Topic 2 - Bond

Topic 2 :
VALUATION AND
CHARACTERISTICS OF BONDS
Dr. Rasidah Mohd Rashid

Contents :
1. Definition of Bonds
2. Terminology & Characteristics of Bonds
3. Definition and determinants of value
4. Bond Valuation
5. Yield to Maturity (YTM)
6. Important factors in bond relationship

Definition of Bonds
A type of debt (long-term promissory
note) issued by the borrower, promising
to pay fixed coupon (interest) payments
at fixed intervals (6 months, 1 year
etc ) and pay the par value at maturity.
$I $I $I $I $I $I+$M
0
1 2 ... n
Terminology & Characteristic of Bonds..
1. Par Value (M) : the bonds face value that is returned to the
bondholder at maturity, usually $1000
2. Coupon Interest Rate ( I ) : percentage of the par value of the
bond will be paid out annually
3. Maturity ( n ) : The length of time until the bond issuer returns
the par value to the bondholder and terminates the bond
Example :
Par Value : RM1000, Interest 5%(annually), Maturity 4 years
RM1000
RM50 RM50 RM50 RM50
0 1 2 3 4
4. Claims on Asset and Income : bonds have a claim on Assets

and Income that comes ahead of common stock and
preferred stock
5. Current Yield : the ratio of the annual interest payment to
the bonds market price
Current Yield : annual interest payment

market price of the bond

6. Indenture : the legal agreement (bond contract) between

the firm issuing the bonds and the bond trustee who
represents the bondholders
Lists all of the bonds features:

- coupon, par value, maturity, etc.
Lists restrictive provisions which are designed to

protect bondholders.
Describes repayment provisions.

7. Bond Ratings : the ratings involve a judgment about the

future risk potential of the bond. The poorer the bond
rating (BBB,CCC) the higher the rate of return demanded
in the capital markets. They are affected by:
- a greater reliance on equity as opposed to debt
in financing the firm
- profitable operations
- a low variability in past earnings
- large firm size
- little use of subordinated debt

Value
Book value: value of an asset as shown on a
firms balance sheet
Liquidation value: the dollar sum that could be
realized if an asset were sold individually and
not as part of a going concern.
Market value: the observed value for the asset
in the marketplace
Intrinsic or economic value: also called fair
value. In general, the intrinsic value of an asset
= the present value of the stream of expected
cash flows discounted at an appropriate
required rate of return.

Present Value of Cash Flows as
Rates Change
Bond Value = PV of coupons + PV of par
Bond Value = PV of annuity + PV of lump
sum
As interest rates increase, present values
decrease
So, as interest rates increase, bond prices
decrease and vice versa
7-9
Bond Prices: Relationship Between Coupon
and Yield
If YTM = coupon rate, then par value = bond

price
If YTM > coupon rate, then par value > bond
price
Why? The discount provides yield above coupon rate
Price below par value, called a discount bond
If YTM < coupon rate, then par value < bond
price
Why? Higher coupon rate causes value above par
Price above par value, called a premium bond
7-10
The Bond Pricing Equation
1
1 -
(1 r) t FV
Bond Value C
(1 r)
t
r

7-11
Bond Valuation
The value of the bond, Vb is
PV (future interest ( I ) and the par value (M)) of the bond.
3 essential elements in bond valuation

- the amount and timing of the cash flows ( I & M)
- the time to maturity of the bond (n)
- the investors required rate of return (kb)
Discount the bonds cash flows at the investors

required rate of return.
the coupon interest rate (an annuity;PVIFA).
the par value payment (a single sum;PVIF).

Valuing a Discount Bond with Annual
Coupons
Consider a bond with a coupon rate of 10% and
annual coupons. The par value is $1,000, and the
bond has 5 years to maturity. The yield to
maturity is 11%. What is the value of the bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = 100[1 1/(1.11)5] / .11 + 1,000 / (1.11)5
B = 369.59 + 593.45 = 963.04
Using the calculator:
N = 5; I/Y = 11; PMT = 100; FV = 1,000
CPT PV = -963.04
7-13
Valuing a Premium Bond with Annual
Coupons
Suppose you are reviewing a bond that has a 10%
annual coupon and a face value of $1000. There
are 20 years to maturity, and the yield to
maturity is 8%. What is the price of this bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = 100[1 1/(1.08)20] / .08 + 1000 / (1.08)20
B = 981.81 + 214.55 = 1196.36
Using the calculator:
N = 20; I/Y = 8; PMT = 100; FV = 1000
CPT PV = -1,196.36
7-14
Types of Bonds
Debentures
Subordinated Debentures
Mortgage Bonds
Eurobonds
Zero and Very Low Coupon Bonds
Junk Bonds (High-Yield Bonds)

Debentures
Any unsecured long-term debt
Viewed as more risky than secured
bonds and provide a higher yield than
secured bonds
Subordinated Debenture
Unsecured junior debt
The claims of subordinated debentures are

honored only after the claims of secured
debt and unsubordinated debentures have
been satisfied.
Mortgage Bond
A bond secured by a lien on real property
Typically, the value of the real property is
greater than that of the bonds issued.
Eurobonds
Securities (bonds) issued in a country different from
the one in whose currency the bond is denominated
example Bond issued in Asia by an American
company that pays interest and principal to the
lender in US dollars. Why do this?
The borrowing rates are lower
To avoid SEC regulations.
Zero and Very Low Coupon Bonds
Issued at a substantial discount from the
$1,000 face value that pay no or very low
coupon rate (interest).
Return comes from appreciation of the bond
Disadvantage:
Issuer faces large cash outflow in excess of the
cash inflow when the bond was issued
Advantages:
Cash outflows dont occur with zero coupon bonds
and are relatively low level with low coupon bonds
Strong investor demand tends to bid up prices and
yields are bid down.
Junk Bonds (High-Yield Bonds)
High risk debt with ratings of BB or below by

Moodys and Standard & Poors
High yield typically pay 3%-5% more than

AAA grade long-term bonds

Efficient Market
The values of all securities at any instant

fully reflect all available public information,
which results in the market and the intrinsic
value being the same.

Bond Example
1. Suppose our firm decides to issue 20-

year bonds with a par value of $1,000
and annual coupon payments. The
return on other corporate bonds of
similar risk is currently 12%, so we
decide to offer a 12% coupon interest
rate.
What would be a fair price for these
bonds?
Mathematical Solution:
PV = PMT (PVIFA k, n ) + M (PVIF k, n )

PV = 120 (PVIFA .12, 20 ) + 1000 (PVIF .12, 20 )
1
PV = PMT 1- (1 + k)n + M/(1 + k)n
k
1
PV = 120 1 - (1.12 )20 + 1000/ (1.12) 20
.12
= $1000

2. Suppose interest rates fall
immediately after we issue the
bonds. The required return on
bonds of similar risk drops to
10%.
What would happen to the bonds

intrinsic value?

PV = 120 (PVIFA .10, 20 )+ 1000 (PVIF 10, 20 )
1
PV = PMT 1 - (1 + k)n + M / (1 + k)n
I
1
PV = 120 1 - (1.10 )20 + 1000/ (1.10) 20
0.10
= $1,170.27
Note:
If the coupon rate > discount rate,

the bond will sell for a premium.

Premium Bond
The market value of a bond will be above

the par or face value when the investors
required rate is lower than the coupon
interest rate. The bond will sell at a
premium or above face value.

3. Suppose interest rates rise
immediately after we issue the
bonds. The required return on
bonds of similar risk rises to
14%.
What would happen to the bonds

intrinsic value?


PV = 120 (PVIFA .14, 20 )+1000 (PVIF.14, 20 )
1
PV = PMT 1- (1 + k)n +M / (1+ k)n
k
1
PV = 120 1 - (1.14 )20 +1000/(1.14)20
.14
= $867.54

Note:
If the coupon rate < discount rate, the

bond will sell for a discount.

Discount Bond
The market value of a bond will be below

the par or face when the investors required
rate is greater than the coupon interest
rate. The bond will sell at a discount or
below face value.

Suppose coupons are semi-annual
Formula for semiannually interest payment :
Vb = ($It /2 )(PVIFA kb/2, 2n) + $M (PVIF kb/2, 2n)

PV = 120/2 (PVIFA .14/2, 20x2 ) + 1000 (PVIF .14/2, 20x2 )
1
PV = PMT 1 - (1 + k)n + M / (1 + k)n
k
1
PV = 60 1 - (1.07 )40 + 1000 /(1.07) 40
.07
= $866.68

Current Yield
The ratio of the interest payment to the bonds current market

price.
Current Yield =
Annual interest payment
Current market price of the bond
Example:
A $1,000 bond with 8% coupon rate and currently selling at
$700 has a current yield of
Current yield = $80 / $700 = 11.4 %

Exercise : Bonds Valuation (Vb)
1) You own a bond that pay $100 in annual

interest, with a $1000 par value. It matures
in 15 years. Your required rate of return is
12%. Calculate the value of the bond
2) Hwa bonds have 10 years remaining to

maturity. Interest is paid annuall, the bonds
have a RM1000 par value, and the coupon
interest rate is 8%. The bonds have a yield to
maturity of 9%. What is the current market
price of these bonds?
3) Golden have five year RM 1000 par bonds pay
9% interest semiannually. Your required rate
of return is 10%. The current market price for
the bond is RM1,250.
a. What is the value of the bonds to you given
your required rate of return?
b. Should you purchase the bond at the
current market price?

4) Sime Darby issues 14 year RM1,000 bonds that
pay RM75 annually. The market price for the
bond is RM980. Your required rate of return is
9%.
a. What is the value of the bond to you?
b. What happens to the value if your required
rate of return (i) increases to 12% or (ii)
decreases to 7%?
c. Under which of the circumstances in part (b)
should you purchase the bond.
Yield To Maturity
Also known as the expected rate of
return (k) on a bond.
The discount rate that equates the PV
of future cash flow with the current
market price of the bond.
The rate of return investors earn on a
bond if they hold it to maturity.
S
n $It $M
P0 =
(1 + kb)t + (1 + kb)n
t=1
YTM Example
Suppose we paid $898.90 for

a $1,000 par 10% coupon bond
with 8 years to maturity and
semi-annual coupon
payments.
What is our yield to maturity?

Vb = 898.90 n = 16 M= 1000 PMT = 50 k = ??
Vb = PMT (PVIFA k, n ) + M (PVIF k, n ) or

1
Vb = PMT 1- (1 + k) n +M/1+ k) n
k
Solve using trial & error.
Try k = 12% / 2 = 6%
TIPS:
Since the Vb < M , so k
>C

1
Vb = PMT 1 - (1 + k) n + M / (1 + k) n
k
1
898.90 = 50 1 - (1 + .06) 16 + 1000/ (1 + .06) 16
.06
= 505.29 + 393.65 = 898.94
So k = 6% x 2 = 12 %

Other method to calculate YTM
(Approximate method)
I : Coupon Interest
M-P
YTM : I +
n M : Par Value
M+P P : Market Price
2 n : year

Example :
A bonds market price is $1100. It has a $1000

par value, will mature in 5 years and pays
interest 10% annually. What is your expected
rate of return (YTM)?
YTM: 100 + (1000 -1100) / 5

= 7.6%
(1000 + 1100) / 2

2) Use trial and error
- your calculation is between 7% -8% (7.6%)
If YTM 7%
- $100 (PVIFA 7%,5) + RM1000 (PVIF 7%,5)
- $100 (4.1002) + RM1000 (0.7130)
- $410.02 + $713.00
- $1123.02
If YTM 8%
- $ 100 (PVIFA 8%,5) + RM1000 (PVIF 8%,5)
- $100 (3.9927) + RM1000 (0.6806)
- $399.27 + $ 680.60
- $1079.87

3) Interpolation
7% $1123.02 (a)
YTM $1100 (b)
8% $1079.87 (c)
4) Calculate YTM
Small % + [ (a-b) / (a-c) x ( large % - small %) ]

:0.07 + [ (1123.02 -1100) / (1123.02- 1079.87)x (0.08-0.07)]
:0.07 + [0.5335 x 0.01]
: 7.533%

Zero Coupon Bonds
No coupon interest payments.

The bond holders return is
determined entirely by the
price discount.

Zero Coupon - Example
Suppose you pay $508 for a zero

coupon bond that has 10 years left
to maturity.
What is your yield to maturity?
-$508 $1000
0 10
Zero Example
PV = 508 FV = 1000
0 10
PV = FV (PVIF i, n )
508 = 1000 (PVIF i, 10 )
.508 = (PVIF i, 10 ) [use PVIF table]
PV = FV /(1 + i) 10
508 = 1000 /(1 + i)10
1.9685 = (1 + i)10
i= [1.9685 1/10 ] - 1
i = 7%
FIVE IMPORTANT RELATIONSHIPS
FIRST RELATIONSHIP
The value of the bond is inversely related to changes in
the investors required rate of return (current interest
rate) kb
kb decrease , the value of the bond will increase
If kb increase , the value of the bond will
decrease

SECOND RELATIONSHIP
The market value (Po) will be less than the par value
(M) if the investors required rate of return (kb) is
above the coupon rate (I), but it will be valued above
the par value if the investors required rate of return
(kb) is below the coupon rate (I),
If kb = I , then Po = M
If kb > I , then Po < M (discount bond)
If kb < I , then Po > M (premium bond)

THIRD RELATIONSHIP
As the maturity approaches, the market value of

the bond approaches its par value
FOURTH RELATIONSHIP
Long term bond have greater interest rate risk

than do short term bonds
FIFTH RELATIONSHIP
The sensitivity of a bonds value to changing -

depends on:
Length of time to maturity
The pattern of the cash flows provided by the bond
Exercise : YTM
1) You just purchased a bond which matures in 5

years. The bond has a face value of RM1,000 and
has an 8% annual coupon. The bond has a current
yield of 8.21%. What is the bonds yield to
maturity?
2) BCD's $1,000 par value bonds currently sell for

$798.50. The coupon rate is 10%, paid
semiannually. If the bonds have five years before
maturity, what is the yield to maturity or expected
rate of return?
3) If you are willing to pay $1,392.05 for a 15-year,
$1,000 par value bond that pays 10% interest
semiannually, what is your expected rate of return?
4) Lambda Co. has bonds outstanding that mature in

10 years. The bonds have $1,000 par value, pay
interest annually at a rate of 9%, and have a
current selling price of $1,125. The yield to
maturity on the bonds is:

An analyst believes a stock's intrinsic value is
greater (less) than its market price, an analyst
makes a "buy" ("sell") recommendation.

Topic 2 - Bond

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Topic 2 :

Dr. Rasidah Mohd Rashid

Dr. Rasidah Mohd Rashid

4. Claims on Asset and Income : bonds have a claim on Assets

Current Yield : annual interest payment

Dr. Rasidah Mohd Rashid

6. Indenture : the legal agreement (bond contract) between

Lists all of the bonds features:

Lists restrictive provisions which are designed to

Describes repayment provisions.

Dr. Rasidah Mohd Rashid

7. Bond Ratings : the ratings involve a judgment about the

Dr. Rasidah Mohd Rashid

Dr. Rasidah Mohd Rashid

If YTM = coupon rate, then par value = bond

3 essential elements in bond valuation

Discount the bonds cash flows at the investors

Dr. Rasidah Mohd Rashid

Dr. Rasidah Mohd Rashid

The claims of subordinated debentures are

High risk debt with ratings of BB or below by

High yield typically pay 3%-5% more than

Dr. Rasidah Mohd Rashid

The values of all securities at any instant

Dr. Rasidah Mohd Rashid

1. Suppose our firm decides to issue 20-

PV = PMT (PVIFA k, n ) + M (PVIF k, n )

Dr. Rasidah Mohd Rashid

What would happen to the bonds

Dr. Rasidah Mohd Rashid

If the coupon rate > discount rate,

Dr. Rasidah Mohd Rashid

The market value of a bond will be above

Dr. Rasidah Mohd Rashid

What would happen to the bonds

Dr. Rasidah Mohd Rashid

PV = PMT (PVIFA k, n ) + M (PVIF k, n )

Dr. Rasidah Mohd Rashid

If the coupon rate < discount rate, the

Dr. Rasidah Mohd Rashid

The market value of a bond will be below

Dr. Rasidah Mohd Rashid

Formula for semiannually interest payment :

Vb = ($It /2 )(PVIFA kb/2, 2n) + $M (PVIF kb/2, 2n)

Dr. Rasidah Mohd Rashid

Dr. Rasidah Mohd Rashid

The ratio of the interest payment to the bonds current market

Current yield = $80 / $700 = 11.4 %

Dr. Rasidah Mohd Rashid

1) You own a bond that pay $100 in annual

2) Hwa bonds have 10 years remaining to

Dr. Rasidah Mohd Rashid

Suppose we paid $898.90 for

What is our yield to maturity?

Vb = PMT (PVIFA k, n ) + M (PVIF k, n ) or

Dr. Rasidah Mohd Rashid

= 505.29 + 393.65 = 898.94

Dr. Rasidah Mohd Rashid

Dr. Rasidah Mohd Rashid

A bonds market price is $1100. It has a $1000

YTM: 100 + (1000 -1100) / 5

Dr. Rasidah Mohd Rashid