TOPIC 7: BONDS AND THEIR VALUATION

Topic Learning Outcomes

After this topic, you should be able to:
1. Discuss the bond markets, and the legal aspects of bond financing and bond cost.
2. Discuss the general features, yields, prices, popular types, and international issues of
corporate bonds.
3. Discuss the key inputs and basic model used in the valuation process.
4. Discuss the process of assessing a bond’s riskiness.
5. Apply the basic valuation model to bonds and describe the impact of required return and
time to maturity on bond values.
6. Explain the yield to maturity (YTM), its calculation, and the procedure used to value
bonds that pay interest semiannually.

Be Engaged
Read:

SMC’s food unit finalizes P15-billion maiden bond offering

San Miguel Food and Beverage Inc., a unit of San Miguel Corp., finalized the terms of a planned P15-billion
maiden bond offering.

San Miguel Food said in a disclosure to the stock exchange the five-year series A bonds due 2025 would have a
fixed interest rate equivalent to 5.05 percent a year, while the seven-year series B Bonds due 2027 would offer
a fixed interest rate of 5.25 percent yearly.

San Miguel Food set the offering period from February 24, 2020 to March 2, 2020. It will issue and list the bonds
with Philippine Dealing & Exchange Corp. on March 10, 2020.

San Miguel Food started offering the bonds after securing a permit to sell from the Securities and Exchange
Commission. The bonds will be issued in minimum denominations of P50,000 each and in integral multiples of
P10,000 thereafter.

The company plans to use the net proceeds from the offering to fund the redemption of outstanding 15,000,000
Series 2 Perpetual Preferred Shares. San Miguel Food will redeem the shares on March 12, 2020 at a redemption
price of P1,000 per share.

San Miguel Food said it might redeem in whole the outstanding Series A Bonds at 101.0 percent on the third
year, or at 100.5 percent on the fourth year. For the Series B Bonds, the company may redeem the bonds at
101.0 percent on the fifth year or 100.5 percent on the sixth year.

BDO Capital & Investment Corp., BPI Capital Corp., China Bank Capital Corp., Philippine Commercial Capital Inc.,
PNB Capital and Investment Corp., RCBC Capital Corp. and SB Capital Investment Corp. have agreed to act as
joint lead underwriters and book runners of the offering.

BAFIMARX – Topic 7 1
The bonds received top credit rating from local debt watcher Philippine Rating Services Corp., which means the
obligations are expected to have minimal credit risk.

Source: https://manilastandard.net/mobile/article/318088?__cf_chl_captcha_tk__=8f5811e365290cb0a9d106d635abf691cfc89171-1594951731-0-
AdO03DETmGRXwzrrIMKs_cI3F2bApvQrey909oAesMLZ45AAIPZQDNFpmKGc73W4pymS0O6g0ApLZj-
PtlYSH2c1cfpSP_A0H7CFXclqS3PwUN3t9jF3DQT_GTe0ZUYKLn8oTTLeRCtc4s_Fao2ssbmJ6aTW4ARD5Jwws_f21V7HxdRyN6yAatF-
FNUNJEFGHH9z3qkDdpNUnhUEIdVbo5259J0n7nmUT4U4CCjTXCjLdyOmO3SS9jHaUxRUI9uv_l9Tv6QmJolB8IWVQXSjkySi0VnDPRFCa9e-
ncn5QYydBa_2VYL70_2dHVoxs_8LvMwy4dkfiMGHCr7OCaYRRKJtKksjjCwrlJZ2yM1SRaz_OUPms5AiL3PfQXFnYAc1nh9ZR0AFMz2y5LnfDQqR0od1Qdwb0P0WLycdthHc
hXKFHcRjCYmoAIaw9aEUhOE3CzXkmYESn89ZWHuhLifjyyxKiJSJKturyrtA-qIwr7akv1ePHJmNZERi0qXnqhdiCtvYwipAG3C2jhWD4VJrFRU

Think:
1. As a prospective investor, what are the factors you consider in investing?
2. What materials or sources you read to get information about your prospective investment?
3. In financial accounting, you are focus on financial reporting of bonds but are you familiar with how
those market values, intrinsic values, etc. computed?
4. Base on your existing knowledge of bonds, are you willing to invest in it? Why or why not?

BAFIMARX – Topic 7 2
 Let’s Discuss
1. Key characteristics of bonds
2. Bond Yields, Prices, Ratings
3. Valuation Fundamentals
4. Bond Valuation
5. Changes in bond values over time
6. Bonds with semiannual coupons
7. Assessing a bond’s riskiness
8. Default risk
1.1 Bond markets
2.
Bonds
• A long-term debt instrument issued to raise capital
• Issued by either
o Government
o corporation
• A contract that is long-term that stipulates that holder will receive Coupon Payment on stipulated
period and the Face Value or principal on the Maturity date.

Types of Bonds based on who issued them

Treasury Bonds
• Bonds issued by the government
• generally called treasuries or simply government bonds

Corporate Bonds
• Bonds issued by corporations.
• A long-term debt instrument indicating that a corporation has borrowed a certain amount of money
and promise to repay it in the future under clearly defined terms
• These bonds are exposed to default risk

Municipal Bonds or Munis

• Bonds issued by state and local governments.

Foreign Bonds
• Bonds issued by foreign governments or by foreign corporations.
• All foreign corporate bonds are exposed to default risk

Bond Markets
• Most bonds are owned by and traded among large financial institution
• Corporate bonds are traded over the counter most of the time
• it is relatively easy for bonds to be traded over the counter as compared to shares or stocks, since
there is a transfer of large blocks of bonds among the relatively few holders while stock market is
trading among the literally millions of large and small stockholders.

BAFIMARX – Topic 7 3
 • In the Philippines, the reports on the Bond Market, even other financial market securities, are available
on the Bureau of Treasury website (treasury.gov.ph) under the supervision of the Department of
Finance.

Key Characteristics of Bonds

Even though all bonds have common characteristics, different types of bonds can have different contractual
features

Common Characteristics
Face Value
• Also known as the Par Value
• It is the amount borrowed by the issuer to be paid at the maturity date

Maturity Value
• A specified date on which the par value of a bond must be repaid.

Coupon Payment
• The percentage of a bond’s par value that will be paid annually, typically in two equal semiannual
payments, as interest
• Computed by multiplying the interest rate with the face value of the bond

Coupon Interest Rate

• Also known as the nominal rate or stated rate in the bond
• The rate used to compute the coupon payment

Other Characteristics
Call Provision
• A provision in a bond contract that gives the issuer the right to redeem the bonds under specified
terms prior to the normal maturity date.
• Bonds with call provision are called Callable Bond.
Put Provision
• A provision that gives right to the bond holder to “put back” or require the issuer to repurchase the
said bond at a certain price before the maturity.
• Bonds with call provision are called Puttable Bond.
Issued with Warrants
• This gives the bond holders the option to buy shares of common stock from a company at a
predetermined price.
Issued with Convertible Feature
• This gives the bond holders the option to convert the bond into number of shares of common stock at
a predetermined price.
• Bonds with this provision are called Convertible Bond.

Bond Valuation
The value of any financial asset—a stock or a bond, among others—is the present value of the cash flows the
asset is expected to produce. We conclude that it is the present value of the cash flows from:

BAFIMARX – Topic 7 4
 • Interest or Coupon payments, and
• Face value received at maturity date or the terminal value

Value of a bond
• the present value of the payments its issuer is contractually obligated to make, from the current time
until it matures

The basic model for Bond Valuation

BV = PVCP + PVFV

o Interest or Coupon Payments Component:

CP = CIR * FV
PVCP = CP * PV(OA-D, n)

o Par or Face Value Component:

PVFV = FV * PV(1-D, n)

Where:
CP = Coupon Payment
CIR = Coupon Interest Rate or Nominal or Stated Rate
FV = Face Value
PVCP = Present Value of Coupon Payment
PVFV = Present Value of Face Value or Par Value
PV (OA-D, n) = Present Value Factor for Ordinary Annuity
PV (1-D, n) = Present Value Factor of Single Payment
D = Discount or Effective Interest Rate
n = number of years or periods

Bonds with Semiannual Coupons

To evaluate semiannual bonds, we must modify the valuation Model:
1. Divide the annual coupon interest payment by 2 to determine the dollars of interest paid each 6
months.
2. Multiply the years to maturity, N, by 2 to determine the number of semiannual periods.
3. Divide the nominal interest rate by 2 to determine the periodic (semiannual) interest rate.

Example:
SMPH issued a 12-year bond with 8% yield to maturity and 7% coupon interest rate. If the par value of the
bond is P1,000, compute the following:
a. The price of the bond today
b. Price of the bond on the 10th year
c. The price on the maturity date
d. If the bond has a characteristic of semi-annual payment, what is the bond price?

Solution:
a. BV = PVCP + PVFV
BV = (CP * PV(OA-D, 12)) + (FV * PV(1-D, 12))
BV = [(7%*1,000)*7.5361] + [1,000 * 0.3971]
BAFIMARX – Topic 7 5
 BV = 924.63

b. BV = PVCP + PVFV
BV = (CP * PV(OA-D, 12-10)) + (FV * PV(1-D, 12-10))
BV = [(7%*1,000)*1.7833] + [1,000 * 0.8573]
BV = 982.13

c. P1,000; the bond price at maturity date is the face value

d. BV = PVCP + PVFV
BV = (CP * PV(OA-D, 24)) + (FV * PV(1-D, 24))
BV = [(3.5%*1,000)*15.2470] + [1,000 *0.3901]
BV = 923.75

Bonds issued at Par, at Discount, or at Premium

Discount Bond
• A bond that sells below its par value
• occurs whenever the going rate of interest is above the coupon rate.

Premium Bond
• A bond that sells above its par value
• occurs whenever the going rate of interest is below the coupon rate.

Relationship Bond Price issued at Interest Expense

EIR > NIR Discount Increasing
EIR = NIR Par Same
EIR < NIR Premium Decreasing

Where:
EIR = Effective Interest Rate, Market Rate, Discount rate
NIR = Nominal Interest Rate, Sated Interest Rate, Coupon Rate
Note:
When EIR increases, Bond price decreases, and vice versa

Bond Yields
The yield, or rate of return, on a bond is frequently used to assess a bond’s performance over a given period of
time.

The three most widely cited bond yields:

1. current yield
• A measure of a bond’s cash return for the year; calculated by dividing the bond’s annual
interest payment by its current price.
• This measure indicates the cash return for the year from the bond. It does not measure the
total return since it ignores any change in bond value
• Example:
BAFIMARX – Topic 7 6
 For example, a P1,000 par value bond with an 8 percent coupon interest rate that
currently sells for P970 would have a current yield of 8.25% [(0.08 * P1,000) / P970].

2. yield to maturity (YTM)

• this is the required rate of return on a bond if the bond holder does intend to hold the bond
until maturity rather than selling it.
• In other words, it is the interest rate that can be used to discount the coupon and the face value
to arrive at the bond’s market value.
• Formula for Approximate YTM:

𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒

[𝐶𝑃 + ]
𝑌𝑇𝑀 = 𝑡
𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒 ∗ (0.6) + 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 (0.4)
Where:
CP = Coupon payment
t = term of the bond (or years until maturity)

Example:
You have just purchased an outstanding 15-year bond with a par value of P1,000 for P1,145.68. Its annual
coupon payment is P75. What is the bond’s yield to maturity?

Solution:
1,000 − 1,145.68
[75 + ]
𝟔% = 15
1,145.68 ∗ (0.6) + 1,000 ∗ (0.4)

3. yield to call (YTC)

• The rate of return earned on a bond when it is called before its maturity date.
• Formula for Approximate YTC:
𝐶𝑎𝑙𝑙 𝑃𝑟𝑖𝑐𝑒 − 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒
[𝐶𝑃 + ]
𝑌𝑇𝐶 = 𝑛
𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 ∗ (0.6) + 𝐶𝑎𝑙𝑙 𝑃𝑟𝑖𝑐𝑒 ∗ (0.4)
Where:
CP = Coupon payment
n = no. of years when the call provision is exercisable

Example:
The SMC bonds currently sell for P1,275. They pay a P120 annual coupon, have a 20-year maturity, and a par
value of P1,000, but they can be called in 5 years at P1,120. What is the YTC?

Solution:
1,120 − 1,275
[120 + ]
𝟕. 𝟑𝟑% = 5
1,275 ∗ (0.6) + 1,120 ∗ (0.4)

Expected Total Return (ETR) of a bond

Formula:
BAFIMARX – Topic 7 7
 𝐸𝑇𝑅 = 𝐶𝑌 + 𝐶𝐺/(𝐿)𝑌

𝐶𝑃 BPn – BPo
𝐸𝑇𝑅 = +
𝐵𝑃𝑜 BPo

Where:
ETR = Expected Total Return
CY = Current Yield
𝐶𝐺/(𝐿)𝑌 = Capital Gains or Loss Yield
BPo = New Bond Price (Selling Price now)
BPn = Old Bond Price (Cost or original price)

Example:

The CEB bonds currently sell for P1,275. They pay a P120 annual coupon for the 20-year maturity. The bond
was originally issued at P1,150. What is the Expected total return of the bond?

Solution:
120 1,275 − 1,150
𝟐𝟏. 𝟑𝟎% = +
1,150 1,150

Assessing a Bond’s Riskiness

Two key factors that impact a bond’s riskiness

a. Price Risk
• risk of a decline in a bond’s price due to an increase in interest rates.
• increase in interest rates hurts bondholders because it leads to a decline in the current value
of a bond portfolio, when interest rate rise, the value of outstanding bonds decline
b. Reinvestment Risk
• The risk that a decline in interest rates will lead to a decline in income from a bond portfolio.
• It is obviously high on callable bonds and on short-term bonds

Default Risk
the quoted interest rate includes a default risk premium to compensate for the probability of default. Default
risk on Treasuries is zero.

Mortgage Bonds
• A bond backed by fixed assets.
Indenture
• a legal document that spells out in detail the rights of the bondholders and the corporation
Debentures
• an unsecured bond and quite risky
• provides no specific collateral as security for the obligation
• debenture holders
o general creditors whose claims are protected by property not otherwise pledged

BAFIMARX – Topic 7 8
Subordinated Debentures
• Bonds having a claim on assets only after the senior debt has been paid in full in the event of
liquidation.

Bond Ratings
Investment-Grade Bonds
• are the lowest-rated bonds that many banks and other institutional investors are permitted by law to
hold
• examples are Single-A and triple-B bonds
Junk Bonds
• speculative-grade bonds and
• High-risk, high-yield bonds
• Examples are Double-B and lower bonds are

Bond Rating Criteria

Determinants of bond ratings include the following:
a. Financial Ratios
b. Qualitative Factors: Bond Contract Terms
c. Miscellaneous Qualitative Factors

Bond transactions
1.

Bond
Bond
Holder
Issuer
1

Observation:
• Bond Holder 1 holds the bond until maturity
• The Total expected Return that Bond Holder 1 receives equal to the Yield to Maturity (YTM)

BAFIMARX – Topic 7 9
2.

Bond Issuer

Bond
...Bond Holder 1
Holder 2 sells the
bond to...

Observation:
• Scenario
o Bond Holder sells the bond to another holder (Bond Holder 2)
• Bond Holder 1
o Will sell the bond when market interest rates decline to take advantage of the increase in Bond
price
o Expected total return is the Current Yield plus the capital gains
• Bond Holder 2
o Expected total return is the Yield to maturity

3.

Bond Holder
Bond Issuer
1
•issued callable
bonds •Issuer exercised
its right to call

Observation:
• Scenario
o Bond with call provision was issued to Bond holder 1 and Bond issuer exercise its right to call
and pays a call premium.
• Bond Holder 1
o Expected total return is the Yield to call
• Bond issuer
o Expects to call the callable bond when the market interest rate drops below or equal to the
projected Yield to Call

BAFIMARX – Topic 7 10
4.
Observation:
• Bond issuer issues new bonds to new investors after the bond
Bond issuer exercise its right to call due to decrease in the market interest
Holder 1 rate
• Newly issued bonds have higher price because of the decrease in
market interest rate.
• Lower interest rate: higher bond price; higher interest rate: lower
bond price
Bond
Issuer

New
investor

References
• Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
• Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
• Bagayao, I. Y., & et al. (n.d.). Financial Management Volume 1.
• Bagayao, I. S., & et al. (n.d.). Financial Management Volume 2.

Other online resources

https://corporatefinanceinstitute.com/resources/knowledge/valuation/corporate-bond-valuation/
https://efinancemanagement.com/investment-decisions/bond-valuation
https://www.youtube.com/watch?v=I7FDx4DPapw
https://www.youtube.com/watch?v=5L_zQGPNXOk

BAFIMARX – Topic 7 11