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Bonds and Their Valuation

Introduction
Corporations typically have two sources of financing: bonds and
stocks.
Business actually follows a cycle.
During economic recession, investors usually invest in bonds, and
during economic boom, investors usually invest in stocks.
During recession, people dont spend money. They save. Thus
economy is depressed. Companies lose money and some even go
bankrupt. Their stocks are highly unattractive. The government has
to step in, and use monetary policy to boost economy.
To boost spending, the government LOWERS the interest rate, so that
people will take their money out of the bank and spend them.
When people spend money, the economy improves. Corporations
grow, and investors will buy stocks because they are attractive.

Introduction
More money is pushed into the system, and eventually, the supply
will be more than demand, thus the value of money goes down.
Products will become more expensive and inflation rises. The
government has to step in and use monetary policy to control the
level of inflation
To fight inflation, the government RAISES the interest rate, so people
would rather put their money in the bank rather than spend it. When
savings increase and spending decrease, economy is once again
depressed.
For investors, when interest rates are raised, bond prices go down,
making them attractive.
Bonds
A bond is a long-term debt instrument
A bond is an IOU a promise to pay both interest
and principal.
Issuance of bonds is a type of financing.
Interest is usually semiannual.
Principal is paid at maturity.
May be new issues or outstanding bonds/seasoned
issues.
4 main types of bonds, and they differ with respect
to expected return and degree of risk.
Kinds of Bonds
Kinds of
Bonds
What they are Exposure to Default
Risk
Expected Return Other Risks
Treasury
Bonds
Bonds issued by the
federal government,
a.k.a. Government
bonds
None
(T-bond decline
when interest rates
rise)
Small May be
subject to
other risks
(liquidity risk,
maturity risk)
Corporate
Bonds
Bonds issued by
corporation
Present Larger than T-
bonds
May be
subject to
other risks
Municipal
Bonds
Bonds issued by
state and local
governments
Present Lower than
corporate bonds
with the same
default risk
May be
subject to
other risks
Foreign
Bonds
Bonds issued by
foreign governments
or by foreign
corporations.
Foreign Corps
Present
Foreign Government
Some
Depends May be
subject to
other risks,
including
currency risk.
Key Features of a Bond
Par Value - face value of a bond.
Coupon interest rate stated annual interest rate on a
bond.
Maturity Date the date when the par value of bonds
should be repaid.
Issue Date the date when the bonds are issued.
Call Provisions provision that the issuer has the right
to redeem bonds under specified terms before the
normal maturity date
Sinking Fund Provisions provision in a bond contract
that requires the issuer to retire a portion of the bond
issue each year.
Par Value
Face value
Assume $1,000 (multiples of 1000 also okay)
Coupon interest rate
Stated Annual Interest rate on a bond
Eg: If you hold $10,000 nominal of a bond described as
a 4.5% loan stock, you will receive $450 per year (in
two installments of $225)
Generally fixed and paid every six months
Multiply by par to get $ of interest
Coupon interest payment = Coupon Payment/Par Value
Common Bonds
Fixed Rate Bond
A bond whose interest rate is fixed for its entire life.
Floating Rate Bond
Its interest rate fluctuates with shifts in general level of interest rates.
A bond whose interest is pegged to a benchmark, such as a T-bill rate, and
adjusted periodically.
Prices of floating rate bond remain relatively stable because neither a capital
gain nor a capital loss occurs as market interest rates go up or down.
Zero Coupon Bond (Discount bond/deep discount
bond)
Pays no annual interest but is sold at a discount below par.
Compensation is not in the form of interest, but in the form of capital
appreciation.
Original Issue Discount Bond
Any bond originally offered at a price below its par value.
Sample Problem:
You have the choice of choosing between a
one-year zero-coupon bond with a face value
of $1,000, which can be purchased for
$952.38 or a one-year 4% semi-annual coupon
bond trading at its face value of $1,000.
Which bond will you choose and why?
Maturity
Years until the bond has to be repaid.
Maturity declines
Original Maturity the number of years to maturity
at the time a bond is issued.
Issue Date
Date when the bond was issued.
Call Provisions
Allows the issuer to pay back the bond before maturity it allows them to
refinance the bonds
Call Premium amount that is paid by the issuer to the bondholder for the right to
call the bonds before maturity.
Issuers will call the bond, when interest rate is declining.
Subjects the bondholder to reinvestment risk.
Most bonds have a deferred call and a declining call premium.
Deferred call bonds cannot be called until after several years after issuance.
Declining call premium the value of call premium decreases as the bond nears
maturity.
Sinking Fund Provision
A provision in a bond contract that requires the issuer to retire a portion of the
bond issue each year.
May be advantageous to the bondholder as it creates liquidity.
May de disadvantageous to the bondholder in times of declining interest rate.
Sinking funds are generally handled in 2 ways
Call x% at par per year for sinking fund purposes Lottery
(at par value - $1,000 per bond)
Buy bonds on open market

The Company will choose the lowest cost way.

If the bonds sell for more than $1,000 in the open market or
when interest rate is falling, the issuer will call the bonds.

If the bonds are selling for less than $1,000, or when interest
rate is rising, the issuer will buy the bonds in the open
market.
Other Features
Convertible Bond
Bondholders option to convert bonds for common stock of the issuing firm
(Convert during boom).
Warrant
Long-term option to buy a stated number of common stock at a specified price
(Buy when specified price is less than market price).
Putable Bond
Bondholders option to sell the bond back prior to maturity at a prearranged
price (BH put when interest rates are rising).
Income Bond
A bond that pays interest only if interest is earned. They are riskier than
regular bonds.
Indexed (Purchasing Power) Bond
Interest payments are based on an inflation index to protect the holder from
inflation.
Interest paid rises automatically when inflation rate rises.
Discount versus Premium Bonds
Discount Bonds
A bond that is issued for less than its par value.
A bond that is currently trading for less than its
par value in the secondary market.
Premium Bonds
A bond that is issued for more than its par value.
A bond that is currently trading for more than its
par value in the secondary market.
Bond Valuation
The value of any financial asset is the PV of
the cash flows it is expected to generate.
There are mainly two cash flows of a bond:
Principal and Interest
Bond Value = PV of interest + PV of principal
Pbond = INT (PVIFA) + M (PVIF)

1998 The Dryden Press
Financial Asset Values
( ) ( ) ( )
PV =
CF
1 + k
. . . +
CF
1 + k
1 n
1
2
2
1
CF
k
n
.
0 1 2 n
k
CF
1
CF
n
CF
2
Value
...
+ +
+
1998 The Dryden Press
The discount rate (k
i
) is the opportunity
cost of capital, i.e., the rate that could
be earned on alternative investments of
equal risk.
It is also called the bonds required rate
of return (yield) or the effective rate.
Ex: GM bond must yield 9% but a Lady
Luck bond must yield 18%

1998 The Dryden Press
Whats the value of a 10-year, 10% coupon bond
if k
d
= 10%? (assume annual compounding)
( ) ( ) ( )
V
k k
B
d d
=
$100 $1 ,
1
000
1
1 10 10
. . .
+
$100
1 + k
d
100 100
0 1 2 10
10%
100 + 1,000 V = ?
...
= $90.91 + . . . + $38.55 + $385.54
= $1,000.
+ +
+ +
Changes over time
Generally, the coupon rate is set to equal required
yield when bond issued. So they generally sell at par
$1,000
If coupon is set too low (sell at a discount), you arent willing
to pay $1,000 for the bond (coz the PV is lower than par)
If the coupon is set too high (sell at a premium), the demand
for the bond will be high (coz the PV is higher than par)
Over time the required yield changes (changes in
market interest rates, inflation, recession, etc)
Thus the price of the bond will change
Bond Terminology
Discount Par Premium
Price of Bond Sold for less than
face value
Sold for equal to
face value
Sold for more than
face value
Investor
Requirement
Higher return than
coupon rate
Equal to coupon
rate
Less return than
coupon rate
Find the present value of a 4 year 10%, 1,000 bonds with a
discount rate of 10%, assuming semi-annual payments.
N = 8; I = 5%; PV = ?; PMT = 50; FV = 1,000
PV of Principal: 1,000 x 0.676839362 = 676.84
PV of Interest : (1,000 x 5%) x 6.463212759 = 323.16
PV of Principal and Interest = 676.84 + 323.16 = 1,000
Par Bonds
If expected inflation remains the same after 1 year.
Find the present value of a 3 year 10%, 1,000 bonds with a
discount rate of 10%, assuming semi-annual payments.
N = 6; I = 5%; PV = ?; PMT = 50; FV = 1,000
PV of Principal: 1,000 x 0.746215397 = 746.22
PV of Interest : (1,000 x 5%) x 5.075692067 = 253.78
PV of Principal and Interest = 746.22 + 253.78 = 1,000
Interest paid Interest expense Amortization Balance
1,000.00
1 50.00 50.00 - 1,000.00
2 50.00 50.00 - 1,000.00
3 50.00 50.00 - 1,000.00
4 50.00 50.00 - 1,000.00
5 50.00 50.00 - 1,000.00
6 50.00 50.00 - 1,000.00
Discount Bonds
If expected inflation rose by 2%, causing k = 12% after 1 year.
Find the present value of a 3 year 10%, 1,000 bonds with a
discount rate of 12%, assuming semi-annual payments.
N = 6; I = 6%; PV = ?; PMT = 50; FV = 1,000
PV of Principal: 1,000 x 0.7049054 = 704.91
PV of Interest : (1,000 x 5%) x 4.917324326 = 245.87
PV of Principal and Interest = 704.91 + 245.87 = 950.78
Interest expense Interest paid Amortization Balance
(Increasing) (Same) (Increasing) 950.78
1 57.05 50.00 7.05 957.82
2 57.47 50.00 7.47 965.29
3 57.92 50.00 7.92 973.21
4 58.39 50.00 8.39 981.60
5 58.90 50.00 8.90 990.50
6 59.43 50.00 9.43 999.93
Premium Bonds
If expected inflation fell by 2%, causing k = 8% after 1 year.
Find the present value of a 3 year 10%, 1,000 bonds with a
discount rate of 8%, assuming semi-annual payments.
N = 6; I = 4%; PV = ?; PMT = 50; FV = 1,000
PV of Principal: 1,000 x 0.790314526 = 790.31
PV of Interest : (1,000 x 5%) x 5.242136857 = 262.11
PV of Principal and Interest = 790.31 + 262.11 = 1,052.42
Interest expense Interest paid Amortization Balance
(Decreasing) (Decreasing) 1,052.42
1 42.10 50.00 (7.90) 1,044.52
2 41.78 50.00 (8.22) 1,036.30
3 41.45 50.00 (8.55) 1,027.75
4 41.11 50.00 (8.89) 1,018.86
5 40.75 50.00 (9.25) 1,009.61
6 40.38 50.00 (9.62) 1,000.00
Premium and Discount Bonds
@ K of 12%: Price

= $950.78 (Less than par -
called a discount bond)
@ K of 8%: Price = $1,052.42 (More than par-
called a premium bond)
Note there is an INVERSE relationship between
yield and price
Because the coupon rate and the par value cant
be changed, the price must change
1998 The Dryden Press
M
Bond Value ($)
Years remaining to Maturity
1052.42
1,000
950.78
3 0
k
d
= 8%.
k
d
= 12%.
k
d
= 10%.
Bond Yields
Yield to Maturity (YTM) or Redemption Yield
The rate of return earned on a bond if it is held to maturity.
The discount rate which forces the PV of all the cash flows to equal the
price paid for the bond
Solving for k (or for the i)
Equal to ERR only if
The probability of default is zero
The bond cannot be called.
Yield to Call (YTC)
The rate of return earned on a bond if it is called before its maturity date.
Current Yield (CY)
The annual interest payment on a bond divided by the bonds current
price.
Yield to Maturity
Suppose your 7% $1,000 par value bond is
selling for $950 and it matures in 4 years.
What is the YTM?
a. 6%; b. 6.5%; c. 7%; d. 8%; e. 8.5%
PMT (1+YTM)^-1 + PMT (1+YTM)^-2.. + PMT (1+YTM)^-n
Par(1+YTM)^-n = PV
70 (1+YTM)^-1 + 70 (1+YTM)^-2 + 70 (1+YTM)^-3 + 70
(1+YTM)^-4 + 1,000 (1+YTM)^-4 = 950
YTM will never be A,B,C because it is sold at a discount. So
you have to do trial and error to get YTM.
Yield to Call
A 2-year, 10% semiannual coupon, $1,000 par
value bond is selling for $1,135.90 with a
2.95% YTM. It can be called after 1 year at
$1,050. Compute its YTC.
a. 2.58% b. 5.17% c. 10.15% d. 12.3% e. 14.24%
YTC: N = 4; I = ?; PV = 1135.90; PMT = 50; FV = 1050
PMT (1+YTC/2)^-1 + PMT (1+YTC/2)^-2.. + PMT (1+YTC/2)^-n
FV(1+YTC/2)^-n = PV
50 (1+YTC/2)^-1 + 50 (1+YTC/2)^-2 + 50 (1+YTC/2)^-3 + 50
(1+YTC/2)^-4 + 1050 (1+YTC/2)^-4 = 1,135.90

Current Yield or Interest Yield
If 1,000 Allied bonds with a 10% coupon were
currently selling for $985, and interest is
compounded annually, what is the current
yield?
How about if it is compounded semi-annually?
Current Yield = Annual Interest Payment/Bonds Current Price
Current Yield = Annual PMT / PV
Current Yield = 100 / 985 = 10.15%
Solving for Total Yield
Total Yield = Current Yield + Capital Gains Yield
You have a bond priced at (with a carrying value of) $95.75
and has an annual coupon of $5.10. If the bond is a 10-year
bond with nine years remaining and you were only planning
to hold it for one year and the price of your bond fell to
$87.34, what would be your net gain or loss for that period?
your actual return for the period would be - 3.45% (-
$3.31/$95.75) because although you gained $5.10 in PMT,
your capital loss was $8.41.
CY = PMT/PV = 5.1/95.75 = 5.33%
CGY = (P1 Po) / Po = (87.34 95.75) / 95.75 = - 8.78%
Total ROR or Total Yield = 5.33% + - 8.78% = - 3.45%
You can also use the Holding Period Return Formula to solve
for Total Yield.
1998 The Dryden Press
You could buy, for $1,000, either a 10%, 10-year, annual
payment bond or an equally risky 10%, 10-year
semiannual bond. Which would you prefer?
The semiannual bonds EFF% is:
10.25% > 10% EFF% on annual bond, so buy
semiannual bond.
EFF
i
m
Nom
m
%
.
. = +
|
\

|
.
| = +
|
\

|
.
| = 1 1 1
0 10
2
1 10 25%
2
.
Risks Associated with a Bond
Interest Rate Risk
The risk that interest rate will increase, thus the bonds value will
decrease.
For bonds that are similar with regards to all respects, except that one
has a longer maturity, the bond with the longer maturity is typically
exposed to more risk from a rise in interest rates.
14 year 1000 par bonds that yielded 10% vs. a 15 year 1000 par bonds
that yielded 10%. If interest rise to 15%, you are stuck with 100
interest for only 14 years, and u can reinvest 1000 par bonds in 15%
for a year and get 150 on the 15
th
year
But if you have 15 years, then you are stuck with 100 interest for 15
years.
Risks Associated with a Bond
Reinvestment Rate Risk
The risk that interest rate will decrease and the issuer will call the
bonds, therefore, you are forced to reinvest at a lower rate.
Riskier for callable bonds, or normal bonds with shorter maturity.
CONCLUSION
Long-term bonds = high interest rate risk, low reinvestment risk
Short-term bonds = low interest rate risk, high reinvestment risk


Default Risk
A big factor in corporate bonds
The higher the probability of default, the lower the price of the bond, the
higher the required yield.
Default risk will depend on the type of the bond issued.
Mortgage Bonds
Have a specific asset pledged as collateral.
Lower required yields.
Debentures
Unsecured bonds
No lien or claim against specific property
Higher required yields.
Subordinated debentures has claims on assets only after senior debt has
been paid off in times of bankruptcy.

Stronger companies can easily issue debentures. They dont need to pledge
specific property because they already established their reputation and
have gained the confidence of investors; but definitely not small
companies.



1998 The Dryden Press
Bond Ratings Provide One Measure
of Default Risk
Investment Grade Junk Bonds
Moodys
Aaa Aa A Baa Ba B Caa C
S&P
AAA AA A BBB BB B CCC D


Is measured by bond ratings, such as Moodys, S&P, and Fitch Investors Service
Bonds can be rated as Investment Grade or Junk.



What factors affect default risk and
bond ratings?
Financial performance
Debt ratio
TIE, FCC ratios
Current ratios
Provisions in the bond contract
Secured vs. unsecured debt
Senior vs. subordinated debt
Sinking fund provisions
Debt maturity
Other factors
Earnings stability
Regulatory environment
Potential product liability
Accounting policies


Bond Ratings
Changes in ratings will have large impact on
bond prices.
Higher ratings = higher prices = lower yields.
Cheaper to raise capital
Downgrades have the opposite effect
Junk bonds= low ratings
Exercises:
A bond matures in 12 years and pays an 8
percent annual coupon. The bond has a face
value of $1,000 and currently sells for $985.
What is the bonds current yield and yield to
maturity?
Exercises:
The current price of a 10-year, $1,000 par
value bond is $1,158.91. Interest on this bond
is paid every six months, and the nominal
annual yield is 14 percent. Given these facts,
what is the annual coupon rate on this bond?
Exercises:
Matteo Toys has bonds outstanding that have
a 9 percent annual coupon and a face value of
$1,000. The bonds will mature in 10 years,
although they can be called before maturity at
a call price of $1,050. The bonds have a yield
to call of 6.5 percent and a yield to maturity of
7.4 percent. How long until these bonds may
first be called?
Exercises:
Recently, Ohio Hospitals Inc. filed for bankruptcy. The firm
was reorganized as American Hospitals Inc., and the court
permitted a new indenture on an outstanding bond issue to
be put into effect. The issue has 10 years to maturity and a
coupon rate of 10 percent, paid annually. The new
agreement allows the firm to pay no interest for 5 years.
Then, interest payments will be resumed for the next 5
years. Finally, at maturity (Year 10), the principal plus the
interest that was not paid during the first 5 years will be
paid. However, no interest will be paid on the deferred
interest. If the required annual return is 20 percent, what
should the bonds sell for in the market today?

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