Chapter 11

Bond Valuation
 Bond valuation

• Valuation of a security involves two tasks:

1. Forecast its future cash flow
2. Determine its discount rate (the required rate of return)
• The future cash flows from a bond are known
(coupons+principal), as long as there is no default.
• The key for bond valuation then is to determine its
discount rate.

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 Determine the discount rate

• The required rate of return =[Real rate of return + Expected

inflation premium] + Risk premium
• The first two terms in the bracket is captured by the Treasury
yield, which we usually label as riskfree.
• Term risk premium: Bond yields at longer maturities tend to
be higher on average than at shorter maturities. This is driven
by the interest rate variation.
• Credit risk premium: Bonds that have a higher chance of
default tend to have a larger credit yield spread.
• Tax: Some bonds are tax free, in which case one would ask
for a lower return

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 Major Bond Sectors

• Bond market is comprised of a series of

different market sectors:
– U.S. Treasury issues
– Municipal bonds
– Corporate bonds
– Sovereign bonds
• Differences in interest rates between the
various market sectors are called
yield spreads

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 Factors Affecting Yield Spreads

• Municipal bond rates are usually 20-30% lower

than corporate bonds due to tax-exempt feature
• Treasury bonds have lower rates than corporate
bonds due to no default risk
• The lower the credit rating (and higher the
default risk), the higher the interest rate
• Bonds with longer maturities generally yield more
than shorter maturities

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 Determine credit risk
• Credit risk is the key driver of yield spreads
• How to determine credit risk?
– It is the risk that borrower cannot afford to pay the debt
and its interest.
• What determines the borrower’s capability to pay
back the debt?
– Does the company has too much debt relative to asset:
leverage ratio = Debt/Asset
– Does the company make enough money each year to pay
off its interest expense: Interest coverage ratio
=Operating Income/Interest expense
• Credit rating is largely based on these two metrics
– +some other metrics such as liquidity.

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 Term Structure of Interest Rates
and Yield Curves

• Term Structure of Interest Rates: relationship

between the interest rate or rate of return (yield)
on a bond and its time to maturity
• Yield Curve: a graph that represents the
relationship between a bond’s term to maturity and
its yield at a given point in time

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 Figure 11.2 Two Types of Yield Curves

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 Theories on Shape of Yield Curve

• Slope of yield curve affect by:

– Investors’ expectations regarding the future behavior of
interest rates
– Risk premiums: Long bonds are riskier and demand higher
returns on average)
– Convexity: Drives longer-term bond yield down because
bond-rate relation is nonlinear.
– Supply and demand for bonds of different maturities

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 Theories on Shape
of Yield Curve (cont’d)

• Expectations Hypothesis
– Shape of yield curve is based upon investor expectations
of future behavior of interest rates
– When investors expect interest rates to go up, they will
only purchase long-term bonds if those bonds offer higher
yields than short-term bonds; hence the yield curve will
be upward sloping
– When investors expect interest rates to go down, they will
only purchase short-term bonds if those bonds offer
higher yields than long-term bonds; hence the yield curve
will be downward sloping

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 Interpreting Shape of Yield
Curve
• Upward-sloping yield curves result from:
– Expectation of rising interest rates
– Lender preference for shorter-maturity loans
– Greater supply of shorter-term loans
• Flat or downward-sloping yield curves result
from:
– Expectation of falling interest rates
– Lender preference for longer-maturity loans
– Greater supply of longer-term loans

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 Basic Bond Investing Strategy

• If you expect interest rates to increase, buy

short-term bonds
• If you expect interest rates to decrease,
buy long-term non-callable bonds

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 The Pricing of Bonds

• Bonds are priced according to the present

value of their future cash flow streams

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 The Pricing of Bonds (cont’d)

• Bond prices are driven by market yields

• Appropriate yield at which the bond should
sell is determined before price of the bond
– Required rate of return is determined by market,
economic and issuer characteristics
– Required rate of return becomes the bond’s
market yield
– Market yield becomes the discount rate that is
used to value the bond

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 The Pricing of Bonds (cont’d)

• Bond prices are comprised of two components:

– Present value of the annuity of coupon payments, plus
– Present value of the single cash flow from repayment of
the principal at maturity
• Compounding refers to frequency coupons are paid
– Annual compounding: coupons paid once per year
– Semi-annual compounding: coupons paid every
six months

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 Ways to Measure Bond Yield

• Current yield
• Yield-to-Maturity
• Yield-to-Call
• Expected Return

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 Current Yield

• Simplest yield calculation

• Only looks at current income

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 Yield-to-Maturity

• Most important and widely used yield calculation

• True yield received if the bond is held to maturity
• Assumes all interest income is reinvested at rate
equal to market rate at time of YTM calculation—no
reinvestment risk
• Calculates value based upon PV of interest received
and the appreciation of the bond if held until
maturity
• Difficult to calculate without a financial calculator

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 Yield-to-Maturity (cont’d)

• Yield-to-Maturity Example:
– Find the yield-to-maturity on a
7.5 % ($1,000 par value) bond that has 15 years
remaining to maturity and is currently trading in the
market at $809.50?

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 Yield-to-Call

• Similar to yield-to-maturity
• Assumes bond will be called on the first call
date
• Uses bonds call price (premium) instead of
the par value
• True yield received if the bond is held to call

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 Yield-to-Call (cont’d)

• Yield-to-Call Example:
– Find the yield-to-call of a 20-year, 10.5 % bond (annual
payment) that is currently trading at $1,204, but can be
called in 5 years at a call price of $1,085?

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 Expected Return

• Used by investors who expect to actively

trade in and out of bonds rather than hold
until maturity date
• Similar to yield-to-maturity
• Uses estimated market price of bond at
expected sale date instead of the par value

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 Expected Return (cont’d)

• Expected Return Example:

– Find the expected return on a 7.5% bond (semi-annual
payment) that is currently priced in the market at
$809.50 but is expected to rise to $960 within a 3-year
holding period?

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 Bond Duration
• Bond Duration: A measure of bond price
sensitivity to interest rate changes.

• Macauley duration: Weighted average maturity

of all cash flows, with the weight given by the
present value of the cash flow, divided by the
current bond price. MD=sum(t*w)

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 Bond Duration

• Modified duration: Macauley duration/(1+y),

measures the percentage change in bond value per
change in interest rate

• Example: A bond as a Macauley duration of 7.00

and is priced to yield 5%. If the market interest
rate goes up so that the yield goes up to 5.5%, the
percentage change in the bond price is:

-7*(5.5%-5%)/(1+5%)=-3.33%
The bond price will go down by 3.33%.

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 The Concept of Duration

• Generally speaking, bond duration

possesses the following properties:
– Bonds with higher coupon rates have shorter
durations
– Bonds with longer maturities have longer
durations
– Bonds with higher YTM lead to shorter durations
• The bond duration as a sensitivity measure works
better for small rate moves, but may not work well
for large moves due to convexity effects.

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 Measuring Duration

• Steps in calculating Macauley duration

– Step 1: Find present value of each coupon or
principal payment
– Step 2: Divide this present value by current
market price of bond
– Step 3: Multiple this ratio by the year in which
the bond makes each cash payment
– Step 4: Repeat steps 1 through 3 for each year
in the life of the bond then add up the values
computed in Step 3

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 Table 11.1 Duration Calculation for a 7.5%,
15-Year Bond Priced to Yield 8%

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