Chapter 6

VALUATION OF BONDS
LEARNING After reading this chapter, students will
be able to:
OUTCOMES • Describe various types of bonds

• Determine the intrinsic value of bonds,

current yield, and yield to maturity
• Describe convertible bonds

• Determine the minimum value of bonds

• Describe bond investment strategies

What is a Bond?
A bond is a fixed income instrument that represents a loan taken by the issuing company, from
the investor for a defined period at a fixed interest rate.
The issuing company uses the proceeds from bond issuance to finance its projects and
operations.
The owner of the bonds are called the bondholders or the creditors of the issuer.

Bonds provide cash flow to their holders in the form of coupon payments and principal and as
such, can be referred to as income security.
The coupon rate can either be fixed or varied/floated. The principal of the bonds will be paid
upon maturity.
Bonds and can be securitised as tradeable asset and are traded in the exchange or off-exchange.
 Face Value
• Is the value of the bond at maturity
• The holder of the bonds entitles to receive that amount of money when the bond
matured.
• Acts as the reference amount the bond issuer uses when calculating interest
payments

Coupon rate and coupon date

• The coupon rate is the interest that the bond issuer will pay on the face value of the
bond
• Fixed coupon rate typically payable semi-annually, but some are paid on a
quarterly or monthly basis. The coupon are fixed at certain rate
• The floating rate bonds usually requires the rate to be reset periodically to a
specified prevailing market rate.

Maturity date
• The date that the bond will mature according to its maturity period. Upon maturity,
the holder of the bonds will receive their principal value.
Bond’s
Bond Price
Characteristics • The price at which a bond is selling in the market. The bond can be traded at par, at
premium or at discount. Unlike shares, the bonds are often issued at par, for
example RM1000 payable per RM1000 nominal value.
• Usually reflects its intrinsic value
 Zero coupon
bond

Types of Bonds
Callable
bonds

Puttable
bonds
Bond Valuation
𝑛
V alue = ∑ 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠h 𝑓𝑙𝑜𝑤
𝑡 =0

• The PV of cash flow is calculated as follows:

• PV of Cash flow in year n = Cash flown/(1+yield/discount rate)n

• With regards to bond valuation, the cash flow form investment in bonds comprises of interest or
coupon payment that the investors receive every year and the redemption or principal value that
they receive at the end of the maturity period.
𝑛
B ond Value ( Price )=∑ 𝑃𝑉 𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑃𝑉 𝑜𝑓 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
𝑖 =0
 Example 1

ABC Co. has issued 7% bonds with par value RM100. The redemption yield or the yield to
maturity (market interest rate) of the bond is 8%. The bonds are issued in Jan 2001 and it is now
the year March 2021. The bonds have 10 years remaining life to maturity and the coupon is paid
annually.
Calculate the price of the bonds.
The cash flow from coupon and principal.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Coupon RM7 RM7 RM7 RM7 RM7 RM7 RM7 RM7 RM7 RM7

Par - - - - - - - - - RM100

7% x 100

Receives every year

Principal

Receives upon maturity

 The Intrinsic Value/Price of bonds = PV Coupon + PV Principal
Year Cash Flow PVIF 8%, n Present Value
1-10 Coupon RM7 PV Annuity table 8%, 10 RM7 x 6.710 = RM46.97
6.710

10 Principal RM100 PV 8%, 10 RM100 x 0.463 = RM46.30

0.463
Bond Value RM46.97 + RM46.30 = RM93.27

Note: The intrinsic value/price of the bond is lower than the par value (RM100) because the coupon rate (7%) is
lower than the market interest rate (8%).

TRY: COUPON 10% = Value of Bond RM113.40

COUPON 8% = Value of Bond RM100
 Bonds Price Behaviour
Coupon rate vs Market interest rate Bond Price
Coupon rate is higher than the market At premium; Bond Price > Par value
interest rate

Coupon rate is equal to the market interest Same as par value; Bond Price = Par
rate value
Coupon rate is lower than the market At discount; Bond Price < Par value
interest rate

Bond Price/Value Coupon Market Interest Rate

100 (At par) 8% 8%

113.40 (Premium) 10% 8%
93.27 (Discount) 7% 8%
 Bond Price and Maturity Period (1)
Example 2

Refer to the ABC Co example above. Assume now that the maturity period is increased to 20 years.
Compute the price/intrinsic value of the bond.

Bond price (BPc) = RM7 (PVIFA8%, 20) + RM100 (PVIF8%, 20)

= RM7 (9.818) + RM100 (0.215)
= RM68.73 + RM21.50
= RM90.23

Observation:
When maturity period was increased from 10 years to 20 years, a bond yields a lower price (it goes down
from RM93.27 to RM90.23). Thus, the longer the maturity period of the bond, the lower will be the
intrinsic value of the bond.
 Bond Price and Maturity Period (2)
Example 3

Refer again to the ABC Co example above. Assume now that the maturity period is decreased to 5 years
instead of 10 years. Compute the price/intrinsic value of the bond.

Bond price (BPc) = RM7 (PVIFA8%, 5) + RM100 (PVIF8%, 5)

= RM7 (3.993) + RM100 (0.681)
= RM27.95 + RM68.10
= RM96.05

Observation:
When maturity period was decreased from 10 years to 5 years, a bond yields a higher price (it goes up from
RM93.27 to RM96.05). Therefore, the shorter the maturity period of the bond, the higher will be the
intrinsic value of the bond.
Even though the bond price increases for the shorter maturity period, the price is still below its par value.
This is because the coupon rate of the bonds is lower than the prevailing market interest rate.
 Semi-annual Interest Payments
• Bond price formula is modified for semi-annual interest payments.
• Interest or coupon payment (I) divided into two parts. The interest is altered to I/2.
• Market interest rate or required rate of return (i) divided by 2, i/2.
• Maturity period (n) converted to a number of periods. There are ten six-month periods in
five years (5 × 2 = 10). Now the maturity period becomes n × 2.

The modified bond price formula is:

• Bond price (BPc) = I/2 (PVIFA i/2, n × 2) + P (PVIF i/2, n × 2)
Interest payment = I/2
Required return = i/2
Number of periods = n × 2

Recalculate the price of ABC Co bonds in Example 1 using semiannual interest payments:
Answer: RM93.21 12
 Zero-coupon Bonds
Example 4
Refer to the ABC Co in Example 1 above. Assume now that ABC Co bonds do
not carry any coupon. The bonds will mature in 10 years and the current market
interest rate is 8%.
Compute the price/intrinsic value of the bond.

Bond price (BPc) = 0(PVIFA8%, 10) + RM100 (PVIF8%, 10)

= 0(6.710) + RM100 (0.463)
= 0 + RM46.30
= RM46.30
 Bonds Yield
The bonds’ yield is referred to the investors’ required rate of return.

It shows how the price of the bond relates to its expected cash flows which consist of the
regular payment of coupon and the redemption value of the bonds.
A bond's yield is the discount rate that will equate the present value of the bonds to its
price.
The bond yield is inversely related to its price.

There are two types of yields that measure the required return by the bondholders namely
the current yield and the yield-to-maturity (YTM).
 Current Yield
The current yield is rate of return the bondholders will receive based on the current cash flow that
the bond provides. In this case, the coupon that they receive every as a reward for their initial
investment and for taking a certain amount of risk by investing in bonds

𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑=
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒

ABC Co. has issued 7% bonds with par value of RM100 in Jan 2001. The bonds have 10 years
remaining life to maturity and paying its coupon on an annual basis. The bonds are currently traded
at RM93.27. Calculate the current yield of ABC Co bonds.

Calculate the current if the bonds is selling for

RM120
 Current Yield and Bond Price
Example 5
Zayn buys a four-year bond with a coupon rate of 7%. Calculate the yield when market price of the bond is:
 RM90
 RM100
 RM115

Solution:
Current Yield = 7 × 100 = 7.78%
90
Current Yield = 7 × 100 = 7%
100
Current Yield = 7 × 100 = 6.09%
115
Conclusion
 When market price of a bond is the same as its face value, then the rate of return is the bond’s coupon rate.
 Bonds with a higher coupon payment yield higher return
 Lower coupon payment bonds yield a lower rate.
 We can conclude that a bond’s current yield depends on the coupon rate as well as the market price.
 Bond price has an inverse relationship with its return (current yield); When bond market price drops, bond has higher
yield. When bond market price increases, bond yield will decrease.
 Yield to Maturity
• The yield -to-maturity (YTM) of a bond can be referred to as its total return.

• This includes the current yield earned on its coupon payment plus the potential capital gain/loss
from investment in bonds.
• Yield to maturity is the discount rate that makes the present value of the bond’s payment (interest
and capital gain) equal to its current price ( NPV = 0)
• Yield to maturity assumes that bond holders reinvest the bond’s periodic coupon payments at the
same rate over time
• YTM can be illustrated as the following:

A is the lower discount rate

• Using the trial-and-error method, the YTM can be interpolate using:B is the higher discount rate
C is the NPV of the lower discount rate
D is the NPV of the higher discount rate
 Yield to Maturity
Example 6

Venturi Berhad’s bonds are currently selling for RM110. The bonds carry a
coupon rate of 6% and mature in eight years. Calculate the yield to maturity of
the bonds if interest is payable on a yearly basis.
 Yearly compounding: i. Try discount rate i = 4%

Years Cash Flow AF/DF @ 4% Present Value

RM
0 -110 1 -110
1–8 6 6.733 40.4
8 100 0.731 73.1
NPV 3.5

 So, when we use i=4%, we get a positive NPV of RM3.5.

 This is not the YTM we are looking for. We need to find a discount rate that will give a NPV of zero.
This discount rate will then be the YTM.
 Since we obtained a positive NPV on our first attempt, the second rate that we attempt should be
higher than 4%.

19
 Yearly compounding: ii. Try discount rate i = 7%

Years Cash Flow AF/DF @ 7% Present Value

RM
0 -110 1 -110
1–8 6 5.971 35.83
8 100 0.582 58.2
NPV -15.97
 When we use i=7%, we get a negative NPV of –RM15.97.
 Again, this is not the YTM we are looking for. But we now know that the discount rate that will give a NPV of zero
lies between i = 4% and i = 7%. Then using the interpolation technique we can determine the YTM as follows;

YTM = 4% + [3.50/((3.50 – -15.97)](7% – 4%) = 4.54%

20
 Yield to Maturity and Bond Price
 When the market price of a bond is above its face
value, the bond holders will have to accept a yield
lower than the bond’s coupon rate.
 When the market price drops below the principal
value, the bondholders will expect a higher yield from
the bond.
 we can conclude that one of the factors that affects
bond’s yield to maturity is the current market price of
the bond.

21
 Current Yield vs Yield to Maturity
• They are equal if the bond sells at par.

• If the bond sells at discount (premium), YTM is higher (lower) than the CY
 Bond sells at discount (premium) will give capital gains (loss), thus
generate higher (lower) return.
• From previous Example 6;

Coupon = 6%, Price RM110: Current Yield = 6/110 = 5.45%

YTM = 4.54%.
• TRY Coupon = 6%, Price = 90;

CY = 6/90 = 6.67% YTM = ??? (should be higher than CY)

22
 Yield to Maturity for Zero-coupon Bonds
Example 7

Assume that ABC Co zero-coupon bonds is traded at RM50 per unit. The bonds will mature in 10 years. Find the YTM of the bonds.
Using trial and error method; i = 6% and i = 8%

Years Cash Flow AF/DF @ 6% Present Value AF/DF @ 8% Present Value

0 -50 1 -50 1 -50

1 - 10 0 0
10 100 0.558 55.8 0.463 46.3
NPV 5.8 NPV -3.7

YTM = 6% + [5.8/((5.8 – -3.7)](8% – 6%) = 7.22%

Convertible Bonds
• Convertible bonds are debt instruments that have the option that allows the bondholders to
convert their debt into stock (equity) at some point.
• Convertible bonds usually carry a lower coupon rate than non-convertible bonds.

• The convertible bond may benefit the company because of the lower interest payments while the
project was in its early stages. If the investors converted their bonds, the other shareholders
would be diluted, but the company would not have to pay any more interest or the principal of
the bond.
• From the investor's viewpoint, the convertible bond may be a great solution because they can
profit from the upside in the stock if the project is successful. They are taking more risk by
accepting a lower coupon payment, but the potential reward if the bonds are converted could
make that trade-off tolerable.
Conversion Ratio
• The conversion ratio is the number of issuing company’s shares that the convertible bond can be
converted into. For example, when a convertible bond with a face value of RM100 can be
converted into 20 shares, the conversion ratio of that bond is 20.
• The following is the formula for conversion ratio;

Example 8
A convertible bond with a face value of RM100 and a conversion price of RM5 per share will have a conversion ratio
of:
Conversion Ratio = Face Value of the bond / Conversion Price
= RM100/RM5 = 20 shares
Conversion Price
• Conversion price tells how much the share of the issuing company worth in relation to the face
value of convertible bond. It is the price per share at which the convertible bond can be
converted into shares. The conversion price can be calculated as follows:

Example 9
Using the previous example, the conversion price of RM100 convertible bonds with conversion
ratio of 20 is:
Conversion Price = 100/20 = RM5 per share
Conversion Value
• Conversion value refers to the market value of the shares that the bondholders receive upon
conversion. The conversion value is calculated as follows:

Example 10
Assume that ABC Co convertible bonds with face value of RM100 is convertible into 20 of its
shares. The current market value of the share is RM2.50. What is the conversion value of the bond?
Conversion value = RM2.50 x 20
= RM50
Minimum Value of the Bonds
• The minimum value of a convertible bond is the higher between its conversion value and its
investment value. It is because, when the bonds’ conversion value is higher than its investment
value, the bondholder will convert the bonds and sell the share at the current market price of the
share.
• The convertible bond will trade like a straight bond when the stock price low which makes the
conversion option nearly worthless. Thus, the straight bond value is thus the minimum value of
the convertible bonds. But when stock prices rise, it becomes a profitable strategy. This shows
that investors are protected from a downward move in the stock price as the value of the
convertible bond will not fall below the floor value as a straight bond.
Example 11
ABC Co has issued RM100 9% convertible bonds with RM5 conversion price, convertible anytime now. An
investor’s required rate of return is 10% and the current market price of the underlying share is RM2.50. the bonds
will mature in 5 years.
What is the minimum of the bond?
Conversion ratio = RM100/RM5 = 20 shares
Conversion Value = RM2.50 x 20 = RM50
The value of ABC convertible bonds as a straight bond = PV Coupon + PV Principal
= (9 x 3.7981) + (100 x 0.621)
= RM96.28
The minimum value of the bond is RM96.28. In this scenario, it is worthless for the bondholder to exchange their
bonds with the underlying shares.
Suppose that the share price of ABC Co’ stock is at RM5 per share. The conversion value of the bonds will be
RM100. This will make the minimum value of the bond to be RM100.
Suppose now the market interest falls to 5% and the underlying share is traded at RM5.50 per
share. The conversion value of the bonds is RM110. The value of the bonds as a straight bond is:
The value of ABC convertible bonds as a straight bond = PV Coupon + PV Principal
= (9 x 4.3295) + (100 x 0.7835)
= RM117.32
The minimum value of the bond is therefore RM117.32
 Conversion premium is the amount by which
the convertible bonds’ price exceeds its
conversion price. It generally compares the
current market value of the bonds in terms of
share, which is represented by the conversion
Conversion value, and its value in terms of straight bond
Premium value.
Example 12
For example, ABC Co issues a RM100 par value convertible bond with conversion ratio of 50 of its
shares of common stock. The underlying share is currently valued at RM20 per share while the
convertible is currently traded at RM1200. Calculate the conversion premium of the bond.
Conversion value = 50 shares X RM20 = RM1000

The conversion premium is the premium the bondholder will have over the conversion value. Since
the bond is currently selling for RM1,200, the conversion premium thus:

Conversion Premium = RM1200 – RM1000

= RM200
Forced Conversion
• Firms may issue convertibles that are freely callable. This feature gives the issuing company the right to call
the bonds or to forcibly convert them into shares. Forced conversion usually takes place when the price of the
stock is higher than the amount it would be if the bond were redeemed or at the bond's call date. The issuer
would prefer to exercise the forced conversion during the period of low share prices because the investor will
choose to exercise the conversion of their bonds into shares.
• Thus, forced conversion provides the issuer the flexibility to retire a bond while giving the investor the
following options:
o Convert the bond into common stock
o Redeem the convertible bond at the stipulated call price. Usually, the call price contains some amount of call premium.

• The investor usually will exercise their option to convert the bonds into shares if the share price exceeds the
stipulated call price. After which, the investors may choose to either hold the share or sell the share at the
current market price and gain profit.
• When the share price is lower than the call price, the investors will hold the bond.
Advantages of convertible bonds
Low
Lower transaction
coupon cost

Sweetener Higher issuing Reduce debt

to debt price ratio
 Risk Associated with Bonds

Interest rate risk Credit risk Liquidity risk Call risk

Interest Rate Risk
 The risk that an investment's value will change due to a change in the
absolute level of interest rates, in the spread between two rates, in the shape
of the yield curve or in any other interest rate relationship.

 Such changes usually affect securities inversely and can be reduced by

diversifying (investing in fixed-income securities with different durations) or
hedging (e.g. through an interest rate swap)
Credit Risk
 The possibility that a bond issuer will default, by failing to repay principal
and interest in a timely manner

Liquidity Risk
 Liquidity risk is the risk that you will not be easily able to find a buyer for a
bond you need to sell.
 A sign of liquidity, or lack of it, is the general level of trading activity: A
bond that is traded frequently in a given trading day is considerably more
liquid than one which only shows trading activity a few times a week.
Call Risk
 The cash flow risk resulting from the possibility that a callable bond will be
redeemed before maturity.

 Callable bonds can be called by the company that issued them, meaning the
bonds have to be redeemed by the bondholder, usually so that the issuer can
issue new bonds at a lower interest rate. This forces the investor to reinvest
the principal sooner than expected, usually at a lower interest rate.
Thank You

ANY QUESTION???