CHAPTER 3

Bonds and Their Valuation

 Key features of bonds

 Bond valuation
 Measuring yield
 Assessing risk
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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.

7-2
Bond markets
 Primarily traded in the over-the-counter
(OTC) market.
 Most bonds are owned by and traded among
large financial institutions.
 Full information on bond trades in the OTC
market is not published, but a representative
group of bonds is listed and traded on the
bond division of the NYSE.

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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 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”).
Current yield plus capital gain/loss yield
 Current yield: annual coupon divided by bond price
 Capital gains yield: difference between purchase price and
selling price of a bond divided by purchase price.
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Key Features of a Bond
 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 and a
declining call premium.
 It has reinvestment risk to the bondholder

7-5
Key Features of a Bond
 Put provision:
 Allows holder to redeem the bond if
rates increase (helps the investor, but
hurts the issuer).
 Borrowers are willing to pay less, and
lenders require less, for puttable bonds.
 It has refinancing risk to the issuer.

7-6
Key Features of a Bond
 Sinking fund or Serial bond
 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
average maturity cause of early
collection.
 But not good for investors if rates decline
after issuance (reinvestment risk).

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 Types 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.
 Income bond – pays interest only when interest is
earned by the firm.
 Indexed bond – interest rate paid is based upon the
rate of inflation.
 Zero coupon bond: has no copoun and hence its
current yield is zero as it is sold at a discount.

7-8
Types of bonds
 Mortgage bonds
 Debentures
 Subordinated debentures
 Investment-grade bonds: high quality
bonds
 Junk bonds: risky bonds of low graded
companies
7-10
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 D

 Bond ratings are designed to reflect the

probability of a bond issue going into
default.

7-11
Factors affecting default risk and
bond ratings
 Financial performance
 Debt ratio
 TIE (times Int Erned) ratio
 Current ratio
 Bond contract provisions
 Secured vs. Unsecured debt
 Senior vs. subordinated debt
 Guarantee and sinking fund provisions
 Debt maturity
7-12
Other factors affecting default risk
 Earnings stability
 Regulatory environment
 Potential antitrust or product liabilities
 Pension liabilities
 Potential labor problems
 Accounting policies

7-13
 The value of financial assets
Is computed by present value of cash flows from the asset

0 1 2 n
k
...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value  1
 2
 ...  n
(1  k) (1  k) (1  k)

7-14
What is K?
 The discount rate (ki ) is the
opportunity cost of capital, and is the
rate that could be earned on
alternative investments of equal risk.

ki = k* + IP + MRP + DRP + LP

7-15
 What is the value of a 10-year, 10%
annual coupon bond, if kd = 10%?

0 1 2 n
k
...
VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB  1
 ...  10

(1.10) (1.10) (1.10)10
VB  $90.91  ...  $38.55  $385.54
VB  $1,000
7-16
 The price path of a bond
 What would happen to the value of this bond if
its required rate of return remained at 10%, or
VB
at 13%, or at 7% until maturity?

1,372 kd = 7%.
1,211
kd = 10%.
1,000
837
775 kd = 13%.
Years
to Maturity
30 25 20 15 10 5 0 7-17
Bond values over time
 At maturity, the value of any bond must
equal its par value.
 If kd remains constant:
 The value of a premium bond would

decrease over time, until it reached

$1,000.
 The value of a discount bond would

increase over time, until it reached

$1,000.
 A value of a par bond stays at $1,000.

7-18
 Bond value: Using Formula
 V = Pv(interest) + PV(maturity value)
 = Int (1-1/ (1+Kd) N) + M/ (1+Kd)N
 Kd
Where: Kd is the discount rate (required return) or yield to
maturity and N is number of (perids)years before the bond
matures
The value of bonds changes with the fluctuations in the
market interest rate. When the market rate increases the
value of the bond declines (the bond is sold at a discount)
and when the market rate declines the bonds value
increases (the bond is issued at a premium). How ever,
the value of the bond approaches its par value as its
maturity date approaches.
7-19
 Bond Yield to maturity (YTM)
 This represents a return earned on bonds held until
maturity. It can be viewed as the expected return from a
bond if there is no default risk and the bond is not
callable. It is the discount rate that equates the future
cash flows to the price of the bond. Hence, it equal to the
market interest rate.

 The YTM on a bond changes as the market interest rate

fluctuates. However, one who purchases and holds it until
maturity will earn the YTM that existed on the purchase
date.
 YTM = Interest yield + capital gains yield

7-23
 Bond Yield to maturity (YTM)
 Unless financial calculator or computer program is in use,
the YTM on a bond is found using a trial and error
(interpolation)by substituting various discount rates until a
rate that equates the bonds price to the future cash flows
is found. However, the rate could be approximated using
the following formula:
 YTM = Annual Interest + Capital gain/ N
 0.6 (Market price of the bond) + 0.4 (Par value)
 Holding Period Yield (HPY)
 This is the return earned over holding period of a bond.
This is the discount rate that equates the price of the
bond with interest received when held and the price of the
bond when sold. It is composed of interest and capital
gain/loss upon selling the bond.
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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 kd that solves this model.

INT INT M
VB  1
 ...  N
 N
(1  k d ) (1  k d ) (1  k d )
90 90 1,000
$887  1
 ...  10
 10
(1  k d ) (1  k d ) (1  k d )

7-25
 Bonds Yield to Call (YTC)
 Yield to Call (YTC):- When a bond is callable there is a
high probability that the YTM will not be earned. This is
the discount rate that equates the periodic interest
payments and the call price with the current price of the
bond.
 Example: M Co. issued $1,000 par, 10%, on Jan. 1, year
1. The bond has a provision to call 10 years after the issue
date at a price of $1,100.00. Suppose X.Co. acquired the
bond for $1,494.93 on Jan , year 2. Calculate the YTC of
the bond.
 $1,494.93 = $100 [(1- 1/ (1+YTC)N] + $1,100
 YTC (1+YTC)N
 YTC = 4.21%
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When is a call more likely to occur?
 In general, if a bond sells at a premium,
then (1) coupon > kd, so (2) a call is
more likely.
 So, expect to earn:
 YTC on premium bonds.
 YTM on par & discount bonds.

7-29
 Illustration
 ABC Co. issued bonds on January 1, 1978. The bonds
were sold at par ($1,000.00) have a 12% coupon rate and
mature in 30 years on December 31, 2007. Interest is paid
semi-annually (June 30 and Dec.31).
 Required:

I. YTM on the date of issuance

II. The price of the bond on Jan. 1, 1983 assuming a market
interest rate of 10%.
III. Current yield and capital gains yield based on your
answer for II above.
IV.On July 1, 2001 the bond is sold for $916.42. What is the
YTM?
V. Price of the bond on March 1, 2001 at an interest rate of
15.5%? 7-30
 Illustration…
 Solution:
I. As far as the bond is issued at par, YTM maturity is equal
to coupon rate 12%.
II. VB = $60[1-1/(1.05)50] + $1000
.05 (1.05)50
= $60(18.2559) + $1,000.00(0.0872)
=$1,182.55
III. Current yield = Annual Interest Payment/Price
 = $120.00/$1,182.55
 = 10.15%
YTM = Current yield + capital gain (loss)
 10% = 10.15% - Capital gain (loss)
 Capital Loss = 0.15% 7-31
 Illustration…
IV. $916.42 = $60[1-1/(1+K/2)13] + $1,000.00
 K/2 (1+K/2)13
 K = 14%
 The value of the bond on March 1, 2001 is determined using the
following procedures:
 Find the value of the bond on the next coupon date, July 1, 2001

 V = $60[1- 1/ (1.0775)13] + $1,000

 0.0775 (1.0775)13
 = $859.72
 Add the coupon, $60, to the bond price to get the total value of

the bond on the next interest payment date : $859.72 + $60 =

$919.72
 Discount this total value back to the purchase date:

 $919.72/(1.155)4/12 = $875.11 This is the value of the bond

out of which $20 is the accrued interest from January to March
($120*2/12) 7-32
An example:
Current and capital gains yield
 Find the current yield and the capital gains
yield for a 10-year, 9% annual coupon
bond that sells for $887, and has a face
value of $1,000. Note that interpolation
tells that YTM is 10.91%

Current yield = $90 / $887

= 0.1015 = 10.15%
7-33
Calculating capital gains yield
YTM = Current yield + Capital gains yield

CGY = YTM – CY
= 10.91% - 10.15%
= 0.76%

Could also find the expected price one year from

now and divide the change in price by the
beginning price, which gives the same answer.
7-34
 What is interest rate (or price) risk?
 Interest rate risk is the concern that rising kd
will cause the value of a bond to fall.

% change 1 yr kd 10yr % change

+4.8% $1,048 5% $1,386 +38.6%
$1,000 10% $1,000
-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to interest

rate changes, and hence has more interest rate
risk.
7-35
What is reinvestment rate risk?
 Reinvestment rate risk is the concern that kd
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.
7-36
 Reinvestment rate 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.

7-37
 Conclusions about interest rate and
reinvestment rate risk
Short-term AND/OR Long-term AND/OR
High coupon bonds Low coupon bonds
Interest
Low High
rate risk
Reinvestment
High Low
rate risk

 CONCLUSION: Nothing is riskless!

7-38
Would you prefer to buy a 10-year, 10%
annual coupon bond or a 10-year, 10%
semiannual coupon bond, all else equal?

The semiannual bond’s effective rate is:

m 2
 iNom   0.10 
EFF%  1    1  1    1  10.25%
 m   2 

10.25% > 10% (the annual bond’s

effective rate), so you would prefer the
semiannual bond.
7-41
Default risk
 If an issuer defaults, investors receive
less than the promised return.
Therefore, the expected return on
corporate and municipal bonds is less
than the promised return.
 Influenced by the issuer’s financial
strength and the terms of the bond
contract.

7-44
Bankruptcy
 Two main chapters of the Federal
Bankruptcy Act:
 Chapter 11, Reorganization
 Chapter 7, Liquidation
 Typically, a company wants Chapter 11,
while creditors may prefer Chapter 7.

7-45
 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.
 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.

7-46
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
7-47
Reorganization
 In a liquidation, unsecured creditors
generally get zero. 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,
company “emerges” from bankruptcy with
lower debts, reduced interest charges, and
a chance for success.

7-48