FIN3009 Financial Management

Topic 5:
Bonds and Bond Valuation

1
Key Concepts and Skills
Know the basic types of bonds, their
features and how their value is
determined
Understand the relationship between
bond prices and interest rates
Understand bond ratings and what
they mean
Understand the impact of inflation on
interest rates

2
Chapter Outline
Financial assets valuation
Basic features of a bond
Basic types of bonds and their
valuation
Some other types of bonds
Assessing bond risks
Inflation and Interest Rates

3
Financial Asset Valuation
The intrinsic (or fundamental) value
of a financial asset is the discounted
present value of its expected future
cash flow stream.
0 1 2 ... n
rd
...
Value CF1 CF2 CFn

4
Financial Asset Valuation
The value can be computed using
the following familiar expression:
CF1 CF2 CFn
V
(1 rd ) (1 rd )
1 2
(1 rd ) n

where rd is the discount rate.

We will show later that rd is also called the

Internal Rate of Return (IRR).

5
Discount rate (rd)

How do we know what interest rate

to use to discount the cash flows?
It should be the assets required rate
of return the rate that could be
earned on alternative investments of
equal risk which is determined in
the financial market.
Lets just take rd as given for now.

6
What is a Bond?
A bond is a debt instrument issued
with the purpose of raising capital
through borrowing.
It is an agreement under which the
issuer (i.e., the borrower) promises
to make regular interest (coupon)
payments over the life of the bond, and
repay the principal upon maturity to the
holder (i.e., the lender).

7
Specimen of a Corporate Bond

8
Basic Features of a Bond
Most bonds have the following
features
a par or face value
a promised rate of interest and

a maturity date on which the issuer will

repay the principal.
Some bonds pay no interest but are sold at
a deep discount; some have no maturity
dates but pay interest forever.

9
Corporate Bonds & US Treasuries
Corporate Bonds
Par: usually $1,000; Maturity: varies
U.S. Treasuries
Treasury Bills (T-bills):
Par: $1,000 min.; Maturities: 1, 3, or 6
months.
Treasury Notes (T-notes):
Par: $1,000 1 mil.; Maturities: 2, 5, or 10
years
Treasury Bonds (T-bonds):
Par: $1,000 5 mil.; Maturities: 10 30
years

10
Bonds vs. Stocks
Bonds are fixed income securities
because they pay pre-specified cash
flows at specific dates.
Stocks (equity), on the other hand,
are variable income securities
because dividend payments are not
guaranteed and may vary.

Note: The so-called mini-bonds are actually

derivatives and not bonds.

11
Basic Types of Bonds
Coupon Bonds
Make regular interest payments and
repay the face value at maturity.
Zero Coupon Bonds (or zeros)
Make no interest payments and repay
the face value at maturity.
Perpetual Bonds (or Consols)
Have no maturity dates but make
interest payments forever.

12
 Coupon Bonds
A coupon bond specifies
a par (or face) value
a coupon (promised interest) rate
a maturity date
The issuer promises to make periodic
interest (or coupon) payments and
redeem the bond at face value upon
maturity.

13
Cash flow of a coupon bond
Consider a 3-year bond with $1,000*
par and 5% annual coupon.
0 1 2 3

50 50 50+1,000
This bond has 3 years until maturity and
pays 5% interest annually.
* We will assume in all our examples that the
face value is $1,000.

14
coupons
Valuation of a Coupon Bond
Suppose the discount rate is 4%
0 1 2 3
4%

50 50 50+1,000
The value of this bond is
50 50 50 1,000
V
1 0.04 (1 0.04) 2 (1 0.04) 3 (1 0.04) 3
48.077 46.228 44.449 888.996
1,027.75

16
Valuation of a Coupon Bond
Notice that the stream of coupon
payments is an annuity,

50 50 50 1,000
V
1 0.04 (1 0.04) 2 (1 0.04) 3 (1 0.04) 3
so
1,000
V $50 1 1
3
0.04 0.04(1 0.04) (1 0 .04 ) 3

138.754 888.996
1,027.75

17
Bond with Semi-annual Coupon
If this bond pays semi-annual coupon
(i.e. pays interest every six months)
0 1 2
0
3 1 2 3 4 5 6
2%

25 25 25 25 25 25+1,000
1 1 1,000
V $25
0 .02 0 .02(1 0 .02) 6
(1 0.02 ) 6

140.036 887.971
1,028.007

18
Some notations

Let
M = par (or maturity) value of the bond
rc = coupon rate (a nominal rate)
n = # of years until the bond matures
$
C = annual coupon (interest) payment*
= rc x M
rd = discount rate

* Coupon payments can be made annually,

semi-annually, or quarterly.
19
General formulation
Assume annual coupon
0 1 2 n
rd
...
Value C C C+M
$ $ $ $
VB C C C M
(1 rd )1 (1 rd ) 2 (1 rd ) n (1 rd ) n
1 1 $
M .
C
$

n

r
d rd (1 rd ) (1 rd ) n

20
 Coupon Rate and Discount Rate

Notice that coupon bond valuation

involves two interest rates:
the coupon rate rc
the discount rate rd rc determines the
coupon payments C
0 1 2 n
rd
...
Value C C C+M
rd determines the value of the bond,
i.e. the PV of its cash flows
21
Coupon Rate rc

Coupon rate (rc) is the promised

interest rate on a bond, which is fixed
when the bond is issued.
rc is expressed as a percentage of the
face value and NOT the price of the
bond.
Coupon payment = rc x face value
If rc = 5% and par is $1,000, then
the annual coupon payment is $50
22
Discount Rate rd

The discount rate rd is the required

rate of return of the bond the rate
necessary to attract investors to hold
that bond.
rd is determined by the expected
return on other investments of equal
risk available on the market.
When a bond is issued, rc will be set
very close to rd. Why?
23
Relationship between P and rd

Bond price and interest rate are

inversely related:
If rd P and if rd P
Why? The higher the rd, the more

heavily the cash flow stream will be

discounted PV decreases.
$ $ $ $
P C C C M
(1 rd )1 (1 rd ) 2 (1 rd ) n (1 rd ) n

24
Bond Value Example
Consider a 10-year bond with 12%
annual coupon.
The cash flow of this bond is:
0 1 2 3 ... 10

? 120 120 120 ... 120
+ 1,000

25
Bond Value Example
The value of this bond is given by
$
P 120 120 120 1,000
$ $ $

(1 rd )1 (1 rd ) 2 (1 rd )10 (1 rd )10
$
1,000
120( 1
$ 1 )
rd rd (1 rd )10 (1 rd )10
Though rc (hence C) is fixed, rd will
vary due to market conditions.
So P is determined by rd.

26
Bond Value if rd = rc

If rd = rc, then P = par

10 1,000
P 120
t 1 (1 0 .12) t
(1 0 . 12)10

1 1 1,000
120( )
0.12 0.12(1.12) 10
1.1210
1,000 ( par)

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Bond Value if rd > rc

If rc < rd (=14%), then P < par

10 1,000
P 120
t 1 (1 0. 14) t
(1 0 . 14)10

1 1 1,000
120( )
0.14 0.14(1.14) 10
1.1410
859.68 ( par)

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Bond Value if rd < rc

If rc > rd (=10%), then P > par

10 1,000
P 120
t 1 (1 0 .10 ) t
(1 0 . 10)10

1 1 1,000
120( )
0.10 0.10(1.10) 10
1.1010
1,122.89 ( par)

29
Relationship between rc and rd

If rd > rc, then P < par

the bond will be sold at a discount or
below par.
If rd = rc, then P = par
the bond will be sold at its face value or
at par.
If rd < rc, then P > par
the bond will be sold at a premium or
above par.

30
 Measuring Bond Yield
The coupon rate is the interest rate
the issuer promises to pay, but the
actual rate of return or yield depends
on the price of the bond.
We are interested in 2 measures of
yield
Yield to Maturity (YTM)
Current Yield

31
Yield To Maturity (YTM)
The YTM of a bond is simply the rate
of return an investor will receive if
she pays some price P for the bond
and hold it until maturity, i.e. after
collecting all coupon payments and
the par.
The discount rate of a bond (rd) is the
YTM of that bond.

32
Finding YTM

$ $ $ $
P C C C M
(1 rd ) (1 rd )
1 2
(1 rd ) n
(1 rd ) n

1 1 $
M .
C
$

n

r
d rd (1 rd ) (1 rd ) n

Since C, M and n are all specified in a

bond, the YTM (rd) depends on what
price you paid for the bond.

33
Finding YTM
Yield to maturity is the rate implied
by the current bond price
Finding the YTM requires using a
financial calculator or a spreadsheet
(or trial-and-error)
If you have a financial calculator,
enter N, PV, PMT and FV.
Remember the sign convention: positive for
PMT and FV, negative for PV

34
Relationship Between Price and
YTM of a 10-yr, 8% coupon bond

35
Bonds and Bond Valuation
Exercise 1 (annual coupon)
Consider a 10% coupon bond that
pays annual coupon, with 15 years to
maturity and a par value of $1,000.
The current price is $928.09.
Is the YTM of this bond higher or lower
than 10%?
Show that the YTM = 11%

36
Bonds and Bond Valuation
Exercise 2 (semiannual coupon)
Consider a 10% coupon bond that
pays semi-annual coupons, with 20
years to maturity and is selling for
$1,197.93.
What is the semiannual coupon
payment?
How many periods are there?
Is the YTM more or less than 10%?
Show that YTM = 4%x2 = 8%

37
Current Yield (CY)
CY is an approximation of the YTM on
coupon bonds. It is defined as (C/P):
annual coupon
Current Yield
current bond price
Since CY does not take into account
potential capital gains or losses, it is
not an accurate measure of the
bonds expected total return.

38
Finding Bond Value and YTM

39
Bonds and Bond Valuation
 Zero Coupon Bonds
Zero coupon bonds (zeros) are the
simplest type of bond.
It has no coupon (interest) payments.
It is sold at a discount (below par) and
redeemed at face value upon maturity.
They are usually short-term bonds
e.g. U.S. Saving Bonds, T-bills.
A zero coupon bond has no explicit
(or stated) interest rate but there is
an implicit rate.

40
Cash flow of a zero coupon bond
The cash flow of a zero coupon bond
with a face value of $1,000 and three
years until maturity:
0 1 2 3

Price $1,000

41
Zero Coupon Bonds
Suppose you paid $792 for a $1,000 face
value discount bond with 4 years left to
maturity.
0 1 2 3 4
rd=?

-$792 $1,000
What is the rate of return on this bond?
Think of it this way: you loan someone
$792 today and get back $1,000 four years
later. What interest rate is being paid on
this loan?

42
Zero Coupon Bonds
Let M be the face value of the bond
and P be the purchase price.
We can find the implicit rate of interest
paid on the bond by solving for rd in
P M 4
(1 rd ) 1.2626 (1 rd )4

792
1,000 rd 6%
(1 rd ) 4
rd is the yield to maturity of this bond
its rate of return if held until maturity.

43
Zero Coupon Bonds
If interest rate stays the same, how much
will this bond sell for a year later (t = 1)?
0 6% 1 6% 2 3 4

$792 ? $1,000
The price of a zero at time t is the PV of
the par value at t.

P 1,000
(1 0.06) 3 discount the par value
for 3 periods at 6%
839.62
44
Zero Coupon Bonds
0 6% 1 8% 2 3 4

$792 ? $1,000
If interest rate rises to 8% a year later,
how much will this bond sell for at t = 1?
We discount the face value at the current
discount rate of 8% for 3 periods

P 1,000
discount the par value
(1 0.08)3
for 3 periods at 8%
793.83

45
What does it mean?
0 6% 1 8% 2 3 4

$792 793.83 $1,000

If interest rate rises to 8% the price of the
bond at t = 1 will be $793.83?
If you bought this bond at $792 and sold it
a year later for $793.83, your rate of return
would be
793.83 792 .00231
792
.231%

46
 Perpetual Bonds
A perpetual bond does not have a
maturity date.
The bond will not be redeemed (i.e.
pay back the principal), but will make
interest payments forever (until
perpetuity).
The British consols, first issued in
1752, are a rare example of a
perpetual bond.

47
Cash flow of a perpetual bond
The cash flow of a perpetual bond is
0 1 2 3 ...

C C C ...
Assume interest is paid annually
How is its value determined?
Depends on the discount rate rd

48
Perpetual bond valuation
The price of a perpetual bond is given
by:
P C C 2 C 3
1 rd (1 rd ) (1 rd )

C t
t 1 (1 rd )

PC
rd The formula

49
Perpetual bond example

Suppose par = $1,000, rc = 8%

If rd = 8% = rc
PC 80 1,000 ( par)
rd 0.08
If rd = 7.5% < rc
PC 80 1,066.67 ( par)
rd 0.075
If rd = 10% > rc
PC 80 800 ( par)
rd 0.10

50
U.S. Government Bonds
Treasury Securities (Federal government)
T-bills pure discount bonds with original
maturity of one year or less
T-notes coupon debt with original maturity
between one and ten years
T-bonds coupon debt with original maturity
greater than ten years
Municipal Securities (state and local governments)
Varying degrees of default risk, rated similar to
corporate debt
Interest received is tax-exempt at the federal
level

51
Example: taxable vs. tax-exempt
A taxable bond has a yield of 8% and
a municipal bond has a yield of 6%
If you are in a 40% tax bracket, which
bond do you prefer?
The after-tax return on the corporate bond is
8%(1 - 0.4) = 4.8% which is lower than the
6% return on the municipal
At what tax rate would you be indifferent
between the two bonds?
8%(1 T) = 6% T = 25% tax bracket

52
Some Different Types of Bonds
Other Types of Bonds
Some other types of bonds
Catastrophe (CAT) bonds
Income bonds
Convertible bonds
Put bond
There are many provisions that can
be added to a bond, so it is important
to recognize how these provisions
affect required returns.

53
Floating-Rate Bonds (floaters)
The coupon rate of a floater is adjustable
and tied to an interest rate index (e.g. 90%
of the average yield on 5-yr T-notes over the
previous six months).
Coupons may have a collar the rate has a
specified ceiling and a specified floor.
The iBond of Hong Kong is a type of floater:
an inflation-linked bond ( ): the
coupon rate is adjusted according to the HK
Composite CPI w/ a lower limit of 1% return.

54
 Assessing Bond Risk
Interest Rate Risk
Effect of changes in interest rates
on bond price
Credit Risk (or Default Risk)
Issuer may fail to make payments

55
Interest Rate Risk
A change in interest rate will change
the prices of a bond, all else equal.
How sensitive is the price of a bond
to interest rate changes depends on
its time to maturity
the coupon rate
The more sensitive the price of a
bond is to a change in interest rate,
the higher its interest rate risk.

56
Interest Rate Risk
The longer the term to maturity, the
higher the interest rate risk, ceteris
paribus
More-distant cash flows are more
adversely affected by an increase in
interest rates
The lower the coupon rate, the higher
the interest rate risk, ceteris paribus
More of the bonds value is deferred to
maturity (thus, for a longer time) if the
coupons are small
57
Time to Maturity and Interest Rate

58
Bonds and Bond Valuation
Which 10% bond, a 1-year or a 30-year,
has higher interest rate risk?

The longer the maturity, the larger the

exposure to interest rate risk.
rd 1-year %D 30-year %D
5% $1,047.62 $1,768.62
+4.76% +76.8%
10% $1,000.00 1,000.00
-4.35% -32.8%
15% 956.52 671.70

20% 916.67 502.11

59
Credit Risk
Credit risk (or default risk) is the risk that
the bond issuer may fail to meet its
payment obligations.
While U.S. Treasury securities (T-Bills, T-
Notes, T-Bonds) are considered [default]
risk-free, corporate bonds are not.
The difference between the promised yield
(YTM) on a corporate bond and the yield on
a U.S. Treasury bond with the same
maturity is called the default risk premium.

60
Credit Risk
Most investors lack the resources or
knowledge to assess the default risk
of a bond directly.
Instead, they rely on the ratings
provided by such agencies as
Moodys, S&P, and Fitch to evaluate
the potential risk of bonds.

61
Bond Ratings

Speculative Grade
Investment Grade
(Junk Bonds)

Moodys Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

High Medium Low Very Low

Grade Grade Grade Grade

62
 Meaning of Bond Ratings
Standard
Moody' s & Poor's Safety

Aaa AAA The strongest rating; ability to repay interest and principal
is very strong.
Aa AA Very strong likelihood that interest and principal will be
repaid
A A Strong ability to repay, but some vulnerability to changes in
circumstances
Baa BBB Adequate capacity to repay; more vulnerability to changes
in economic circumstances
Ba BB Considerable uncertainty about ability to repay.
B B Likelihood of interest and principal payments over
sustained periods is questionable.
Caa CCC Bonds in the Caa/CCC and Ca/CC classes may already be
Ca CC in default or in danger of imminent default
C C C-rated bonds offer little prospect for interest or principal
on the debt ever to be repaid.

Safety

63
 The Bond Indenture (deed of trust)
A legal document issued to bondholders
(lenders) describing the key terms of
the bond issue
The total amount of issue
The interest rate (coupon rate)
The maturity date
Any call / convertible provisions?
Sinking fund provisions
Details of protective covenants

64
Bonds and Bond Valuation
 Bond Classifications
Registered bond vs. Bearer bond
In terms of Security
Collateral secured by financial assets
Mortgage secured by real property,
normally land or buildings
Debentures not asset-backed
Notes unsecured debt with original
maturity less than 10 years
In terms of Seniority

65
Bonds and Bond Valuation
Bond Characteristics and Required
Returns
The coupon rate is usually set close to
the yield, which depends on the risk
characteristics of the bond when issued
Which of the following bonds will have a
higher yield, all else equal?
Secured debt versus a debenture
Subordinated debenture versus senior debt
A bond with a sinking fund versus one
without
A callable bond versus a non-callable bond

66
 Differences: Debt vs. Equity
Equity
Ownership interest
Common stockholders vote
to elect the board of directors
and on other issues
Dividends are not considered
a cost of doing business and
are not tax deductible
Dividends are not a liability
of the firm until declared.
Stockholders have no legal
recourse if dividends are not
declared
An all-equity firm cannot go
bankrupt
Bonds and Bond Valuation
Debt
Not an ownership
interest
Creditors do not have
voting rights
Interest is considered a
cost of doing business
and is tax-deductible
Creditors have legal
recourse if interest or
principal payments are
missed
Excess debt can lead to
financial distress and
bankruptcy
67
Inflation and Interest Rates
Nominal rate of interest
is quoted rate of interest
interest rate before adjusting for inflation
Real rate of interest
interest rate adjusted for inflation
the growth rate of purchasing power
The ex ante nominal rate of interest
= desired real rate of return + an
adjustment for expected inflation

68
The Fisher Equation
The relationship between the real and
nominal rates, and the expected inflation
rate is given by the Fisher equation
(1 + R) = (1 + r)(1 + p),
where
R = nominal rate (quoted rate)
r = real rate
p = expected inflation rate
An approximation
R=r+p

69
An Example
If we require a real rate of 10% and we
expect inflation to be 8%, what is the
nominal rate?
Fisher equation
R = (1.1)(1.08) 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18%
Because the real return and expected
inflation are relatively high, there is a
significant difference between the actual
Fisher Effect and the approximation.

70
Quick Quiz
How do you find the value of a bond
and why do bond prices change?
What is a bond indenture and what
are some of the important features?
What are bond ratings and why are
they important?
How does inflation affect interest
rates?

71
Review Problem
What is the price of a 6%, $1,000 par
bond that pays semiannual coupon,
with 9 years to maturity and a 5%
YTM?
If the YTM of this bond rose to 7%
What would be the price of the bond?
What would be its current yield?

72