ACC 153: VALUATION CONCEPTS AND METHODS

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CHAPTER V: BONDS AND THEIR VALUATION

Chapter V: Bonds and Their Valuation

What is a Bond?
- 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.
- back when bonds were ornate, they were engraved pieces of paper rather than electronic
information stored on a computer. Each bond had a number of small (1/2 by 1 inch) dated
coupons attached to them, and on each interest payment date, the owner of the bond
would clip the coupon for that date and send it to the company’s paying agent, and receive
a check for the interest.
Types of Bonds
1. Treasury Bonds
- bonds that are issued by the government
2. Corporate Bonds
- bonds issued by business firms
3. Municipal Bonds / Munis
- Bonds issued by state and local governments
4. Foreign Bonds
- issued by a foreign government or a foreign corporation
Key Characteristics of Bonds
1. Par Value
- the stated face value of the bond
2. Coupon Interest Rate
- The stated annual interest rate on a bond
3. Maturity Date
- A specific date on which the par value of a bond must be repaid
4. Call Provisions
- 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.
5. Sinking Fund Provision
- A provision in a bond contract that requires the issuer to retire a portion of the
bond issue each year
Handling Sinking Fund Requirement
1. Call in for redemption at par value
2. Buy the required number of bonds on the open market

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CHAPTER V: BONDS AND THEIR VALUATION

Pros: Sinking funds are designed to protect investors by ensuring that the bonds are retired in
an orderly fashion.

Cons: Sinking funds work to the detriment of bondholders if the bonds coupon rate is higher
than the current market rate

Other Features of Bonds

1. Convertible Bonds
- A bond that is exchangeable at the option of the holder for the issuing firms’
common stock
2. Warrant
- A long-term option to buy a stated number of shares of common stock at a
specified price
3. Callable Bonds
- Gives the issuer the right to retire the debt prior to maturity
4. Putable Bonds
- A bond with a provision that allows its investors to sell it back to the company prior
to maturity at a prearranged price
5. Income Bonds
- A bond that pays interest only if it is earned
6. Indexed / Purchasing Power Bonds
- A bond that has interest payments based on an inflation index so as to protect the
holder from inflation
Bond Valuation
Formula:

Where,
𝑟𝑑 = the market rate of interest on the bond
N = the number of years before the bond matures
INT = dollars/pesos of interest paid each year = (Coupon rate x Par Value)
M = the par or maturity value of the bond

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CHAPTER V: BONDS AND THEIR VALUATION

Illustration:
Andrei invested in an outstanding bond with a 10% annual coupon and a maturity of 15 years.
The bond has a par value of $1,000. What is the value of the bond if the current market rate is
a. 10%
b. 15%
c. 5%?
Solution:
a. current market rate is 10%

b. current market rate is 15%

c. current market rate is 5%

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CHAPTER V: BONDS AND THEIR VALUATION

In summary,

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
Bond Yields
The bond’s yield gives us an estimate of the rate of return we would earn if we purchased the
bond today and held it over its remaining life.
- If the bond is not callable, its remaining life is its years to maturity.
- If it is callable, its remaining life is the years is the years to maturity if it is not
called or the years to call if it is called.
Yield to Maturity (YTM)
- The rate of return earned on a bond if it is held to maturity
Formula:

Illustration:
You are offered a 14-year, 10% annual coupons, $1,000 par value bond at a price of $1,494.93.
What rate of interest would you earn on your investment if you bought the bond, held it to
maturity, and received the promised interest and maturity payments?
Solution:

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CHAPTER V: BONDS AND THEIR VALUATION

Yield to Call (YTC)

- The rate of return earned on a bond when it is called before its maturity date

Where,
𝑟𝑑 = the yield to call
N = the number of years until the company can call the bond
INT = dollars/pesos of interest paid each year = (Coupon rate x Par Value)
Call Price = the price the company must pay in order to call the bond*
*it is often set equal to the par value plus one year’s interest

Illustration:
Bow Valley’s $1,000 10% coupon bonds had a deferred call provision that permitted the
company if it desired, to call them 10 years after their issue date at a price of $1,100. Interest
rates have fallen from 10% to 5% after 1 year of issuance, causing their price to rise to
$1,494.93. What is the yield to call?
Solution:

Changes in Bond Values Over Time

Bow Valley has 3 equally risky issues that mature in 15 years, current market rate is 10%:

Each of the above 3 bonds has a 15-year maturity, each has the same credit risk; and thus each
has the same market interest rate of 10%. However, the bonds have different prices because of
their different coupon rates.

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CHAPTER V: BONDS AND THEIR VALUATION

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CHAPTER V: BONDS AND THEIR VALUATION

Bonds with Semi Annual Coupons

Illustration:
Andrei invested in an outstanding bond with a coupon rate of 10% with semiannual payments and
a maturity of 15 years. The bond has a par value of $1,000. Current market rate is 5%. What is the
value of the bond?
Solution:

Yield to Maturity for Bonds with Semiannual Coupons

Illustration:
Andrei invested in an outstanding bond with a coupon rate of 10% with semiannual payments and
a maturity of 15 years. The bond has a par value of $1,000. The price of the bond is $1523.26?
What is the yield to maturity?
Solution:

Assessing a Bond’s Riskiness

Two factors that impact a bond’s riskiness:
1. Price Risk
2. Reinvestment Risk

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CHAPTER V: BONDS AND THEIR VALUATION

Price Risk
- The risk of a decline in a bond’s price due to an increased in interest rates

Price risk is higher on bonds that have long maturities than on bonds that will mature in the near
future.
Reinvestment Risk
- The risk that a decline in interest rates will lead to a decline in income from a bond portfolio
Comparing Price Risk and Reinvestment Risk

Investment Horizon
- the period of time an investor plans to hold a particular investment
Default Risk
Quoted interest rates includes a default risk premium – the higher the probability of default, the
higher the premium and the yield to maturity.
Various Types of Corporate Bonds
1. Mortgage Bonds
- A bond backed by fixed assets.
- First mortgage bonds are senior in priority to claims of second mortgage bond.
Indenture
- A formal agreement between the issuer and the bond holders
- It spells out in detail the rights of the bondholder and the corporation
2. Debenture
- A long-term bond that is not secured by a mortgage on specific property.
3. Subordinated Debentures
- A bond having a claim on assets only after the senior debt has been paid in full in
the event of liquidation.

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CHAPTER V: BONDS AND THEIR VALUATION

Bond Ratings
The three major rating agencies are Moody’s Investors Service (Moody’s), Standard and Poor’s
Corporation (S&P), and Fitch Investor’s Service.

Investment Grade Bonds

- bonds rated triple-B or higher
- Many banks and other institutional investors are permitted by law to hold only investment-
grade bonds.
Junk Bonds
- A high-risk, high-yield bond
- Double-B and lower bonds are speculative and they have a significant probability of going
into default.
Determinants of bond ratings
1. Financial ratios
- ratios related to financial risk
2. Qualitative Factors: Bond Contract Terms
- maturity, the coupon interest rate, a statement of whether the bond is secured by
a mortgage on specific assets, any sinking fund provisions, and a statement of
whether the bond is guaranteed by some other party with a high credit ranking
3. Miscellaneous qualitative factors
- sensitivity of the firm’s earnings to the strength of the economy, the way it is
affected by inflation, a statement of whether it is having or likely to have labor
problems, the extent of its international operations (including the stability of the
countries in which it operates), potential environmental problems, and potential
antitrust problems.
Importance of Bond Ratings
1. It is an indicator of its default risk
2. Many institutions are restricted to investment-grade securities.
Bond Markets
a. life insurance companies
b. mutual funds,
c. hedge funds, and
d. pension funds

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CHAPTER V: BONDS AND THEIR VALUATION

Accrued Interest and The Pricing of Coupon Bonds

Accrued interest represents the amount of interest that has accumulated between coupon payments

Clean price - Quoted price, net of accrued interest

dirty price - Actual invoice price (clean price + accrued interest)
Illustration:
On May 11, 2012, you bought an 8% semiannual 5-year corporate bond that was originally
issued on February 22, 2011 with a par value of $1,000. How much is the accrued interest on the
bond? What is the bond’s clean price and dirty price?
Solution:

References:
Brigham, Eugene and Houston, Joel F. 2015. Fundamentals of Financial Management. Thirteenth
edition. C&E Publising, Inc. Quezon City, Philippines

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