Bryan Tay

Bond Valuation
A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal on specific dates to the holders of the bond.

 Bonds are grouped in several ways:

o Treasury Bonds – called Treasuries and are referred to as government bonds, issued
by the federal government.
 No default risk but the bond prices decline when interest rates rise.
o Corporate Bonds – issued by business firms.
 There is default risk/credit risk (if issuing company gets into trouble, it may
be unable to make the promised interest)
 The higher the credit risk, the higher the interest rate investors demand.
o Municipal Bonds – bonds issued by the state and local governments.
 Interest earned on most municipal bonds is exempt from federal taxes and
from state taxes if the holder is a resident of the issuing state.
 Therefore, the market interest rate on municipal bonds is considerably
lower than on a corporate of equivalent risk.
o Foreign Bonds – Issued by a foreign government or a foreign corporation.

Characteristics of Bonds
1. Par Value
 Par value is the stated face value of the bond and is generally assumed to have a par
value of $1,000.
 The par value generally represents the amount of money the firm borrows and
promises to repay.

2. Coupon Interest Rate

 Bonds usually require the company to pay a fixed number of dollars of interest
(known as the coupon payment)
o This is set at a level which would entice investors to buy the bond.
 When the coupon payment is divided by the par value, the result is the coupon
interest rate.

Fixed-Rate vs Floating-Rate

 Where the coupon interest rate is fixed for the life of the bond, it is known as fixed-
rate bonds.
 In contrast, when a bond’s coupon payment is allowed to vary over time, it is known
as a floating-rate bond.

 Some bonds pay no coupons at all, but are offered at a discount below their par
values and provide capital appreciation instead of interest income. These bonds are
known as zero coupon bonds.

3. Maturity Date
 Bonds have a specified maturity date on which the par value must be repaid.
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4. Call Provisions
 Many corporate and municipal bonds contain a call provision that gives the issuer
the right to call the bonds for redemption.
o It generally states that the issuer must pay the bondholders an amount
greater than the par value if they are called. This is known as the call
premium.
o Call premiums usually decline over time as the bonds approach maturity.
o If the bonds are not immediately callable, they are known as deferred calls
and these bonds have call protection.

 Companies are unlikely to call bonds unless interest rates have declined significantly
since the bonds were issued.
 The process whereby companies issue new lower-yielding securities when interest
rates drop and then use the proceeds to retire higher-yield securities to reduce its
interest expense is called a refunding operation.

5. Sinking Funds
 Some bonds include a sinking fund provision that facilitates the orderly retirement
of the bond issue.
 Sinking fund provisions require the issuer to retire a portion of the bond issue each
year  A failure to do so constitutes a default.
 In other words, it is a provision to pay off a loan (the principal of the loan) over its
life rather than all at maturity.
 This is similar to amortization on a term loan.
 A sinking fund provision reduces risk to investors and shortens the average maturity.
 2 ways of handling sinking funds:
o Call x% at par per year for sinking fund purposes.
 Call if rd is below the coupon rate and bond sells at a premium.
o Buy bonds on open market.
 Use open market purchase if rd is above coupon rate and bond sells
at a discount.

6. Other Features
 Convertible bonds are bonds that are exchangeable into shares of common stock at
a fixed price at the option of the bondholder.
 Bonds issued with warrants are similar to convertibles but gives the holder an
option to buy stock for a stated price and therefore providing capital gain if the
stock’s price rises.
 Both convertible bonds and bonds with warrants carry lower coupon rates than
other similar nonconvertible bonds.

 Puttable bonds allow investors to require the company to pay in advance.

o If interest rates rise, investors will put the bonds back to the company and
reinvest in higher coupon bonds.
 Income bonds pay interest only if the issuer has enough money to pay the interest.
 Indexed/Purchasing Power Bonds  based on an inflation index such as the
consumer price index (CPI). When the inflation rates rise, interest paid rises as well.
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Bond Valuation
 The value of any financial asset is the present value of the cash flows the asset is expected
to produce.

 INT = PMT on the financial calculator = Coupon Payment (amount of interest paid every
year)
 The cash flows consist of an annuity of N years + a lump sum payment at the end of year N.
 M is the Par (Maturity) Value of the bond. It is basically the value that must be paid back at
maturity of the bond and is the future value (FV).
 Rd% represents the market rate of interest on the bond. This is different from the coupon
rate.

 When the bond’s market rate is the same as its coupon-rate, a fixed-rate bond will sell at its
par value.
 When the going rate of interest rises above its coupon-rate, a fixed-rate bond’s price will fall
below its par value. (known as a discount bond)
o Rd > coupon rate, fixed-rate bond sells below par.
 When the going rate of interest falls below its coupon-rate, a fixed-rate bond’s price will rise
above its par value. (known as a premium bond)
o Rd < coupon rate, fixed-rate bond sells above par.

Bond Yields
 A bond’s yield provides an estimate of the rate of return we would earn if we purchased the
bond today and held it over its remaining life.
o If the bond is not callable, its remaining life is its years to maturity. ( Yield to
Maturity)
o If it is callable, its remaining life is the years to maturity if it is not called or the years
to the call if it is called. (Yield to Call)

A. Yield to Maturity

 The yield to maturity is the rate of interest earned on the investment if we buy a bond, hold
it to maturity and receive the promised interest and maturity payments.

Example: 14-year bond, 10% annual coupon, $1,000 par value bond purchased at the price of
$1494.93. What is the yield to maturity? (solve for I/YR)
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 The yield to maturity is also called the bond’s promised rate of return/promised yield. The
expected rate of return would usually be lesser due to risk of default or a chance that the
bond is called.

B. Yield to Call

 If a bond that is callable is purchased and the company calls it, the yield to maturity would
not be earned.
 If current interest rates are well below the outstanding bond’s coupon rate, any callable
bonds are likely to be called and investors will have to estimate its most likely rate of return
as the yield to call.
 The calculations are slightly modified, where:
o N is now the years to call (number of years until the company can call the bond), and
o The call price is used as the ending payment (FV) rather than the maturity value.

Example: A bond has a deferred call provision that allows the company to call them 10 years after
the issue date at the price of $1,100. 1 year after issuance, the going interest rate had declined,
causing the price of the bond to increase to $1494.93. Calculate the YTC.

 The rate of return or YTC is 4.21%. This is the return earned if a bond was purchased at a
price of $1494.93 and it was called 9 years from today. (Remember one year has gone past,
so there are 9 years left until the first call date)

Changes in Bond Values over Time

 A bond that has just been issued is known as a new issue.
 Once it has been issued, it is an outstanding bond or called a seasoned issue.

Current Yield = Coupon Interest Payment (Annual Coupon Payment)/Current Price of Bond
Capital Gains Yield = Bond’s annual change in Price/Beginning-of-year Price

A Bond’s total return = Yield to Maturity = Current Yield + Capital Gains Yield

 A premium bond has a high current yield but has an expected capital loss each year (as the
premium amortizes and the bond value trends towards the par value)
 A discount bond has a low coupon rate and a low current yield, but provides a capital gain
each year.

Bonds with Semi-Annual Coupons

 Most bonds make interest payments semi-annually.
 A few changes need to be made in order to value these bonds:
o Divide annual coupon interest payment by 2 to determine the dollars of interest
paid in 6 months
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o Multiply the years to maturity (N) by 2 to determine the number of semi-annual

payments.
o Divide the nominal (quoted) interest rate (R d) by 2 to determine the periodic (semi-
annual) interest rate.

Assessing a Bond’s Riskiness

Price Risk/Interest Rate Risk
 Interest Rates fluctuate over time  When they rise, the value of outstanding bonds
decline.
 The risk of a decline in bond values/bond price due to an increase in interest rates is called
price risk or interest rate risk.
 Price Risk is higher on bonds that have long maturities compared to bonds that will mature
in the near future.
o This is because the longer the maturity, the longer before the bond will be paid off
and the bondholder can replace it with another bond with a higher coupon.
 Bonds with lower/smaller coupon bonds are more sensitive to interest rate changes and
have more price/interest rate risks.

Reinvestment Risk
 While an increase in interest rates hurts bondholders because it leads to a decline in the
current value of a bond portfolio, a decrease in interest rates also hurt bondholders.
o This is because long-term investors suffer a reduction in income.
 This risk of an income decline from a bond portfolio due to a drop in interest rates is called
reinvestment risk.
 Reinvestment risk is high on callable bonds as well as short-term bonds because the shorter
the bond’s maturity, the fewer the years before the relatively high old-coupon bonds will be
replaced with the new lower-coupon issues.
o Investors whose primary holdings are short-term bonds or other debt securities are
affected by a decline in rates but holders of noncallable long term bonds will
continue to enjoy the old high rates.

Comparing Price Risk vs Reinvestment Risk

 Price Risk relates to the current market value of the bond portfolio, while Reinvestment Risk
relates to the income the portfolio produces.
o Holding long-term bonds increases the price risk, but not reinvestment risk.
o Holding short-term bonds increases the reinvestment risks, but not price risk.
 Which type of risk is “more relevant” depends on how long the investor intends to hold onto
the bonds. This is known as the investment horizon, or the period of time an investor plans
to hold a particular investment.

Default Risk
 Potential default is another important risk that bondholders face.
o If the issuer defaults, investors will receive less than the promised return.
o Investors will pay more for the one with less chance of default  If default risk on
bonds increase, the price of the bond will fall and the yield to maturity will increase.
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Bond Ratings
 Bonds are assigned quality ratings that reflect their probability of going into default.
o Bonds rated triple-B or higher are classified as investment-grade bonds.
o Bonds rated double-B and lower are speculative and are known as junk bonds.
 These bonds have a higher risk and have a more restricted market.
Therefore, lower-grade bonds have higher required rates of return.

 Bond Rating Criteria/Factors that Affect Default Risk and Bond Ratings
o Financial Ratios
 Debt ratios, coverage ratios, profitability ratios, current ratios
o Qualitative factors: Provisions in the Bond Contract/Bond Contract Terms
 Secured vs Unsecured Debt
 Senior (Higher priority of claim, more secured) vs Subordinated Debt
 Guarantee Provisions
 Sinking Fund Provisions
 Debt Maturity
 Call Provisions

Bond Markets
 Corporate bonds are traded primarily in the over-the-counter market.
 High-yield bonds have a much higher yield to maturity because of the higher default risk
compared to convertible bonds, who have lower yields that investors accept in return for
the option to convert their bonds to common stock.
 Bond with a yield to maturity above their coupon rate trade at a discount, whereas bonds
with a yield to maturity below their coupon rate trade at a premium.
 When bonds with similar ratings are compared, bonds with longer maturities tend to have
higher yields.