Bonds and Their Valuation

After reading this chapter, students should be able to:

List the four main classifications of bonds and

differentiate among them.

Identify the key characteristics common to all bonds.

Calculate the value of a bond with annual or semiannual

interest payments.

Explain why the market value of an outstanding fixed-rate

bond will fall when interest rates rise on new bonds of
equal risk, or vice versa.

Calculate the current yield, the yield to maturity, and/or

the yield to call on a bond.

Differentiate between interest rate risk, reinvestment rate

risk, and default risk.

List major types of corporate bonds and distinguish among

them.

Explain the importance of bond ratings and list some of the

criteria used to rate bonds.

Differentiate among the following terms: Insolvent,

liquidation, and reorganization.

Read and understand the information provided on the bond

market page of your newspaper

Characteristics of Bonds
A bond is a long-term contract under which a borrower (the
issuer) agrees to make payments of interest and principal, on
specific dates, to the holders (creditors) of the bond.

Bearer bond - Bonds that are not registered on the books of the
issuer. Such bonds are held in physical form by the owner, who
receives interest payments by physically detaching coupons from
the bond certificate and delivering them to the paying agent.

Registered bond - A bond whose issuer records ownership and

interest payments. Differs from a bearer bond, which is traded
without record of ownership and whose possession is the only
evidence of ownership.

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Par value - Also called the maturity value or face value; the
amount that an issuer agrees to pay at the maturity date.

Coupon interest rate - With bonds, notes, or other fixed income

securities, the stated percentage rate of interest, usually
paid twice a year (semiannually). Coupon payments - A
bond's dollar interest payments.

Maturity date - Date on which the principal amount of a bond or

other debt instrument becomes due and payable.

Call provision - An embedded option granting a bond issuer the

right to buy back all or part of an issue prior to maturity.

Bond indenture - Contract that sets forth the promises of a

corporate bond issuer and the rights of investors.

Sinking fund - A fund to which money is added on a regular basis

that is used to ensure investor confidence that promised payments
will be made and that is used to redeem debt securities or
preferred stock issues.

Sinking fund provision - A condition included in some corporate

bond indentures that requires the issuer to retire a specified
portion of debt each year.

Convertible bond - General debt obligation of a corporation that

can be exchanged for a set number of common shares of the issuing
corporation at a prestated conversion price.

Warrant - A security entitling the holder to buy a proportionate

amount of stock at some specified future date at a specified
price, usually one higher than current market price. Warrants are
traded as securities whose price reflects the value of the
underlying stock. Corporations often bundle warrants with another
class of security to enhance the marketability of the
other class. Warrants are like call options, but with much longer
time spans-sometimes years. And, warrants are offered by
corporations, while exchange-traded call options are not issued
by firms.

Bond Valuation
The value of any financial asset - a stock, a bond, etc., or
even a physical asset - is simply the present value of the cash
flows (discounted at the assets required rate of return) which
the asset is expected to generate over its lifetime.

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 CF1 CF2 CF3 CFn n
CFt
VALUE = PV =
(1 k) (1 k) (1 k)
1 2 3
...
(1 k)n
(1 k) .
t 1
t

Bond terminology:

kd = the bonds market rate of interest or required rate of

return; also called the yield to maturity (YTM); (can
change many times over the bonds life).

N = the number of years before the bond matures.

M = the par, or maturity, value of the bond (usually $1,000).

CIR = the coupon interest rate (does not change over the bonds
life).

INT = the dollar amount of interest the bond pays per year
(INT = CIR x M).

Note: Always discount the bonds cash flows with kd.

Bond valuation model with annual coupons:

N
INT M
VB = (1 k )
t 1 d
t

(1 kd)N
= INT(PVIFA kd,n) + M(PVIF kd,n)

Bond valuation model with semi-annual coupons:

2N
INT/2 M
VB = (1 k /2) +
t1 d
t
(1 kd /2)2N = INT/2(PVIFA kd/2,2n) + M(PVIF

kd/2,2n)

Zero Coupon bond valuation model:

VZero = M/(1 + kd)n = M(PVIFkd,n)

Bond Valuation: Important Relationships

A decrease in interest rates (required rates of return) will

cause the value of a bond to increase; an interest rate
increase will cause a decrease in value. The change in

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 value caused by changing interest rates is called interest
rate risk. A bondholder owning a long-term bond is exposed
to greater interest rate risk than when owning a short-term
bonds.
The market value of the bond will always approach its par
value as its maturity date approaches, provided the firm
does not go bankrupt.
If the bondholder's required rate of return (current
interest rate) equals the coupon interest rate, the bond
will sell at "par," or maturity value.
If the current interest rate exceeds the bond's coupon rate,
the bond will sell below par value or at a "discount."
If the current interest rate is less than the bond's coupon
rate, the bond will sell above par value or at a "premium."

Bond Yields

Yield to maturity - The percentage rate of return paid on a

bond, note, or other fixed income security if the investor buys
and holds it to its maturity date. The calculation for YTM is
based on the coupon rate, length of time to maturity, and market
price. It assumes that coupon interest paid over the life of the
bond will be reinvested at the same rate.

INT + [(M VB)/n]

Estimated YTM = --------------------------
(M + 2VB)/3

Current yield - The annual interest payment on a bond divided by

the bond's current price.

Current yield = INT/VB

Capital gains (loss) yield - The price change portion of a bond's

return.

Capital gains (loss) yield = (VB+1 - VB)/VB

Therefore, the total return on a bond is equal to the bond's YTM,

and the YTM = Current yield + Capital gains (loss) yield.

YTM = INT/VB + (VB+1 - VB)/VB

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Yield to call - The percentage rate of return on a bond or note
if the investor buys and holds the security until the call date.
This yield is valid only if the security is called prior to
maturity. Generally bonds are callable over several years and
normally are called at a slight premium. The calculation of yield
to call is based on coupon rate, length of time to call, call
price and market price.

INT + [(Call Price VB)/Years to Call]

Estimated YTC = -----------------------------------------
(Call Price + 2VB)/3

Yield to maturity on a zero coupon bond:

YTMZero = (M/VZero)1/n - 1.0

Types of bonds

Treasury bonds - Debt obligations of the US Treasury that

have maturities of 10 years or more.
Municipal bond - State or local governments offer muni bonds
or municipals, as they are called, to pay for special
projects such as highways or sewers. The interest that
investors receive is exempt from some income taxes.
Foreign bond - A bond issued on the domestic capital market
of another country.
Corporate bonds - Debt obligations issued by corporations.

1. Mortgage bond - A bond in which the issuer has

granted the owner a lien against the pledged assets.
2. Debenture - Any debt obligation backed strictly by
the borrower's integrity, e.g. an unsecured bond. A
debenture is documented in an indenture.
3. Subordinated debenture bond - An unsecured bond that
ranks after secured debt, after debenture bonds, and
often after some general creditors in its claim on
assets and earnings.

Bond Ratings
Bond ratings are critical to a company's ability to issue debt at

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an acceptable interest rate.

1. What is the purpose of rating debt?

Answer: Unrated debt is extremely difficult, if not impossible to

sell. Corporations desiring to sell bonds must submit their
proposals to an independent rating company like Moody's Investor
Service or Standard & Poors Corporation for the debt to be
assigned a rating. This rating, coupled with market rates of
interest and the special features of the debt, will determine how
much the company will have to pay in interest.

2. Why would a company's debt rating be changed subsequent to

issue?

Answer: Any time new information relevant to the company's

ability to repay the debt (i.e. changes in the company's
financial health) is discovered and determined to be of
sufficient impact, that company's debt rating might be changed.
Obviously, good information should result in a better rating or
upgrade and bad information should result in a downgrade.

3. What impact would a change in debt rating have on the value

of an outstanding bond?

Answer: Bonds of companies that suffered downgrades would decline

in value to equate the yield to the new level of risk.
Conversely, bonds that were upgraded should increase in price.

Bond ratings are important for firms raising capital via a debt
offering. Companies that are financially sound enough to get a
higher rating will be able to sell debt with lower interest
payments than their riskier counterparts. Bond rating agencies
also actively monitor outstanding debt they have rated for
changes in status. Companies placed on watchlists are companies
who are facing potential changes in the rating of their debt.

Junk bond - A bond with a speculative credit rating of BB (S&P)

or Ba (Moody's) or lower. Junk or high-yield bonds offer
investors higher yields than bonds of financially sound
companies.

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 Bond Quotations

1 2 3 4 5
Bonds Cur Yld Vol Close Net Change
Chiquita 10 1/2 04 10.7 144 98 1/4 + 3/8
K Mart 6.2s97 cv 50 91 + 1/4
Disney zr05 414 45 3/4 + 3/4

Column 1: Bond, Coupon Rate, Date of Maturity

A bond issued by Chiquita which matures in 2004 has a coupon rate

of 10 1/2. This stated interest rate represents the 10.5 percent
paid on the bond's $1,000 face value. The holder of this bond
will receive $105 annually.

The "s" in the K Mart quotation separates the 6.2 percent rate
from the 1997 maturity rate. Note this bond is listed in
fractions of 10s instead of 8s.

The Disney bonds are zero coupon bonds as indicated by the "zr."
They do not pay annual interest.

Column 2: Current Yield

At this day's price, the holder of a Chiquita bond annually will

receive 10.7 percent or $10.70 for every $100 invested. The
current yield is calculated by dividing the annual interest by
the closing price.

"cv" indicates the K Mart bond is convertible and can be

exchanged for K Mart stock.

Column 3: Volume

On this day, 500,000 K Mart bonds were sold. The number 50 has
been multiplied by 10,000.

Columns 4 & 5: Close, Net Change

The final price for Chiquita bonds was $982.50 which was $3.75
more than the final price on the day before.

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 1 2 3 4 5
Bonds Cur Yld Vol Close Net Change
USAir 16 1/4 09 14.5 15 111 7/8
IBM zr13 20 42 1/8 - 3/4
CBS 9.8s20 cv 32 109 1/2 +2

1. How many transactions of USAir bonds were made? _________

2. What year are each of these bonds due?

USAir __________
CBS __________

3. What is the stated coupon interest paid to the bondholder

for each of these bonds?

USAir _______________
IBM _______________
CBS _______________

4. If you bought the following bonds at these prices, what

would your yield to maturity be?

USAir _________________
IBM _________________

5. What was the closing price for these bonds on the previous
day?

USAir _________________
CBS _________________

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 Interest Rate Price Risk for 10 percent Coupon
Bond Value Bonds with Different Maturities
($)
1,800

1,400

1,000
1-Year
5-Year
10-Year
20-Year
600 30-Year

5 6 7 8 9 10 11 12 13 14 15
Interest Rate (%)

An Investor's Guide to the Many Meanings of Yield

Let us assume that you are reading the financial pages of your
favorite newspaper. You read that even though stock returns have
been dismal for the last two years, bond returns have been very
good. In fact, you read that over the past two years, many bond
funds returned well over 15%. While the returns look pretty darn
good relative to stocks, you may wonder: Does that mean I can
expect to earn 15% next year if I buy bonds? If the answer is not
obvious, read on.

The direction of interest rates is one of the chief determinants

of bond prices. A strong market for bonds is one in which
interest rates are declining. That causes bond prices to go up.
A weak market is one in which interest rates are going up. That
causes bond prices to decline. Clearly, then, since changes in
interest rate levels affect bond prices, they also affect what
you earn from investments in bonds.

But that is only the beginning. In order to understand what you

actually earn from bonds, you need to understand two different
concepts: yield and total return.

When you buy an individual bond, you can expect to receive coupon
payments (usually every six months) for most bonds. When you buy
a bond fund, you can expect a monthly payout of the income earned
by the bond fund. That stream of income is variously described as
the bonds yield. But you also have to bear in mind that when

9
you sell or redeem your bond (or bond fund), you may sell at a
higher or at a lower price than the price you paid. That
difference can be an additional source of earnings, or it may
result in a loss. That change in price is one of the main factors
that determines a bonds total return.

What may be confusing, however, is that the term yield has a

number of different meanings. Even more confusing is the fact
that these meanings are not directly comparable for individual
bonds and for bond funds. Moreover, individual bonds are usually
sold to investors and are discussed primarily in terms of yield,
not returns. But discussions of bond funds often focus on total
return.

Yield

When you buy an individual bond, you derive income from three
different sources: Simple interest, Interest on interest, and
Return of principal at maturity, or proceeds from the sale of the
bond at an earlier date.

Simple interest consists of the bonds coupons, which are usually

paid twice a year. Let us say you invest $10,000 in a four-year
bond, paying 8% a year, semiannually. In return, you will receive
two coupon (or interest) payments of $400 each, at six-month
intervals every year. If you hold the bond until it
matures, you will receive eight coupons that total $3,200. Those
eight coupons are the simple interest.

If the coupon payments are spent, only the simple interest is

earned. But if the coupons are reinvested, they produce
additional interest; subsequently, if those earnings are
reinvested, you earn interest on that interest, and so on. That
entire income stream is called, logically enough, interest-on-
interest, or compounded interest. Both interest income, and
interest-on-interest, in different combinations, lie behind
the different meanings of yield.

Yield appears in a number of phrases: coupon yield, current yield

and yield to maturity. Each has a very precise meaning. Lets
look at each in turn.

Coupon Yield

Coupon yield is set when a bond is issued. It is the interest

rate paid by the bond (for example, 5%,7%), and it is listed as
a percentage of par, or face value, which is the principal amount

10
that will be owed at maturity.

The coupon yield designates a fixed dollar amount that never

changes through the life of the bond. If a $1,000 par value bond
is described as having a 10% coupon, that coupon will always be
$100 for each bond, paid out in two $50 increments for the entire
life of the bondno matter what happens to the price of the bond,
or to interest rates. That is the reason bonds are called fixed-
income securities.

Current Yield

Almost as soon as a bond starts trading in the secondary market,

it ceases to trade at par due to changing interest rates. A
bonds current yield is its coupon divided by its market price.

To illustrate, let us assume you purchased three bonds: the first

you bought at par, for $1,000; the second you bought at a premium
to par, and paid $1,200; the third you bought at a discount to
par, for $800. Each bond has a 10% coupon, and so each pays $100
in annual coupons. Dividing the coupon ($100) by the price
results in a current yield of 10% for the par bond; 8.33% for the
premium bond; and 12.5% for the discount bond. Thus, the current
yield is equal to coupon yield for the par bond; the current
yield is lower than the coupon yield for the premium bond; and
the current yield is higher than the coupon
yield for the discount bond. Current yield is quoted for fixed-
income securities of any maturity, whether short or long.

Yield to Maturity

You can see from the above description that current yield is
based only on the coupon and the current market price. Current
yield, therefore, fails to measure two important sources of
income that investors earn from bonds: interest-on-interest and
capital gains or losses.

Yield to maturity (YTM) is a more comprehensive measure of

potential earnings than current yield. It estimates the total
amount that a bond will earn over the entire life of an
individual bond, from all possible sources of income coupon
income, interest-on-interest, and capital gains or losses due to
the difference between the price paid when the bond was purchased
and par, the return of principal at maturitybased on a number of
assumptions regarding the holding period, reinvested income and
interest rates over the life of the bond.

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Yield to maturity calculations are not easily made using paper
and pencil, but they can easily be determined using either a
financial calculator, or by using the various calculators
available on the Internet.

YTM is the measure most widely quoted by brokers when selling

individual bonds. However, it is not a prediction of what you
will actually earn on a bond. Your actual return is likely to
differ from the YTM, perhaps considerably, because the YTM will
only be realized under certain conditions, which are:

That you hold the bond to maturity;

That the coupons are reinvested (rather than spent); and
That coupons are reinvested at an interest rate equal to the
yield-to-maturity.

Lets look briefly at each assumption:

-Holding to Maturity: The YTM quote is based on the redemption

price of par (that is, $1,000). If you sell a bond before it
matures at a price other than par, then the capital gain or loss
will considerably alter what you actually earn.

-Reinvesting Coupons: YTM calculations are based on the

assumption that coupons are never spent; they are always
reinvested. If you spend coupons, then you do not earn the
interest-on-interest, and your return would be less than the
anticipated YTM. How much less depends both on how many coupons
you spend and on the maturity of the bonds.

-Coupons are Reinvested at an Interest Rate Equal to the YTM:

This may sound like double talk, but it means that if a bond has
a YTM of 7%, it is assumed that each and every coupon is
reinvested at a rate of 7%. However, if in reality you reinvest
coupons at a higher rate than 7%, you will earn more than the
bonds stated YTM, while if you reinvest coupons at lower rates
than 7%, you will earn less.

Reinvestment Risk

Reinvestment risk is the risk that coupons may have to be

reinvested at a lower interest rate, in which case an investors
actual return would then be lower than the YTM quoted at the time
of purchase. On the other hand, the reinvestment risk may work in
your favor if coupons are reinvested at a higher rate, and that
would increase the actual return above the YTM quoted at the time
of purchase.

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If YTM does not predict your actual return, what does it tell
you? The chief usefulness of YTM quotes is that they allow you to
compare different kinds of bondsthose with dissimilar coupons,
different market prices relative to par (for instance, bonds
selling at premiums or discounts), and different maturities.

Default Risk

The risk that an issuer of a bond may be unable to make timely

principal and interest payments.

Zero Coupon Bonds

Zero coupon bonds result from the separation of coupons from

the body of a security.
Zeros sell at deep discounts from face value.
The difference between the purchase price of the zero and
its face value when redeemed is the investor's return.
Zeros can be purchased from private brokers and dealers, but
not from the Federal Reserve or any government agency.

Creating Zeros by Coupon Stripping - Coupon stripping is the act

of detaching the interest payment coupons from a note or bond and
treating the coupons and the body as separate securities. Each
coupon, or interest payment, entitles its owner to a specified
cash return on a specific date; the body of the security calls
for repayment of the principal amount at maturity.

The body of the stripped securities and the separate coupons are
known as "zero coupons" or "zeros" because there are no periodic
interest payments on each instrument. After stripping, the body
and coupons are sold at a deep discount from their face values.
An owner benefits only from the difference between the purchase
price and the payment received upon sale or at maturity.

For example, a 20 year bond with a face value of $20,000 and a

10% interest rate could be stripped into its principal and its
40-semi-annual interest payments. The result would be 41 separate
zero coupon instruments, each with its own maturity date. The
principal would be worth $20,000 upon maturity, and each interest
coupon $1,000, or one-half the annual interest of 10% on $20,000.
Each of the 41 securities, now possessing a distinct ID number,
could be traded separately until its maturity date at prices
determined by the market.

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Proliferation of Treasury STRIPS - Some Treasury securities were
traded in the secondary market without one or more of their
interest coupons in the late 1970s. Stripped securities offered
investors a financial instrument that had abundant supply, no
default risk, and low incidence of being "called," or paid off,
before their maturity date. However, their popularity raised
fears within the Treasury Department that zeros would result in a
sizable loss of tax revenues.

Detached coupons and the body of the security were sold at deep
discounts, $.05 or $.10 on the dollar. After purchase, an
investor claimed a capital loss on the difference between the
sale price of the security and its face value, thus reducing the
investor's overall tax liability.

The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982

adjusted the tax treatment of stripped securities to reduce their
tax advantage. The Treasury Department then withdrew its
objections to coupon stripping, prompting several securities
dealers to create new products incorporating receipts for
stripped debt securities.

TEFRA also required the Treasury to begin issuing all of its

securities in book-entry (electronic)form only, beginning on
January 1, 1983. This provision eliminated Treasury issues of
bearer notes and bonds with coupons attached. Physical stripping
would no longer be possible.

In response, bond dealers began to market receipts that evidenced

ownership of Treasury zeros held by a custodian. The first of
these "receipt products" were named Treasury Investment Growth
Receipts, or TIGRS. Similar products appeared in 1984, such as
Certificates of Accrual on Treasury Securities (CATS) and
Treasury Receipts (TRs). However, most of these securities were
not exchangeable with other stripped securities, and thus lacked
the liquidity customers had come to expect from "zero"
instruments.

In February 1985, the Treasury took a more active role by

introducing its own coupon stripping program called STRIPS, an
acronym for Separate Trading of Registered Interest and Principal
of Securities. The STRIPS program was intended primarily to
reduce the cost of financing the public debt "by facilitating
competitive private market initiatives."

Under the STRIPS program, U.S. government issues with maturities

of ten years or more became eligible for transfer over Fedwire.

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The process involves wiring Treasury notes and bonds to the
Federal Reserve Bank of New York and receiving separated
components in return. This practice also reduced the legal and
insurance costs customarily associated with the process of
stripping a security. In May 1987, the Treasury began to allow
the reconstitution of stripped securities.

Part of a Balanced Portfolio - Stripped securities can be

purchased only from private dealers and brokers. Although the
Federal Reserve provides services to the zero coupon market, it
does not actually sell these securities for the Treasury.
Financial services companies decide when and what portion of an
eligible security are stripped and sold.

Because their increase in value is taxable yearly as it accrues,

zeros have become most popular for investments on which taxes can
be deferred, such as individual retirement accounts and pension
plans, or for nontaxable accounts. However, their known cash
value at specific future dates enables savers and investors to
tailor their use to a wide range of portfolio objectives.

Problems

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1) The bonds of the Nordy Company have a coupon interest rate of
9%. The interest on the bonds is paid semiannually, the bonds
mature in 8 years, and their par value is $1,000. If the
required rate of return, kd = 8%, what is the value of each bond?
What is the value of each bond if the interest is paid annually?

2) You own a bond that pays $100 in interest annually, has a par
value of $1000, and matures in 15 years. What is the value of
the bond if your required rate of return is 12%? What is the
value of the bond if your required rate of return (a) increases
to 15% or (b) decreases to 8%? Now, recompute all three answers
assuming that the bond matures in 5 years instead of 15 years.

3) Dullco Company bonds are selling in the market for $1,045

(104.50). These bonds will mature in 15 years and pay $70 in
interest annually. If the bonds are purchased at the market
price, what is the (a) coupon rate, (b) current yield,
(c) approximate yield to maturity and (d) capital gains yield?

4) Apex Company is planning to issue zero coupon bonds that will

mature at $1,000 in 20 years. If your required rate of return on
these bonds is 9.35%, what are you willing to pay for the bonds?
If these bonds are currently selling for $213.50, what is their
yield to maturity (YTM)?

Answers

1) $1,058.26; $1,057.47

2) $863.78; (a)$707.63; (b)$1,171.19

$927.90; (a)$832.39; (b)$1,079.85

3) (a)7%; (b)6.70%; (c)6.50%; Exact YTM = 6.5208%;

(d)-0.20%; Exact CGY = -0.1792%

4) $167.35; 8.03%

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