3-1

Bond Valuation

Application of present value

techniques to bonds and stocks
Pricing and Valuation are the
core issues in finance

3-2

Some standard forms of Bonds

C=coupon, F=face value, T=maturity date
Pure Discount or Zero-coupon bonds
PV=FV/(1+r)T

Level-coupon bonds
PV=C/1+r + C/(1+r)2 + + C/(1+r)T + F/(1+r)T

Consols
PV=C/r

Floaters
Convertibles

3-3

Bond Features
Coupon Payments: Regular interest
payments
Semi annual for most US corporate bonds
Types of Coupon payments
Fixed Rate: 8% per year
Floating Rate: 6-month Treasury bill rate +
100 basis points.

3-4

Bond Features
Face or Par Value: amount of money to be
repaid at end of loan
$1,000/bond

Maturity: number of years from issue date until

principal is paid

Coupon Rate: annual coupon / face value

Features of a May Department Stores Bond

Terms
Explanations
Amount of issue $200 million

3-5

The company will issue $200 million worth of bonds.

Date of issue

8/4/94

The bonds were sold on 8/4/94.

Maturity 8/1/24

The principal will be paid in 30 years.

Face Value

$1,000

Annual coupon
(8.375% of

8.375
Each bondholder will receive
the face value).

$83.75 per bond per year

Offer price
bond.

100

The offer price will be 100% of the

$1,000 face value per

Coupon dates

2/1, 8/1

$41.875 will be paid on these dates

Denomination of the bond is in $1,000

Security None
Sinking Fund
Annual from 8/1/05 Annual payments to this fund
the indicated date
Call Provision

not callable before 8/1/04

Call Price
104.188 initially
to $1,000 on 8/1/1
Rating Moodys A2
a low probability
of default.

starting from

Deferred call feature

Buy back price is $1041.88, declining declining to 100

This is one of Moodys higher ratings.

The bonds have

3-6

Bond Valuation
(Assuming Level Coupon Payments)
Discounted Cash Flow Valuation
Bond Value = PV (Promised Cash Flows)
Bond Value = PV (Coupon Payments)
+ PV (Face Value)
Bond Value = PV (Annuity) + PV (Lump sum)

Yield-to-Maturity (YTM)
Required market interest rate that
makes the discounted cash flows of
the bond equal to its price
Interest rate that we will use in the
bond valuation equation
Does not always equal the bonds
coupon rate

3-7

3-8

IPC issues 5-year $1,000 face value bonds with an annual

coupon of 100. What is the coupon rate and what is the price
of the bonds if the YTM on similar bonds is 10%?

Time

Coupons PV=price
Face
Value

100

100

100

100

100
1000

3-9

General Expression for the

Value of a Bond

C
1
Face Value

Bond Value =
1
t +
t
YTM
(1+ YTM)
(1+ YTM)
Annuity Formula

3-10

Example 2: Pricing of a regular bond

IPS issues a 10-year bond
YTM = 24%
Coupon Rate = 8%
Face value = $1,000

What is the price of the bond at the issue

date?
What is your minimum selling price if you
sell this bond one year before its maturity?

3-11

Notes on the Bond Pricing Formula

Semi annual coupons: 10-year bond with

12% coupon rate paid semi annually
Halve the coupon rate and quoted YTM
Double the number of periods
YTM=APR!

Risk-free market interest rate versus YTM

YTM takes into consideration the risk of the
cash flows

Finding YTM: trial and error, EXCEL,

financial calculator.

3-12

Semi-annual coupons:
What is the price of a $1000 bond maturing in ten
years with a 12% coupon that is paid semiannually
if the YTM is 10%

3-13

Discount bond example:

Suppose a year has gone by and the IPC 10% annual
coupon bond has 4 years to maturity. What is the
price (present value) of the bonds if the YTM on
similar bonds is 11%?

3-14

Premium Bond Example:

Suppose in the second year the yield-to-maturity for
similar bonds decreases to 9% instead of increasing
to 11%. What is the price of the 4-year IPC $1000 par
value 10% annual coupon bond?

Par, Discount and Premium Bonds

The relation of YTM and the coupon rate

Par Bonds:
Price = Face Value
YTM = Coupon Rate

Discount Bonds:
Price < Face Value
YTM > Coupon Rate

Premium Bonds:
Price > Face Value
YTM < Coupon Rate

3-15

3-16

Interest Rate Risk of Bonds

Risk that the bond you own will
change in value because interest
rates (e.g. YTM) have changed
Review:
As interest rates rise, PV decreases all
else equal
As interest rates fall, PV increases all else
equal

Interest rate sensitivity depends on

time to maturity and coupon rate

3-17

Determinants of the Interest Rate Risk of

Bonds: Part I

Time to Maturity:
The longer the time to maturity, the greater the
interest rate risk, all else equal
Higher t in formula => greater compounding
effect => small changes in r, big changes in price

10% 2-year and 15-year bonds

15 year bonds price will change more with a
change in the YTM.

Interest Rate Changes and Bond Values:

Both bonds are par bonds originally
Suppose YTM decreases to 8%:
Price 2 =

100
1
1,000
1
+
1,035.67

2
2
0.08 (1.08) (1.08)

Price15 =

100
1
1,000
1
+
1,171.19

15
15
0.08
(1.08)
(1.08)

Suppose YTM increases to 12%:

100
1
1,000
Price 2 =
1+
966.20

2
2
0.12
(1.12)
(1.12)

Price

15

100
1
1,000
1
+
863.78

0.12
(1.12)
(1.12)
15

15

3-18

3-19
Interest Rate Risk and Time to Maturity (Figure 7.2)
Bond values ($)

2000

$1,768.62
30-year bond
Time to maturity

1500

Interest rate 1 year

5%

1-year bond

$1,047.62
1000

$916.67

$1,047.62

$1,768.62

10

1,000.00

1,000.00

15

956.52

671.70

20

916.67

502.11

$502.11

500

10

15

20

30 years

Interest rates (%)

Value of a Bond with a 10% Coupon Rate for Different Interest Rates and
Maturities

3-20

Determinants of the Interest Rate

Risk of Bonds: Part II
Coupon Rate:
The lower the coupon rate, the greater the
interest rate risk, all else equal
Low coupon => more of the bonds value
comes from the face amount

0% (pure discount) and 10% 8-year bonds

100% of the 0% coupon bonds price comes
from face amount
10% bonds price depends on eight $100
annual coupons plus face value

3-21

Which Bond has a higher interest rate risk?

A: 30-year, 10% coupon or B: 15-year, 10% coupon?
A: 30-year, 10% coupon with face value of $1,000 or B: 25-year, 10%
coupon, with face value of $10,000?
A: 30-year, 11% coupon or B: 30-year, 9% coupon?
A: 30-year, zero-coupon with face value of $1,000 or B: 30-year, 10%
coupon, with face value of $10,000?
A: 30-year, 10% coupon or B: 25-year, 15% coupon?
A: 30-year, 10% coupon or B: 20-year, 8% coupon?

3-22

The Interest Rate Risk of Bonds

Duration
A measure of the interest rate risk of a bond
average maturity of a bonds cash flows

PV(CF) t t
Duration =
t =1 Price of Bond
N

The higher the duration measure, the greater

the interest rate risk

Bond pricing Theorems

3-23

The following statements about bond pricing are always true.

Bond prices and market interest rates move in opposite
directions.
When a bonds coupon rate is (greater than / equal to / less
than) the markets required return (YTM), the bonds market
value will be (greater than / equal to / less than) its par
value.
Given two bonds identical except for maturity, the price of
the longer-term bond will change more than that of the
shorter-term bond, for a given change in market interest
rates.
Given two bonds identical but for coupon, the price of the
lower-coupon bond will change more than that of
the
higher-coupon bond, for a given change in market interest
rates.

3-24

Implicit Interest on a Zero-coupon

Suppose EIN company issues a
$1,000, 5-year zero-coupon bond.
Calculate the price if the YTM-15%
What is the total amount of implicit
interest on this bond?
What is the yearly implicit interest
using amortization (required by law)?

3-25

Solution
PV = 1,000 / 1.155 = $497
Total Implicit Interest = $1,000 - $497 = $502
Using straight-line interest expense, we have $502/5 =
$102.60 per year.
Using amortization, we have for the first year:
Beginning value = $497
Ending value = $1,000 / 1.154 = $572
Implicit interest in year 1 = $572 - $497 = $75
Implicit interest in year 2 = ($1,000 / 1.15 3) - $572 = $86
et cetera

What would be preferred by the corporation?

3-26

Inflation and Returns

Key issues:
What is the difference between a real and a
nominal return?
How can we convert from one to the other?
Example: Suppose we have $1,000, and Diet Coke costs
$2.00 per six pack. We could buy 500 six packs. Now
suppose the rate of inflation is 5%, so that the price rises to
$2.10 in one year. When we invest the $1,000 it grows to
$1,100 in one year.
Whats the return in dollars?
Whats the return in six packs?

3-27

Reading the Wall Street Journal

Majority of bonds is traded OTC
Bonds are quoted as a % of the face value
Bonds are quoted as ATT 7s05
AT&T issue, maturing in 2005, 7% coupon

Close = last available price on close previous

business day (% of F)
Net Change
Current Yield = coupon / closing quote
Volume

3-28

Treasury Bonds
Always semi-annually
Quoted in 32nds (smallest tick size)
Bid price = 132:20 means 132 + 20/32
percent of the face value = $1,329.375
Change: -46 means the price (bid or
ask) fell by 46/32%, or 1.4375%.
YTM is based on ask price
Bid-ask spread
n indicates notes, rather than bonds

3-29

Inflation and Returns

A.

Dollars. Our return is

($1100 - $1000)/$1000 = $100/$1000 = ________.
The percentage increase in the amount of
green stuff is 10%; our dollar return is 10%.

B.

Six packs. We can buy $1100/$2.10 = ________

six packs, so our return is
(523.81 - 500)/500 = 23.81/500 = 4.76%
The percentage increase in the amount of
brown stuff is 4.76%; our six-pack return is
4.76%.

3-30

Inflation and Returns, concluded

The relationship between real and nominal returns is described
by the Fisher Effect. Let:
R
=
the nominal return
r
=
the real return
h
=
the inflation rate
According to the Fisher Effect:
1 + R = (1 + r) x (1 + h)
From the example, the real return is 4.76%; the nominal return
is 10%, and the inflation rate is 5%:
(1 + R) = 1.10
(1 + r) x (1 + h) = 1.0476 x 1.05 = 1.10