The bond has a par value of
RM1,000 and an annual interest payments of
RM120, indicating 12% coupon interest rate. The
maturity period is 5 years.

Vb  I PVIFA i ,n   1000PVIFi ,n 
 120PVIFA 10%,5 years   1000PVIF10%,5 years 
 1203.7908  10000.6209
 RM 454.896  RM 620.9  RM 1,075.796

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 11.6.3 BOND VALUATION (INTEREST PAID
SEMIANNUALLY)
Vb  I ( PVIFA i )  1000( PVIF i )
2 , n ( 2) ,n ( 2)
2 2

Vb  120 ( PVIFA10% )  1000( PVIF10% )

2 , 5( 2 ) , 5( 2 )
2 2

Vb  60( PVIFA 5%,10 years )  1000( PVIF5%, 10 years )

Vb  RM 463.302  RM 613.9  RM 1,077.202

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 11.6.4 Zero Coupon Bonds
If you purchase a zero coupon bond for RM500 and
it matures at RM1,200 in 5 years, what rate of return
will you earn on that bond?
1
 Future Value  n
return (%) zero coupon bond     1
 Pr esent Value 
1
 1,200  5
return (%) zero coupon bond     1  19.135%
 500 

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 11.7 Bonds Relationship
11.7.1 First Relationship:
The value of the bond is inversely or negatively related to
changes in the investor’s present required rate of return(the
current interest rate).
Coupon payment = 12%, Par RM1,000, Required rate = 12%

Vb  I PVIFAi ,n   1000PVIFi ,n 
 120PVIFA12%,5   1000PVIF12%,5 
 1203.605  10000.567   RM 432.60  RM 567.00
 RM 999.60  RM 1,000

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11.7.1.1 First Relationship: Example 1
The value of the bond is inversely or negatively
related to changes in the investor’s present required
rate of return(the current interest rate).
Coupon payment = 12%, Par RM1,000, Required rate
= increase to 14%
Vb  I PVIFA i ,n   1000PVIFi ,n 
 120PVIFA14%,5   1000PVIF14%,5 
 1203.4331  10000.5194   RM 411 .972  RM 519.40
 RM 931.372

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11.7.1.1 First Relationship: Example 1

The value of the bond is inversely or negatively

related to changes in the investor’s present required
rate of return(the current interest rate).
Coupon payment = 12%, Par RM1,000, Required rate
= decrease to 8%

 120PVIFA 8%,5   1000PVIF8%,5 

 1203.9927   10000.6806 
 RM 479.124  RM 680.60  RM 1,159.724

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11.7.1.1 First Relationship : Conclusion

Coupon rate Investor required Value bond

(%) rate of return (%)
12% 12% RM1,000
12% 8% RM1,159.724
12% 14% RM931.372

The value of the bond is inversely or negatively

related to changes in the investor’s present
required rate of return(the current interest rate).

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11.7.1.1 First Relationship : Conclusion

Coupon rate Investor required Value bond

(%) rate of return (%)
12% 12% RM1,000
12% 8% RM1,159.724
12% 14% RM931.372

PAR VALUE
DISCOUNT BOND
PREMIUM BOND

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

11.7.1.1 First Relationship : Conclusion

Coupon rate Investor required Value bond

(%) rate of return (%)
12% 12% RM1,000
12% 8% RM1,159.724
12% 14% RM931.372
This bond sells at a premium, because coupon rate > YTM/ required rate of return

This bond sells at a par, because Coupon rate = YTM/required rate of

return
This bond sells at a discount , because Coupon rate < YTM/required rate of return

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 Figure 11.1
Premium Bond
V
a
L RM1,159.724
U Bond At Par
e
RM1,000
Discount Bond
B
o
n RM931.372
d

8% 12% 14%

X-axis : Required rates of return

Y-axis : Market value (Ringgit Malaysia)

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 11.7.3 Third Relationship :
As the maturity dates approaches, the market value of
a bond approaches its par value.
RM1,075.796

RM1,000

RM931.372

5 2 1 0
4 3
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Vb  I PVIFAi ,n   1000PVIFi ,n 
 120PVIFA10%, 4 years   1000PVIF10%, 4 years  After 1 year issued,
 1203.1699  10000.6830 there will be 4
 RM 380.388  RM 683 years left.
 RM 1,063.388

Vb  I PVIFA i ,n   1000PVIFi ,n  After 4 year issued,

 120PVIFA10%,1 years   1000PVIF10%,1 years  there will be 1 years
 1200.9091  10000.9091 left. The price of the
 RM 109.092  RM 909.10 bond is near to par
 RM 1,018.192 value.

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11.7.4 Fourth Relationship :
Long term bonds have greater interest rate risk than do
short-term bonds.
A change in current interest rate causes a change in the
market value of a bond.
However the impact on value is greater for long term bonds
than it is for short – term bonds.

Coupon rate Interest Rate 1 year 30 year

10% 5% 1,047.62 1,768.62
10% 10% 1,000.00 1,000.00
10% 15% 956.52 671.70
10% 20% 916.67 502.11

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 11.8 YTM
• Yield to maturity – rate of return
earned on a bond held until
maturity (also called the “promised
yield”).

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11.8 Yield To Maturity :

 Po  Mo 
I  
 n 
YTM 
 Po  Mo 
 2 
 

I  Coupon payment
Po  Par Value
M 0  Market price
YTM  Yield to maturity

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 11.8 .1 Yield To Maturity :Example 1

Rab’s 20 year bonds pay 9 percent interest annually on a

RM1,000 par value. If bonds sell at RM945, what is the bond
expected rate of return?

1000  945 
90   
 20  92.75
YTM    9.537%
1000  945  97.25
 
 20 

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