Bonds, Bond Valuation,

and Interest Rates

Presented by Kanon Kumar Sen

 Bonds Vs. Debentures
 The bond is the most common type of debt instrument
used by private corporations and by governments.
 Bond is generally considered to be a relatively
safe investment.
 Debentures generally have a more specific purpose
than other bonds. While both are used to raise
capital, debentures typically are issued to raise
capital to meet the expenses of an upcoming project
or to pay for a planned expansion in business.
 Bonds Vs. Debentures
 Debentures carry a either a floating or a
fixed-interest coupon rate return to
investors and will list a repayable date.
 They may pay in one lump sum or make
installment payments. The installment plan
is known as a debenture redemption reserve,
and the company will pay a set amount each
year to the investor until maturity.
Who Issues Bonds?
 Treasury bonds (T-bonds) and Treasury
bills (T-bills)
 Corporate bonds: Pran Group and Ashuganj Power Ltd
 Municipal bonds
 Foreign bonds
 Key Characteristics of Bonds
 Par Value
 Coupon Interest Rate
zero coupon bonds
 Maturity Date
 Provisions to Call or Redeem Bonds
Call provision
Call premium
Deferred Call: Bonds are often not callable
until several years
Refunding Operation: company retires when face
loss.
Key Characteristics of Bonds
Redeemable at par at the holder’s option
protect investors against a rise in interest
rates. If rates rise, the price of a fixed-
rate bond declines. However, if holders have
the option of turning their bonds in and
having them redeemed at par, then they are
protected against rising rates.
 Sinking Funds
Sinking fund provision: Sinking fund is used to
buy back a certain percentage of the issue each
year.
The company can call in for redemption (at par
value) a certain percentage of the bonds.
The company may buy the required number of bonds
on the open market.
Other Provisions and Features
 Convertible bonds
 Warrants: Options that permit the holder to buy
stock at a fixed price
 Income Bonds
 Indexed Bonds/purchasing power bonds
 A Tale of Bond market in
Bangladesh
 The global bond market has more than tripled in the
past 15 years and exceeds $100 trillion that is 40
percent larger than the total value of global stock
markets.
 Bond market and its developments are mostly
confined to words
 Government bond with 7.86 percent of GDP.
 The size of the corporate bond market is very
scanty-only 0.2 percent of GDP, whereas China and
India are having 18.63 percent and 2.89 percent
respectively.
 A Tale of Bond market in
Bangladesh
 Banks have, although all are in private
placement, issued a total of 57 subordinate bonds
amounting to Tk 19,824 crore since 2009 to insert
capital under tier II.
 Debt capital is always preferable up to a certain
limit due to inborn benefits of its lower cost
compared to costs of equity.
 Therefore, public pension funds, insurance
companies, and other contractual savings
institutions Can invest in corporate bond
markets.
 Barrier to the development of
the bond market include
 Dominance of savings certificates in public debt
collection
 A lack of initiatives to issue bond for financing
major infrastructure projects undertaken by the
government, city and municipality corporations
 Captive bond market of Bangladesh with mandatory
rules
 A lack of good reasons in fixing interest rate on
savings and investment instruments.
Time Line, Cash Flows, and Valuation
Formulas for a Bond
The following general equation, written in
several forms, can be used to find the value of
any bond
Finding the Value of MicroDrive’s
Bond
 Interest Rate Changes and Bond
Prices
 Discount bond
 Premium bond
 A bond that matures in 6 years has a par value of
$1,000, an annual coupon payment of $80, and a
market interest rate of 9%. What is its price?
 ($955.14)
 A bond that matures in 18 years has a par value of
$1,000, an annual coupon of 10%, and a market
interest rate of 7%. What is its price?
 ($1,301.77)
Time Path of the Value of a 9% Coupon,
$1,000 Par When IR Are 4%, 9%, and 14%
 Last year, a firm issued 30-year, 8% annual
coupon bonds at a par value of $1,000.
 (1) Suppose that 1 year later the going rate
drops to 6%. What is the new price of the
bonds, assuming that they now have 29 years
to maturity?
 $1,271.81
 (2) Suppose instead that 1 year after issue
the going interest rate increases to 10%
(rather than dropping to 6%). What is the
price?
 $812.61
 Bonds with Semiannual Coupons

A bond has a 25-year maturity, an 8% annual coupon

paid semiannually, and a face value of $1,000. The
going nominal annual interest rate r is 6%. What is
the bond’s price?
($1,257.30)
 Bond Yields
Yield to Maturity:
Suppose you purchased MicroDrive’s bond at a price
of $1,528.16 exactly 1 year after it was issued.
The bond you now own has a 9% annual coupon, $1,000
par value, and a maturity of 14 years. What rate of
interest would you earn on your investment if you
bought the bond and held it to maturity?
Yield to Maturity
Yield to Call
If MicroDrive’s 9% coupon bonds were callable and
if interest rates fell from 9% to 4%, then the
company could call in the 9% bonds, replace them
with 4%.
Yield to Call
Suppose MicroDrive’s bonds had a provision that
permitted the company, if it desired, to call
the bonds 10 years after the issue date at a
price of $1,100. Suppose further that 1 year
after issuance the going interest rate had
declined, causing the price of the bonds to rise
to $1,528.16.
Current Yield

If MicroDrive’s bonds (1000 par value) with a 9%

coupon were currently selling at $985, then the
bond’s current yield would be $90/$985 = 0.914 =
9.14%.
• A bond currently sells for $850. It has an 8-year
maturity, an annual coupon of $80, and a par
value of $1,000. What is its yield to maturity?
• 10.90%
• What is its current yield?
• 9.41%
• A bond (par value $1000) currently sells for
$1,250. It pays a $110 annual coupon and has a
20-year maturity, but it can be called in 5 years
at $1,110. What are its YTM and its YTC?
• 8.38%, 6.85%
• Is the bond likely to be called if interest rates
don’t change?
The Cost of Debt and Intrinsic
Value
The Risk-Free Interest Rate: Nominal
(rRF) and Real (r )
The Inflation Premium (IP)
 The Maturity Risk Premium (MRP)
All bonds, even Treasury bonds, are exposed to two
additional sources of risk: interest rate risk and
reinvestment risk. The net effect of these two
sources of risk upon a bond’s yield is called the
maturity risk premium (MRP).
Interest Rate Risk
Interest rates go up and down over time, and an
increase in interest rates leads to a decline in
the value of outstanding bonds. This risk of a
decline in bond values due to rising interest
rates is called interest rate risk.
Value of Long- and Short-Term 10%
Annual Coupon Bonds at Different
Market Interest Rates
Reinvestment Rate Risk
An increase in interest rates will hurt
bondholders because it will lead to a decline in
the value of a bond portfolio. But can a decrease
in interest rates also hurt bondholders? The
answer is “yes,” because if interest rates fall,
then a bondholder may suffer a reduction in his
or her income.
Comparing Interest Rate Risk and
Reinvestment Rate Risk: The
Maturity Risk Premium
The Default Risk Premium (DRP)
 The greater the default risk, the higher
the bond’s yield to maturity.
• The default risk on Treasury securities is
virtually zero, but default risk can be
substantial for corporate and municipal
bonds.
Bond Contract Provisions That
Influence Default Risk

 Bond Indentures
 Secured Debt and Mortgage Bonds
 Debentures and Subordinated Debentures
 Bond Ratings
 Moody’s Investors Service (Moody’s),
Standard & Poor’s Corporation
 (S&P), and Fitch Ratings
• Investment-grade bonds
• Junk bonds.
Bond Rating Criteria, Upgrades,
and Downgrades
• Financial Ratios
• Bond Contract Terms
• Qualitative Factors: Inflation, environmental
problem;
• Wilson Corporation’s bonds have 12 years
remaining to maturity. Interest is paid annually,
the bonds have a $1,000 par value, and the coupon
interest rate is 10%. The bonds sell at a price
of $850. What is their yield to maturity?
• 12.47%
• Heath Food Corporation’s bonds have 7 years
remaining to maturity. The bonds have a face
value of $1,000 and a yield to maturity of 8%.
They pay interest annually and have a 9% coupon
rate. What is their current yield?
• 8.55%