CHAPTER 7

Bonds and Their Valuation

Key features of bonds

Bond valuation
Measuring yield
Assessing risk
7-1

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.

7-2

Key Features of a Bond

Par value face value of the bond, which

is initially borrowed when the bond is
sold and then paid at maturity.
Coupon interest rate quoted/stated
interest rate (generally fixed) paid by the
issuer. Multiply by par to get dollar
payment of interest called coupon
payment.
Maturity date years until the bond must
be repaid.
7-3

Types of Bonds

Treasury Bonds: Bonds issued by the federal

government. No default risk.
Corporate Bonds: Bonds issued by
corporations. Different levels of default
risk/credit risk.
Municipal Bonds: Bonds issued by local
government.
Foreign Bonds: Bonds issued by foreign
government or foreign corporations.
Exchange rate risk.
7-4

Types of Corporate bonds

Mortgage bonds
Debentures
Subordinated debentures
Investment-grade bonds
Junk bonds

7-5

Types of Bonds

Fixed-rate bonds: A bond whose coupon rate is

fixed for its entire life.
Floating-rate bonds: A bond whose coupon rates
fluctuates with shifts in the general level of interest
rates.
Zero Coupon bond: A bond that pays no periodic
coupon.
Discount bond: Any bond whose price is lower than
the par value.
Premium Bond: A bond that sells above its par
value.
7-6

Types of Bonds

Convertible bond: A bond that is exchangeable

at the option of the holder for the issuing
firms common stock.
Putable bond: A bond that has the provision to
allow investors to sell the bond back to the
issuer prior to maturity at a prearranged price.
Callable bond: A bond with a call provision that
gives the issuer right to redeem the bonds
prior to maturity date under specified terms

7-7

Effect of a 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 call premium.
7-8

Sinking Fund Provision

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.
But not good for investors if
rates decline after issuance.
7-9

The value of financial

assets
0

r
PVCF

...
CF1

CF2

CFn

CF1
CF2
CFn
Value

...
1
2
n
(1 r) (1 r)
(1 r)
7-10

Value of a Bond

Two cash flows of a bond are

periodic coupon payments and
the principal amount (par value)
at the end.
Thus the value of a bond is
ki = k* + IP + MRP + DRP + LP
7-11

Value of a Bond

7-12

Bond Yields

Yields are the returns on bonds based on

market conditions.
Yield To Maturity is the rate of return
earned on a bond if it is held till maturity.
At the time of issue YTM is equal to
coupon rate.
Yield To Call is the rate of return earned
when bonds are held till the call period
before maturity.
7-13

Estimated Yield To
Maturity

Without a financial calculator it is not

possible to find the exact YTM of any
bond.
However YTM can be estimated using
the following formula:

7-14

Bond values over time

At maturity, the value of any bond must

equal its par value.
If rd remains constant:
The value of a premium bond would
decrease over time until it reaches
par value.
The value of a discount bond would
increase over time, until it reaches
par value.
A value of a par bond stays constant.
7-15

The price path of a bond

What would happen to the value of three

different bonds whose par was $1000
issued at different time periods with
different coupons of 10%, 13%, and 7%
held until maturity? All three bonds have
15 years of maturity left and current
market interest rate is 10%.

7-16

Bonds with Semiannual

Coupons

Divide annual coupon payment by

2 (INT/2).
Multiply years to maturity by 2 (N
X 2).
Divide nominal (quoted) interest
rate by 2 (rd/2)

7-17

Bonds Riskiness

Bonds are exposed to both Interest Rate risk

and Reinvestment Risk.
Interest Rate risk: The risk of a decline in a
bonds price due to an increase in interest rate.
Reinvestment Risk: The risk of short-termed
bonds due to a decline in interest rates.
Which risk is more relevant to an investor
depends on his/her investment horizon

Investment horizon is the period of time an investor

plans to hold a particular investment.

7-18

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 issuers financial
strength and the terms of the bond
contract.
7-19

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.
7-20

Factors affecting default risk and

bond ratings

Financial performance

Debt ratio
TIE ratio
Current ratio

Bond contract provisions

Secured vs. Unsecured debt

Senior vs. subordinated debt
Guarantee and sinking fund provisions
Debt maturity
7-21

Other factors affecting default

risk

Earnings stability
Regulatory environment
Potential antitrust or product
liabilities
Pension liabilities
Potential labor problems
Accounting policies
7-22

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.
7-23