Bond Valuation An Overview

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 Chapter overview

Introduction to bonds and bond markets

» What are they? Some examples

Zero coupon bonds

» Valuation
» Interest rate sensitivity

Coupon bonds
» Valuation
» Interest rate sensitivity

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 What is a Bond?

A bond is a security that obligates the issuer to make specified interest

and principal payments to the holder on specified dates.
» Coupon rate
» Face value (or par)
» Maturity (or term)
» Interest rate
Bonds are also called fixed income securities.
Bonds differ in several respects:
» Repayment type
» Issuer
» Maturity
» Security
» Priority in case of default
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 Repayment Schemes/Types
Pure Discount or Zero-Coupon Bonds
» Pay no coupons prior to maturity.
» Pay the bond’s face value at maturity.
Coupon Bonds
» Pay a stated coupon at periodic intervals prior to maturity.
» Pay the bond’s face value at maturity.
Floating-Rate Bonds
» Pay a variable coupon, reset periodically to a reference rate.
» Pay the bond’s face value at maturity.
Perpetual Bonds (Consols)
» No maturity date.
» Pay a stated coupon at periodic intervals.
Annuity or Self-Amortizing Bonds
» Pay a regular fixed amount each payment period.
» Principal repaid over time rather than at maturity.

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 Types of Bonds: Issuers

Bonds Issuer
Government Bonds Government Agencies
Mortgage-Backed Securities Government agencies
Municipal Bonds State and local government
Corporate Bonds Corporations
Asset-Back Securities Corporations

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 Government Bonds

Treasury Bills
» No coupons (zero coupon security)
» Face value paid at maturity
» Maturities up to one year
» Low risk and high liquidity
Treasury Notes
» Coupons paid semiannually/quarterly
» Face value paid at maturity
» Maturities from 2-10 years

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 Government Bonds (Cont.)
Treasury Bonds
» Coupons paid semiannually
» Face value paid at maturity
» Maturities over 10 years
» The 30-year bond is called the long bond.
Treasury Strips (sell at discount and pay full amount at
maturity)
» Zero-coupon bond
» Created by “stripping” the coupons and principal from Treasury
bonds and notes.
No default risk. Considered to be risk free.
Exempt from state and local taxes.
Sold regularly through a network of primary dealers.
Traded regularly in the over-the-counter market. 7
 Corporate Bonds

Bonds issued by corporations

» Bonds vs. Debentures
» Fixed-rate versus floating-rate bonds.
» Investment-grade vs. Below investment-grade bonds.
» Additional features:
– call provisions
– convertible bonds
– puttable bonds

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 Seniority of Corporate Bonds

In case of default, different classes of bonds have different

claim priority on the assets of a corporation.

Secured Bonds (Asset-Backed)

» Secured by real property.
» Ownership of the property reverts to the bondholders upon default.

Debentures
» Same priority as general creditors.
» Have priority over stockholders, but subordinate to secured debt.

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 Bond Ratings

Moody’s S&P Quality of Issue

Aaa AAA Highest quality. Very small risk of default.
Aa AA High quality. Small risk of default.
A A High-Medium quality. Strong attributes, but potentially
vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially
unreliable.
Ba BB Some speculative element. Long-run prospects
questionable.
B B Able to pay currently, but at risk of default in the future.
Caa CCC Poor quality. Clear danger of default.
Ca CC High speculative quality. May be in default.
C C Lowest rated. Poor prospects of repayment.
D - In default.
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 Bond Valuation: Zero Coupon Bonds
P = Market price of the Zero-coupon bond
FV= Face value
i = Interest rates
N = Number of compounding periods

What is the price of a Zero-coupon/discount bond?

Use present value formula:

P= FV
(1+i)N

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 Valuing Zero Coupon Bonds:
An Example
Value a 5 year, U.S. Treasury strip with face value of $1,000. The i=10% with
annual compounding? What about quarterly compounding?

If i = 12%, what will be the price of a zero-coupon bond if the maturity period
is 10 years? Whether there is any relationship between i and price of the zero-
coupon bond?

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 Valuing Coupon Bonds

Current price of coupon bonds (P)

1 1  
=CF − n + n  F 
 i(1+i)  (1+i) 
i

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 Valuing Coupon bonds - Example
Consider a bond pays 10% coupon rate with 5 years maturity period
and $1000 face value. The interest rate of the bond is i=12%. What
will be the price of the bond?

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Valuation of coupon bonds: if compounded
more than one per year (m=1)

The application of EIR in calculating the price

e.g., If ABC bond pays 10% coupon per year and the coupon
payment is made quarterly with 12% discount rate, what will be the
price of the coupon bond?

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Yield to Maturity (YTM)

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 Example:
If CR is 10% and FV is $1000 and the maturity period of the bond is
5 years with current market price $928. What will be the YTM of the
coupon bond? YTM = 11.86%

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