Bond Valuation

Econ 181 Corporate Finance

Wadia Haddaji Department of Economics Duke University RK-CH

Bond Valuation An Overview



Introduction to bonds and bond markets

What are they? Some examples

Zero coupon bonds

Valuation Interest rate sensitivity

Coupon bonds
Valuation Interest rate sensitivity

The term structure of interest rates

2

What is a Bond?


 

A bond is a security that obligates the issuer to make specified interest and principal payments to the holder on specified dates. Coupon rate Face value (or par) Maturity (or term) Bonds are also called fixed income securities. Bonds differ in several respects: Repayment type Issuer Maturity Security Priority in case of default
3

Repayment Schemes


Pure Discount or Zero-Coupon Bonds

Pay no coupons prior to maturity. Pay the bonds face value at maturity.

Coupon Bonds
Pay a stated coupon at periodic intervals prior to maturity. Pay the bonds face value at maturity.

Floating-Rate Bonds
Pay a variable coupon, reset periodically to a reference rate. Pay the bonds face value at maturity.

Perpetual Bonds (Consols)

No maturity date. Pay a stated coupon at periodic intervals.

Annuity or Self-Amortizing Bonds

Pay a regular fixed amount each payment period. Principal repaid over time rather than at maturity.
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Types of Bonds: Issuers

Bonds Government Bonds Mortgage-Backed Securities Municipal Bonds Corporate Bonds Asset-Back Securities

Issuer US Treasury, Government Agencies Government agencies (GNMA etc) State and local government Corporations Corporations

U.S. Government Bonds



Treasury Bills
No coupons (zero coupon security) Face value paid at maturity Maturities up to one year

Treasury Notes
Coupons paid semiannually Face value paid at maturity Maturities from 2-10 years

U.S. Government Bonds (Cont.)



Treasury Bonds
Coupons paid semiannually Face value paid at maturity Maturities over 10 years The 30-year bond is called the long bond.

Treasury Strips
Zero-coupon bond Created by stripping the coupons and principal from Treasury bonds and notes.

   

No default risk. Considered to be risk free. Exempt from state and local taxes. Sold regularly through a network of primary dealers. Traded regularly in the over-the-counter market.
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Agency and Municipal Bonds



Agency bonds: mortgage-backed bonds

Bonds issued by U.S. Government agencies that are backed by a pool of home mortgages. Self-amortizing bonds. (mostly monthly payments) Maturities up to 30 years. Prepayment risk.

Municipal bonds
Maturities from one month to 40 years. Usually exempt from federal, state, and local taxes. Generally two types: Revenue bonds General Obligation bonds Riskier than U.S. Government bonds.
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Corporate Bonds


Bonds issued by corporations

Bonds vs. Debentures Fixed-rate versus floating-rate bonds. Investment-grade vs. Below investment-grade bonds. Additional features:
call provisions convertible bonds puttable bonds

Seniority of Corporate Bonds

In case of default, different classes of bonds have different claim priority on the assets of a corporation. Secured Bonds (Asset-Backed)
Secured by real property. Ownership of the property reverts to the bondholders upon default.

Debentures
Same priority as general creditors. Have priority over stockholders, but subordinate to secured debt.

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Bond Ratings
Moodys Aaa Aa A Baa Ba B Caa Ca C D S&P AAA AA A BBB BB B CCC CC C Quality of Issue Highest quality. Very small risk of default. High quality. Small risk of default. High-Medium quality. Strong attributes, but potentially vulnerable. Medium quality. Currently adequate, but potentially unreliable. Some speculative element. Long-run prospects questionable. Able to pay currently, but at risk of default in the future. Poor quality. Clear danger of default. High speculative quality. May be in default. Lowest rated. Poor prospects of repayment. In default.
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The US Bond Market

Debt Instrument Treasury securities Municipal securities Corporate and foreign bonds Consumer Credit Mortgages Corporate equities 2006 Q2 4759.6 2305.7 8705.3 2327.4 12757.7 18684.5

Amount ($bil.). Source: U.S. Federal Reserve (Table L.4, September/2006)

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Bond Valuation: Zero Coupon Bonds

B F R m i T N


= Market price of the Bond of bond = Face value = Annual percentage rate = compounding period (annual m = 1, semiannual m = 2,) = Effective periodic interest rate; i=R/m = Maturity (in years) = Number of compounding periods; N = T*m Two cash flows to purchaser of bond: -B at time 0 F at time T What is the price of a bond? Use present value formula:
B! F

1  i N
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Valuing Zero Coupon Bonds:

An Example


Value a 5 year, U.S. Treasury strip with face value of $1,000. The APR is R=7.5% with annual compounding? What about quarterly compounding?

What is the APR on a U.S. Treasury strip that pays $1,000 in exactly 7 years and is currently selling for $591.11 under annual compounding? Semi-annual compounding?

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Interest Rate Sensitivity:

Zero Coupon Bonds


Consider the following 1, 2 and 10-year zero-coupon bonds, all with

face value of F=$1,000 APR of R=10%, compounded annually. We obtain the following table for increases and decreases of the interest rate by 1%:

Interest Rate 9.0% 10.0% 11.0%



Bond 1 1-Year $917.43 $909.09 $900.90

Bond 2 2-Year $841.68 $826.45 $811.62

Bond 3 10-Year $422.41 $385.54 $352.18

Bond prices move up if interest rates drop, decrease if interest rates rise
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Bond Prices and Interest Rates

$1,200 $1,000 $800 $600 $400 $200 $0 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
 

1-Year 2-Year 10-Year



Bond prices are inversely related to IR Longer term bonds are more sensitive to IR changes than short term bonds The lower the IR, the more sensitive the price.

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Measuring Interest Rate Sensitivity

Zero Coupon Bonds


We would like to measure the interest rate sensitivity of a bond or a portfolio of bonds. How much do bond prices change if interest rates change by a small amount? Why is this important? Use Dollar value of a one basis point decrease (DV01): Basis point (bp): 1/100 of one percentage point =0.01%=0.0001 Calculate DV01: Method 1: Difference of moving one basis point down: DV01= B(R-0.01%)-B(R). Method 2: Difference of moving 1/2bp down minus 1/2pb up: DV01=B(R-0.005%) -B(R+0.005%). Method 3: Use calculus: xB DV 01 !  v 0.0001 xR
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Computing DV01: An Example



Reconsider the 1, 2 and 10- year bonds discussed before:

Interest Rate 9.990% 9.995% 10.000% 10.005% Method 1 Method 2 Method 3 Bond 1 1-Year $909.1736 $909.1322 $909.0909 $909.0496 $0.082652 $0.082645 $0.082645 Bond 2 Bond 3 2-Year 10-Year $826.5966 $385.8940 $826.5214 $385.7186 $826.4463 $385.5433 $826.3712 $385.3681 $0.150283 $0.350669 $0.150263 $0.350494 $0.150263 $0.350494

Method 3:
 1 xB $1,000 v 0.0001 ! T v 0.0001 ! T * $0.10 * xR 1.10T 1 1.10 T 1
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DV01: A Graphical Approach

10-Year $1,200.00 $1,000.00 $800.00 $600.00 $400.00 $200.00 $0.00 Interest Rate

DV01 estimates the change in the Price-Interest rate curve using a linear approximation. higher slope implies greater sensitivity
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Valuing Coupon Bonds

Example 1: Amortization Bonds


Consider Amortization Bond

T=2 m=2 C=$2,000 c = C/m = $2,000/2 = $1,000 R=10% i = R/m = 10%/2 = 5%

How can we value this security?

Brute force discounting Similar to another security we already know how to value? Replication

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Valuing Coupon Bonds

Example 1: Amortization Bonds


Compare with a portfolio of zero coupon bonds:

Buy Coupon Bond Buy 6-Month Zero Buy 1-Year Zero Buy 1.5-Year Zero Buy 2-Year Zero Portfolio

0 1 2 3 4 -$3,545.95 $1,000.00 $1,000.00 $1,000.00 $1,000.00 -$952.38 -$907.03 -$863.84 -$822.70 -$3,545.95

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A First Look at Arbitrage



Reconsider amortization bond; suppose bond trades at $3,500 (as opposed to computed price of $3,545.95)
Can we make a profit without any risk?
What is the strategy? What is the profit?

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A First Look at Arbitrage



Reconsider amortization bond; suppose bond trades at $3,500 (as opposed to computed price of $3,545.95) Can make risk less profit Buy low: buy amortization bond Sell high: Sell portfolio of zero coupon bonds
0 -$3,500.00 $952.38 $907.03 $863.84 $822.70 $3,545.95 $45.95 Time Period 1 2 3 4 $1,000.00 $1,000.00 $1,000.00 $1,000.00 -$1,000.00 $0.00 $0.00 $0.00 $0.00 -$1,000.00 $0.00 $0.00 $0.00 $0.00 -$1,000.00 $0.00 $0.00 $0.00 $0.00 -$1,000.00 -$1,000.00 -$1,000.00 -$1,000.00 -$1,000.00 $0.00 $0.00 $0.00 $0.00

Buy Coupon Bond Sell 6-Month Zero Sell 1-Year Zero Sell 1.5-Year Zero Sell 2-Year Zero Portfolio Net Cash Flow

riskless profit of $45.95 no riskless profit if price is correct

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Valuation of Coupon Bonds:

Example 2: Straight Bonds


What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of $1,000 and matures exactly 10 years from today if the interest rate is 10% compounded semiannually? 6 45 12 45 18 45 24 ... 45 120 1045 Months

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Valuing Coupon Bonds The General Formula



What is the market price of a bond that has an annual coupon C, face value F and matures exactly T years from today if the required rate of return is R, with m-periodic compounding? Coupon payment is: c = C/m Effective periodic interest rate is: i = R/m number of periods N = Tm 1 c 2 c 3 c 4 ... c N c+F

B ! ?Annuity A ?ZeroA 1 c ! 1  i   i N 1 F  N 1   i
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The Concept of a Yield to Maturity

 

So far we have valued bonds by using a given interest rate, then discounted all payments to the bond. Prices are usually given from trade prices
need to infer interest rate that has been used

Definition: The yield to maturity is that interest rate that equates the present discounted value of all future payments to bondholders to the market price: Algebraic:
c F 1 1   B! yield / m   yield / m N   yield / m N 1 1

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Yield to Maturity
A Graphical Interpretation
$2,500.00 $2,000.00 $1,500.00 $1,000.00 $500.00 $0.00 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%

Consider a U.S. Treasury bond that has a coupon rate of 10%, a face value of $1,000 and matures exactly 10 years from now. Market price of $1,500, implies a yield of 3.91% (semi-annual compounding); for B=$1,000 we obviously find R=10%.
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Interest Rate Sensitivity:

Coupon Bonds


Coupon bonds can be represented as portfolios of zerocoupon bonds

Implication for price sensitivity

Consider purchasing the US Treasury bond discussed earlier (10 year, 9% coupon, $1,000 face)
Suppose immediately thereafter interest rates fall to 8%, compounded semiannually. Suppose immediately thereafter interest rate rises to 12% compounded semiannually. Suppose the interest rate equals 9%, compounded semiannually.

What are the pricing implications of these scenarios?

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Implication of Interest Rate Changes on Coupon Bond Prices



Recall the general formula:

c 1 F  B ! 1  N i   i   i N 1 1


What is the price of the bond if the APR is 8% compounded semiannually?

Similarly: If R=12%: B=$ 827.95 If R= 9%: B=$1,000.00

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Relationship Between Coupon Bond Prices and Interest Rates



Bond prices are inversely related to interest rates (or yields).

A bond sells at par only if its interest rate equals the coupon rate

A bond sells at a premium if its coupon rate is above the interest rate.

A bond sells at a discount if its coupon rate is below the interest rate.

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DV01 and Coupon Bonds

  

Consider two bonds with 10% annual coupons with maturities of 5 years and 10 years. The APR is 8% What are the responses to a .01% (1bp) interest rate change?
Yield 7.995% 8.000% 8.005% DV01
5-Year Bond

$1,080.06 $1,079.85 $1,079.64

$ Change % Change 10-Year Bond $ Change % Change $0.21019 0.0195% $1,134.57 $0.36585 0.0323% $1,134.20 -$0.21013 -0.0195% $1,133.84 -$0.36569 -0.0322% $0.42032 $0.73154

Does the sensitivity of a coupon bond always increase with the term to maturity?

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Bond Prices and Interest Rates

$2,500.00 5-Year Bond $2,000.00
Price (P)

10-Year Bond

$1,500.00 $1,000.00 $500.00 $0.00 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
Interest Rate (R)

Longer term bonds are more sensitive to changes in interest rates than shorter term bonds, in general.
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Bond Yields and Prices



Consider the following two bonds: Both have a maturity of 5 years Both have yield of 8% First has 6% coupon, other has 10% coupon, compounded annually. Then, what are the price sensitivities of these bonds, measured by DV01 as for zero coupon bonds?
Yield 7.995% 8.000% 8.005% DV01 6%-Bond $920.33 $920.15 $919.96 $0.3782 ($0.1891) 0.0411% $0.4203 $ Change $0.1891 % change 10%-Bond $1,080.06 $1,079.85 $1,079.64 ($0.2101) 0.0389% $ Change $0.2102 % change

Why do we get different answers for two bonds with the same yield and same maturity?
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Maturity and Price Risk



Zero coupon bonds have well-defined relationship between maturity and interest rate sensitivity: Coupon bonds can have different sensitivities for the same maturity
DV01 now depends on maturity and coupon

Need concept of average maturity of coupon bond:

Duration
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Duration


Duration is a weighted average term to maturity where the weights are relative size of the contemporaneous cash flow.
PV (c ) PV (c ) PV(c ) N  T PV(F) 1 T 2 .  T Duration ! T 1 2 N N B B B B

Duration is a unitless number that quantifies the percentage change in a bonds price for a 1 percentage change in the interest rate. xB
xB 1  R B Duration !  ! xR xR B 1 R

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Duration (cont.)


The duration of a bond is less than its time to maturity (except for zero coupon bonds). The duration of the bond decreases the greater the coupon rate. This is because more weight (present value weight) is being given to the coupon payments. As market interest rate increases, the duration of the bond decreases. This is a direct result of discounting. Discounting at a higher rate means lower weight on payments in the far future. Hence, the weighting of the cash flows will be more heavily placed on the early cash flows -- decreasing the duration. Modified Duration = Duration / (1+yield)
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A Few Bond Markets Statistics

U.S. Treasuries, May 20th 2007.

Bills
3-Month 6-Month MATURITY DISCOUNT/YIELD DATE 08/16/2007 4.72 / 4.84 0.01 / .010 13:41 11/15/2007 4.78 / 4.98 0.01 / .015 13:41 DISCOUNT/YIELD CHANGE TIME

Notes/Bonds
2-Year 3-Year 5-Year 10-Year 30-Year COUPON DATE 4.500 4.500 4.500 4.500 4.750 CURRENT PRICE/YIELD PRICE/YIELD CHANGE 04/30/2009 99-1214 / 4.84 -0-02 / .03514:08 05/15/2010 99-0812 / 4.77 -0-0312 / .040 14:06 04/30/2012 98-2812 / 4.75 -0-06 / .04314:07 05/15/2017 97-15 / 4.82 -0-0912 / .038 14:07 02/15/2037 96-17+ / 4.97 -0-17 / .03514:07 MATURITY TIME

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Spot Rates

A spot rate is a rate agreed upon today, for a loan that is to be made today
r1=5% indicates that the current rate for a one-year loan is 5%. r2=6% indicates that the current rate for a two-year loan is 6%. Etc.

The term structure of interest rates is the series of spot rates r1, r2, r3,
We can build using STRIPS or coupon bond yields. Explanations of the term structure.

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The Term Structure of Interest Rates

An Example
Yield 6.00 5.75

5.00

Maturity
39

Term Structure, July 1st 2005.

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Term Structure, September 12th, 2006

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Term Structure, May 20th, 2007

42

Term Structure of Interest Rates

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44

Summary
  

Bonds can be valued by discounting their future cash flows Bond prices change inversely with yield Price response of bond to interest rates depends on term to maturity.
Works well for zero-coupon bond, but not for coupon bonds

 

Measure interest rate sensitivity using DV01 and duration. The term structure implies terms for future borrowing:
Forward rates Compare with expected future spot rates
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Amount ($bil.). Source: U.S. Federal Reserve (June/2005)

The US Bond Market

Debt Instrument U.S. Gov. Municipal

1999

2000

2001

2002

2003

2004

2005Q1

3681.0 1457.2

3385.1 1480.9

3379.5 1603.6

3637.0 1763.1

4033.1 1898.2

4395.0 2028.0

4559.7 2098.9

Domestic Corporate Bonds

2067.7

2230.3

2578.8

2711.0

2869.3

2947.4

2954.0

Consumer Credit

1553.1

1731.3

1870.7

1954.4

2047.0

2140.7

2117.1

Mortgages

6174.6

6727.9

7399.0

8218.2

9215.7

10405.2

10642.1

For comparison, the total market capitalization of NYSE firms is approximately 12.6 trillion as of April/2005.

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A Few Bond Markets Statistics

U.S. Treasuries, October 12th 2006.
Bills
MATURITY DISCOUNT/YIELD DISCOUNT/YIELD DATE CHANGE 3-Month 6-Month 01/11/2007 04/12/2007 4.86 / 4.99 4.88 / 5.07 0.01 / .010 0.00 / .000

Notes/Bonds
COUPON 2-Year 3-Year 5-Year 10-Year 30-Year 4.625 4.875 4.500 4.875 4.500 MATURITY DATE 09/30/2008 08/15/2009 09/30/2011 08/15/2016 02/15/2036 CURRENT PRICE/YIELD 99-22+ / 4.79 100-13+ / 4.72 99-05 / 4.69 101-03 / 4.73 94-07+ / 4.87 PRICE/YIELD CHANGE 0-01 0-03 0-06 / -.029 / -.025 / -.014 0-02+ / -.030 0-05 / -.020
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Valuing Coupon Bonds

Example 1: Amortization Bonds


Consider Amortization Bond T=2 m=2 C=$2,000 c = C/m = $2,000/2 = $1,000 R=10% i = R/m = 10%/2 = 5% Compare with a portfolio of zero coupon bonds:
0 -$3,545.95 -$952.38 -$907.03 -$863.84 -$822.70 -$3,545.95 Time Period 1 2 3 4 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $0.00 $0.00 $0.00 $0.00 $1,000.00 $0.00 $0.00 $0.00 $0.00 $1,000.00 $0.00 $0.00 $0.00 $0.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00
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Buy Coupon Bond Buy 6-Month Zero Buy 1-Year Zero Buy 1.5-Year Zero Buy 2-Year Zero Portfolio

Duration


The logical way to measure sensitivity of the bond price to changes in interest rates is to take the derivative of the price B with respect to effective rate i:
N xB  n 1 !  n c   i  N F (1  i )  N 1 1 xi n !1

We adjust the derivative by dividing by minus the bond price and the number of periods per year m, and multiply by one plus the effective rate. The measure obtained is often called Macaulay Duration.
Duration ! 

1  R / m xB !  1  i xB
B xR Bm xi
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Duration (cont.)


If we replace n/m with Tn -- which will be the time (in years) until the nth cash flow, the formula is:

(1  i ) xB 1 N n N Duration !  ! Tn c   i  TN F   i 1 1 m B xi B n !1


Duration is a weighted average term to maturity where the cash flows are in terms of their present value. We can rewrite the above equation in a simpler format:

1 Duration ! [T1 PV (c1 )  T2 PV (c2 )  ...  TN ( PV (c N )  PV ( F ))] B

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Zero Coupon Valuation Examples



Find the current market price of a STRIP that matures in 5 years and has a face value of $100. Assume the APR is 7.5% with annual compounding.

What if the compounding is quarterly? Continuous?

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Personal Finance Examples

Zero Coupons


One and half years from today, you want to buy a new car that requires a down payment of $5,000. How much do you have to save today assuming Bank A is offering a nominal interest rate of 3.2% with quarterly compounding?

Bank B is advertising a special rate 3.5% with semiannual compounding. Should you switch your account to bank B?

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Personal Finance Example

Coupon Bonds


You are buying a new home and you can only afford monthly payments of $2000. The current APR is 7.9%. How large of a loan can you afford if the term is 20 years? 30 years?

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YTM Examples


Example: Find the yield to maturity on a self-amortizing bond that matures in 1 year, makes semiannual payments of $1000 and is selling for $1,876. Mathematically:

1    yield / m 1 B ! av yield / m


N

F 1  yield / m N

Beyond 5 compound periods, there is no analytic solution for coupon bonds (i.e. must rely on numerical analysis)

54

Limitations of Yield to Maturity



Yield to maturity is simply the internal rate of return with a different name. As such, this measure experiences the same problems when used for comparing investments. Example (from Brealey & Myers) Consider 2 bonds, both with $1000 face value, annual coupon payments and maturing in 5 years. Bond A: 5% coupon; 8.78% yield; market price = $852.11 Bond B: 10% coupon; 8.62% yield; market price = $1,054.29 Is bond A a better buy than bond B? That is, has the market erred in pricing these two bonds at different yields?

55

Limitations of Yield to Maturity (Cont.)



The discrepancy lies with the timing of cash flows. Increasing interest rate Bond A
Period Interest Rate Cash Flow Present Value 1 0.05 $50.00 $47.62 2 0.06 $50.00 $44.50 3 0.07 $50.00 $40.81 4 0.08 $50.00 $36.75 5 0.09 $1,050.00 $682.43 Total $1,250.00 $852.11 Yield 8.78%

Bond B Cash Flow Present Value $100.00 $95.24 $100.00 $89.00 $100.00 $81.63 $100.00 $73.50 $1,100.00 $714.92 $1,500.00 $1,054.30 8.62%

Decreasing interest rate

Bond A Bond B Period Interest Rate Cash Flow Present Value Cash Flow Present Value 1 0.09 $50.00 $45.87 $100.00 $91.74 2 0.08 $50.00 $42.87 $100.00 $85.73 3 0.07 $50.00 $40.81 $100.00 $81.63 4 0.06 $50.00 $39.60 $100.00 $79.21 5 0.05 $1,050.00 $822.70 $1,100.00 $861.88 Total $1,250.00 $991.86 $1,500.00 $1,200.19 Yield 5.19% 5.33%

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Duration Hedging Example

Grinblatt & Titman


I own a $1,000, 10 year zero coupon bond with 8% yield compounded semiannually. How can I perfectly hedge this position with a short position in a 5-year zero with yield to maturity of 8% (semiannual compounding)

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Yield Curve


A sample yield curve

Yield Curve for US Treasuries Source: Bloomberg.com (October 22, 2003) 6.00% 5.00% 4.00% Yield 3.00% 2.00% 1.00% 0.00% 0 0.5 2 3 Bond Maturity 5 10 30

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Real Rates and Nominal Rates

 

Money is of value because of its ability to purchase goods. Measure price changes by inflation defined as the percent change in the Consumer Price Index (CPI). CPI New  CPIOld T! CPIOld Adjust the return for our investment by the rate of inflation. The adjusted rate is called the real rate.
1 R CPIOld 1  rr ! !   R 1 CPI New 1 T

Often see the real interest rate written as rr ! R  T

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