Bonds and Their Valuation

Hyder Ali (PhD, FHEA)

1
Sources of Financing

Equity

Debt
• Short-term
• Long-term
• Term Loans
• Loans obtained from a bank or insurance company, on which the borrower agrees to
make a series of payments, consisting of interest and principal, on specific dates
• Bonds
• A long-term contract where a borrower agrees to make payments of interest and
principal on specific dates to the bondholder (investor)

2
Bond and Financial System

3
 Issuer of Bonds

Indenture - A formal agreement between the

issuer of a bond and the bondholders

Indenture specifies the important features of a

bond, such as its maturity date, the timing of
interest payments, method of interest calculation,
callability, and convertible features, if applicable.
A bond indenture also contains all the terms and
conditions applicable to the bond issue.
4
 Short-, Medium-,
Maturity
Long-term

Secured Mortgage

Security
Debenture
Unsecured
Corporate Bond

Subordinated
Debenture
Zero

Interest Fixed Income

Floating Inflation (Indexed)

Investment grade Interest

Credit Rating
Junk

Callable
Options
Putable 5
 Par/Face Value Zero

Bond’s Coupon Fixed

Features Sinking Fund

Provision
[Amortization]
Floating

Annual
Coupon
Key Frequency
Semi-annual
Features of a Bond

Maturity
Current yield
(CY)
(Indenture)

Capital Gain
yield (CGY)
Yield
Yield to Maturity
(YTM)
Credit Ratings
Yield to Call
(YTC)

To Issuer Call Provision

Embedded
Others Options
Put Provision

To holder Convertible

Warrant 6
 Investors who are interested in equity but uncertain about the future are

Features of Bond encouraged by convertible bonds and warrants. Provide debt, but if the
business does well, you can become a shareholder in it.

Convertible Bond Warrant

Convertible bonds give their owner the right to
exchange the bonds for a set quantity of shares of
stock in the same company.
Example: A 1000 par value can be converted with
10 shares. If stock price in market is 120 per share.
Bondholder can convert bond into shares by getting
10 shares. Bondholder then can sell the 10 shares
in the market at 120 each, a gain of 20 per share.
• Convertibility option is embedded into bond [cannot
be separated]
• Company needs to issue new shares against the value
of the bond.
• Total shares outstanding would increase
• Debt will reduce by 1000 and equity will increase by
1000
A warrant is a security giving its owner the right to
buy a certain number of shares at a set price
directly from the issuing company.
• Warrants are attached to the bond not
embedded
• Warrants can trade separately
Example: A 1000 par value provides holder option
to buy 10 shares of firm at a price of 100 each in 5
years time.
The share price after 5 years is 120.
Now holder has the option to hold the bond till
maturity but exercise the warrant by buying 10
shares of firm at 100 each. A profit of 20 per share.
• Company needs to issue new shares.
• Total shares outstanding and equity would increase
7
Identify the bond
• A six year bond with a par value of 1000 not paying any Interest,
selling at 750.

• A six year bond with a par value of 1000 paying 10% interest annually.
The required rate of return is 15%.

• A six year bond with a par value of 1000 paying 10% interest semi-
annually. The required rate of return is 15%.

8
Identify the bond
• A six year bond with a par value of 1000 not paying any Interest, selling at 750.
• Zero-coupon bond = Not paying any interest (coupon) through life of bond.
• Feature = Must be selling at discount [Selling Price < Par Value]
• Return = Same as i in single-sum FV formula → FV = PV (1+i)n

• A six year bond with a par value of 1000 paying 10% interest annually. The
required rate of return is 15%.
• Coupon Bond with annual coupon payments
• Coupon = Par x Coupon rate = 1000 x 0.1 = 100
• A six year bond with a par value of 1000 paying 10% interest semi-annually. The
required rate of return is 15%.
• Coupon Bond with semi-annual coupon payments
• Semi-annual Coupon = (Par x Coupon rate)/2 = (1000 x 0.1)/2 = 100/2 = 50

9
What is the opportunity cost of debt capital?

• The discount rate (rd ) is the opportunity cost of capital, and is the
rate that could be earned on alternative investments of equal
risk.

rd = r* + IP + MRP + DRP + LP

10
 Bond Valuation [Zero-Coupon Bond]
0 1 2 3 4 5 6
A six year bond with a par value of
1000 not paying any Interest, selling (750) 1000
at 750.

11
 Bond Valuation [Zero-Coupon Bond]
0 1 2 3 4 5 6
A six year bond with a par value of
1000 not paying any Interest, selling (750) 1000
at 750.

12
 Bond Valuation
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 15%.

13
 Bond Valuation
A six year bond with a par value of 0 1 2 3 4 5 6
1000 paying 10% coupon rate. The
required rate of return is 15%. 100 100 100 100 100 100
+
1000

14
 Bond Valuation
A six year bond with a par value of 0 1 2 3 4 5 6
1000 paying 10% coupon rate. The
required rate of return is 15%. 100 100 100 100 100 100
+
1000

15
 Bond Valuation
A six year bond with a par value of 0 1 2 3 4 5 6
1000 paying 10% coupon rate. The
required rate of return is 15%. 100 100 100 100 100 100
+
1000
Years 6
m 1
Par 1000
CR 10%
rd = YTM 15%
Price ?
Periodic
N 6
I 100
rd = YTM 15.00%

PVF 0.43
PVFA 3.78

PV (Interest) 378.45
Question: PV (Par) 432.33
What about value of bond if Coupon is paid semi- Price 810.78

annually? What would be effective annual rate? 16

 Bond Valuation
A six year
bond with a
par value of
1000 paying
10% coupon
rate semi-
annually. The
required rate
of return is
15%.

17
 Bond Valuation
A six year 0 1 2 3 4 5 6 7 8 9 10 11 12
bond with a
Price 50 50 50 50 50 50 50 50 50 50 50 50
par value of +
1000 paying 1000

10% coupon
rate semi-
annually. The
required rate
of return is
15%.

18
 Bond Valuation
A six year 0 1 2 3 4 5 6 7 8 9 10 11 12
bond with a
Price 50 50 50 50 50 50 50 50 50 50 50 50
par value of +
1000 paying 1000

10% coupon Years

m
6
2
rate semi- Par 1000
CR 10.00%
annually. The rd = YTM 15.00%
Price ?
required rate Effective Annual Rate Periodic

of return is N
I
12
50

15%. rd = YTM 7.50%

PVF 0.42
PVFA 7.74

PV (Interest) 386.76
PV (Par) 419.85
Price 806.62

19
Selling Price of Bond

20
Selling Price of Bond
• Selling at Par → Price = Par [Coupon Rate = Discount Rate]
• Selling at Discount → Price < Par [Coupon Rate < Discount Rate]
• Selling at Premium → Price > Par [Coupon Rate > Discount Rate]

• Think about the previous example:

• Selling at Par, Discount or Premium?
• Price = 810.8 [Six years to maturity; CR=10%; rd=15%]

21
Yield (Return) on Bond

22
Yield (Return) on Bond

23
Bond Price at Different Time Remaining to Maturity
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 15%.
Required: Find price when 6, 5, 4, 3,
2, 1, 0 years remaining t maturity.

24
Bond Price at Different Time Remaining to Maturity
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 15%.
Required: Find price when 6, 5, 4, 3,
2, 1, 0 years remaining t maturity.

0 1 2 3 4 5 6

100 100 100 100 100 100

+
1000

Price 810.8 832.4 857.3 885.8 918.7 956.5 1000

25
Bond Yield’s
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 15%.
Required: Find CY & CGY when 6, 5,
4, 3, 2, 1, 0 years remaining t
maturity.
0 1 2 3 4 5 6

100 100 100 100 100 100

+
1000

Price 810.8 832.4 857.3 885.8 918.7 956.5 1000

Capital Gain Yield (CGY) 2.67% 2.99% 3.33% 3.71% 4.12% 4.55%
Current Yield (CY) 12.33% 12.01% 11.67% 11.29% 10.88% 10.45%
YTM (CGY+CY) 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
26
Bond Yield’s
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 15%.
Required: Find CY & CGY when 6, 5,
4, 3, 2, 1, 0 years remaining t
maturity.
0 1 2 3 4 5 6

100 100 100 100 100 100

+
1000

Price 810.8 832.4 857.3 885.8 918.7 956.5 1000

Capital Gain Yield (CGY) 2.67% 2.99% 3.33% 3.71% 4.12% 4.55%
Current Yield (CY) 12.33% 12.01% 11.67% 11.29% 10.88% 10.45%
YTM (CGY+CY) 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
27
 0 1 2 3 4 5 6
Bond’s Yield to Maturity
(830) 100 100 100 100 100 100
A six year bond with a par value of 1000 paying 10% +
coupon rate is being sold in the market at 830. 1000
Required: What is the return to investor, if bond is Outflow Inflows

held till maturity?

28
 0 1 2 3 4 5 6
Bond’s Yield to Maturity
(830) 100 100 100 100 100 100
A six year bond with a par value of 1000 paying 10% +
coupon rate is being sold in the market at 830. 1000
Required: What is the return to investor, if bond is Outflow Inflows

held till maturity?

Method 1: Trial and error

29
 0 1 2 3 4 5 6
Bond’s Yield to Maturity
(830) 100 100 100 100 100 100
+
Method 1: Trial and error 1000
Outflow Inflows

30
 0 1 2 3 4 5 6
Bond’s Yield to Maturity
(830) 100 100 100 100 100 100
+
Method 1: Trial and error 1000
Outflow Inflows

31
 0 1 2 3 4 5 6
Bond’s Yield to Maturity
(830) 100 100 100 100 100 100
A six year bond with a par value of 1000 paying 10% +
coupon rate is being sold in the market at 830. 1000
Required: What is the return to investor, if bond is Outflow Inflows

held till maturity?

Method 2: Approximation Formula

32
 0 1 2 3 4 5 6
Bond’s Yield to Maturity
(830) 100 100 100 100 100 100
A six year bond with a par value of 1000 paying 10% +
coupon rate is being sold in the market at 830. 1000
Required: What is the return to investor, if bond is Outflow Inflows

held till maturity?

Method 2: Approximation Formula

33
 Bond’s Yield to Maturity
0 1 2 3 4 5 6
A six year bond with a par value of
1000 paying 10% coupon rate is (810.8) 100 100 100 100 100 100
being sold in the market at 810.8. +
Required: What is the return to 1000
investor, if bond is held till maturity? Outflow Inflows

Method 2: Approximation Formula

34
Bond Valuation [Selling at Premium → CR>Rd]
A six year bond with a par value of 0 1 2 3 4 5 6
1000 paying 10% coupon rate. The
required rate of return is 6%. 100 100 100 100 100 100
+
1000
Par 1000
CR 10%
N 6
y 6%
C=I 100
PVF 0.70
PVFA 4.92
PV (I) 491.73
PV (Par) 704.96
Price 1196.69

35
Bond Price at Different Time Remaining to Maturity
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 6%.
Required: Find price when 6, 5, 4, 3,
2, 1, 0 years remaining t maturity.

36
Bond Price at Different Time Remaining to Maturity
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 6%.
Required: Find price when 6, 5, 4, 3,
2, 1, 0 years remaining t maturity.

0 1 2 3 4 5 6

100 100 100 100 100 100

+
1000

Price 1196.7 1168.5 1138.6 1106.9 1073.3 1037.7 1000 37

Bond Yield’s
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 6%.
Required: Find CY and CGY when 6,
5, 4, 3, 2, 1, 0 years remaining t
maturity.
0 1 2 3 4 5 6

100 100 100 100 100 100

+
1000

Price 1196.7 1168.5 1138.6 1106.9 1073.3 1037.7 1000

Capital Gain Yield (CGY) -2.36% -2.56% -2.78% -3.03% -3.32% -3.64%
Current Yield (CY) 8.36% 8.56% 8.78% 9.03% 9.32% 9.64%
YTM (CGY+CY) 6.00% 6.00% 6.00% 6.00% 6.00% 6.00% 38
Bond Yield’s
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 6%.
Required: Find CY and CGY when 6,
5, 4, 3, 2, 1, 0 years remaining t
maturity.
0 1 2 3 4 5 6

100 100 100 100 100 100

+
1000

Price 1196.7 1168.5 1138.6 1106.9 1073.3 1037.7 1000

Capital Gain Yield (CGY) -2.36% -2.56% -2.78% -3.03% -3.32% -3.64%
Current Yield (CY) 8.36% 8.56% 8.78% 9.03% 9.32% 9.64%
YTM (CGY+CY) 6.00% 6.00% 6.00% 6.00% 6.00% 6.00% 39
Bond Price and Yield’s [CR = Rd] Selling at Par
A six year bond with a par value of
1000 paying 10% coupon rate. The
required rate of return is 10%.
Required: Find price when 6, 5, 4, 3,
2, 1, 0 years remaining t maturity.

0 1 2 3 4 5 6

100 100 100 100 100 100

+
1000

Price 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000

Capital Gain Yield (CGY) 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Current Yield (CY) 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
YTM (CGY+CY) 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
40
Price vs Years remaining to maturity

N Par Premium Discount

6 1000.0 1196.7 810.8
5 1000.0 1168.5 832.4
4 1000.0 1138.6 857.3
3 1000.0 1106.9 885.8
2 1000.0 1073.3 918.7
1 1000.0 1037.7 956.5
0 1000.0 1000.0 1000.0

CR = 10% CR = 10% CR = 10%

Rd = 10% Rd = 6% Rd = 15%

41
 Relationship between Price and Interest Rate
A 20 years bond with a par value of 1000 paying 10% coupon rate.
Required: Find price when y = 1%, 2%, 3%, . . . . . . ., 20%.

42
 Relationship between Price and Interest Rate
A 20 years bond with a par value of 1000 paying 10% coupon rate.
Required: Find price when y = 1%, 2%, 3%, . . . . . . ., 20%.
rd Price Δ in Price
1% 2624.1
P 2% 2308.1 -12.04%
r 3% 2041.4 -11.55%
e 4% 1815.4 -11.07%
m 5% 1623.1 -10.59%
i 6% 1458.8 -10.12%
u 7% 1317.8 -9.66%
m 8% 1196.4 -9.22%
9% 1091.3 -8.78%
Par 10% 1000.0 -8.36%
11% 920.4 -7.96%
D 12% 850.6 -7.58%
i 13% 789.3 -7.21%
s 14% 735.1 -6.87%
c 15% 687.0 -6.54%
o 16% 644.3 -6.22%
u 17% 606.1 -5.93%
n 18% 571.8 -5.66%
t 19% 540.9 -5.40%
43
20% 513.0 -5.15%
 Relationship between Price and Interest Rate
A 20 years bond with a par value of 1000 paying 10% coupon rate.
Required: Find price when y = 1%, 2%, 3%, . . . . . . ., 20%.
rd Price Δ in Price
1% 2624.1
P 2% 2308.1 -12.04%
r 3% 2041.4 -11.55%
e 4% 1815.4 -11.07%
m 5% 1623.1 -10.59%
i 6% 1458.8 -10.12%
u 7% 1317.8 -9.66%
m 8% 1196.4 -9.22%
9% 1091.3 -8.78%
Par 10% 1000.0 -8.36%
11% 920.4 -7.96%
D 12% 850.6 -7.58%
i 13% 789.3 -7.21%
s 14% 735.1 -6.87%
c 15% 687.0 -6.54%
o 16% 644.3 -6.22%
u 17% 606.1 -5.93%
n 18% 571.8 -5.66%
t 19% 540.9 -5.40%
44
20% 513.0 -5.15%
 Relationship between Price and Interest Rate
A bond with a par value of 1000 paying 10% coupon rate.
Required: Find price when y = 2%, 4%, 6%, . . . . . . ., 20%. And N = 1 and 10

45
 Relationship between Price and Interest Rate
A bond with a par value of 1000 paying 10% coupon rate.
Required: Find price when y = 2%, 4%, 6%, . . . . . . ., 20%. And N = 1 and 10

46
 Relationship between Price and Interest Rate
A bond with a par value of 1000 paying 10% coupon rate.
Required: Find price when y = 2%, 4%, 6%, . . . . . . ., 20%. And N = 0, 1, 2, 3, . . . . . , 10

47
 Relationship between Price and Interest Rate
A bond with a par value of 1000 paying 10% coupon rate.
Required: Find price when y = 2%, 4%, 6%, . . . . . . ., 20%. And N = 0, 1, 2, 3, . . . . . , 10
Years Remaining to Maturity
687.03 0 1 2 3 4 5 6 7 8 9 10
I 2% 1000.0 1078.4 1155.3 1230.7 1304.6 1377.1 1448.1 1517.8 1586.0 1653.0 1718.6
n 4% 1000.0 1057.7 1113.2 1166.5 1217.8 1267.1 1314.5 1360.1 1404.0 1446.1 1486.7
t 6% 1000.0 1037.7 1073.3 1106.9 1138.6 1168.5 1196.7 1223.3 1248.4 1272.1 1294.4
e 8% 1000.0 1018.5 1035.7 1051.5 1066.2 1079.9 1092.5 1104.1 1114.9 1124.9 1134.2
r 10% 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0
e 12% 1000.0 982.1 966.2 952.0 939.3 927.9 917.8 908.7 900.6 893.4 887.0
s 14% 1000.0 964.9 934.1 907.1 883.5 862.7 844.5 828.5 814.4 802.1 791.4
t 16% 1000.0 948.3 903.7 865.2 832.1 803.5 778.9 757.7 739.4 723.6 710.0
18% 1000.0 932.2 874.7 826.1 784.8 749.8 720.2 695.1 673.8 655.8 640.5
R 20% 1000.0 916.7 847.2 789.4 741.1 700.9 667.4 639.5 616.3 596.9 580.8
a 22% 1000.0 901.6 821.0 754.9 700.8 656.4 620.0 590.1 565.7 545.6 529.2
t 24% 1000.0 887.1 796.0 722.6 663.4 615.6 577.1 546.1 521.0 500.8 484.5
e 26% 1000.0 873.0 772.2 692.2 628.8 578.4 538.4 506.7 481.5 461.5 445.6
Δ in Price 6% to 8% 0.00% -1.85% -3.51% -5.00% -6.36% -7.59% -8.71% -9.74% -10.69% -11.57% -12.38%

48
 Relationship between Price and Interest Rate
A bond with a par value of 1000 paying 10% coupon rate.
Required: Find price when y = 1%, 2%, 3%, 6%, . . . ., 20%. And N = 0, 1, 2, 3, . . . . . , 10
Years Remaining to Maturity
687.03 0 1 2 3 4 5 6 7 8 9 10
I 1% 1000.0 1089.1 1177.3 1264.7 1351.2 1436.8 1521.6 1605.5 1688.7 1770.9 1852.4
n 2% 1000.0 1078.4 1155.3 1230.7 1304.6 1377.1 1448.1 1517.8 1586.0 1653.0 1718.6
t 3% 1000.0 1068.0 1133.9 1198.0 1260.2 1320.6 1379.2 1436.1 1491.4 1545.0 1597.1
e 4% 1000.0 1057.7 1113.2 1166.5 1217.8 1267.1 1314.5 1360.1 1404.0 1446.1 1486.7
r 5% 1000.0 1047.6 1093.0 1136.2 1177.3 1216.5 1253.8 1289.3 1323.2 1355.4 1386.1
e 6% 1000.0 1037.7 1073.3 1106.9 1138.6 1168.5 1196.7 1223.3 1248.4 1272.1 1294.4
s 8% 1000.0 1018.5 1035.7 1051.5 1066.2 1079.9 1092.5 1104.1 1114.9 1124.9 1134.2
t 10% 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0 1000.0
12% 1000.0 982.1 966.2 952.0 939.3 927.9 917.8 908.7 900.6 893.4 887.0
R 14% 1000.0 964.9 934.1 907.1 883.5 862.7 844.5 828.5 814.4 802.1 791.4
a 16% 1000.0 948.3 903.7 865.2 832.1 803.5 778.9 757.7 739.4 723.6 710.0
t 18% 1000.0 932.2 874.7 826.1 784.8 749.8 720.2 695.1 673.8 655.8 640.5
e 20% 1000.0 916.7 847.2 789.4 741.1 700.9 667.4 639.5 616.3 596.9 580.8
Δ in Price 3% to 4% 0.00% -0.96% -1.83% -2.63% -3.36% -4.05% -4.69% -5.29% -5.86% -6.40% -6.92%
Δ in Price 3% to 2% 0.00% 0.98% 1.89% 2.73% 3.52% 4.28% 5.00% 5.68% 6.35% 6.99% 7.61%
49
Issuer’s (Firm) Options If Interest Rates Falls
• ABC firm issues a 20 years bond with 10% Coupon Rate.
• At the time of issuance y=10%, bond sold at par.
• In 5 years’ time interest rate falls to 8%.
• Firm’s loss or gain?
• Loss to firm:
• Others can borrow at a rate of 8%
• Firm has to pay 10%
• A loss of 2%
• If provided in agreement:
• Firm can call the bonds issued at 10% coupon and reissue new bonds at 8%.
• But why investors (Lenders/bondholders) would sell their bonds?
• Investors would get call premium
• Instead of getting 1000 par value; they may get 10% premium means 1100

50
Issuer’s (Firm) Options If Interest Rates Falls
• ABC firm issues a 20 years bond with 10% Coupon Rate.
• At the time of issuance y=10%, bond sold at par.
• In 5 years’ time interest rate falls to 8%.
• Firm’s loss or gain?
• Loss to firm:
• Others can borrow at a rate of 8%
• Firm has to pay 10%
• A loss of 2%
• If provided in agreement:
• Firm can call the bonds issued at 10% coupon and reissue new bonds at 8%.
• But why investors (Lenders/bondholders) would sell their bonds?
• Investors would get call premium
• Instead of getting 1000 par value; they may get 10% premium means 1100

51
Issuer’s (Firm) Options If Interest Rates Falls
• ABC firm issues a 20 years bond with 10% Coupon Rate.
• At the time of issuance y=10%, bond sold at par.
• In 5 years’ time interest rate falls to 8%.
• Firm’s loss or gain?
• Loss to firm:
• Others can borrow at a rate of 8%
• Firm has to pay 10%
• A loss of 2%
• If provided in agreement:
• Firm can call the bonds issued at 10% coupon and reissue new bonds at 8%.
• But why investors (Lenders/bondholders) would sell their bonds?
• Investors would get call premium
• Instead of getting 1000 par value; they may get 10% premium means 1100

52
 0
Bond’s Yield to Call 1 2 3 4 5 6

(830) 100 100 100 100 100 100

A six year bond with a par value of 1000 paying 10% + +
coupon rate is being sold in the market at 830. 1100 1000
Required: What is the return to investor, if bond is Outflow Inflows
called by company in 4 years at 10% premium?

53
 0
Bond’s Yield to Call 1 2 3 4 5 6

(830) 100 100 100 100 100 100

A six year bond with a par value of 1000 paying 10% + +
coupon rate is being sold in the market at 830. 1100 1000
Required: What is the return to investor, if bond is Outflow Inflows
called by company in 4 years at 10% premium?

Method 1: Trial and Error

54
 0
Bond’s Yield to Call 1 2 3 4 5 6

(830) 100 100 100 100 100 100

Method 1: Trial and Error + +
1100 1000
Outflow Inflows

55
 0
Bond’s Yield to Call 1 2 3 4 5 6

(830) 100 100 100 100 100 100

Method 1: Trial and Error + +
1100 1000
Outflow Inflows

56
 0
Bond’s Yield to Call 1 2 3 4 5 6

(830) 100 100 100 100 100 100

Method 2: Approximation Formula + +
1100 1000
Outflow Inflows

57
Yield To Call
• In the previous example with 6 years bonds selling at 830, callable at
1100 in 4 years time
• YTM = 14.43%
• YTC = 18.27%

• Should firm call the bonds in 4 years time?

58
Yield To Call
• In the previous example with 6 years bonds selling at 830, callable at
1100 in 4 years time
• YTM = 14.43%
• YTC = 18.27%

• Should firm call the bonds in 4 years time?

• Answer: No
• If bonds are called, firms would pay 18.27% on bonds, whereas if bonds are
held till maturity, firms would be 14.43%.
• Firms can only call bonds if ytm > ytc

59
When is a call more likely to occur?
• In general, if a bond sells at a premium, then (1) coupon > rd, so (2) a
call is more likely.
• As an investor, expect to earn:
• YTC on premium bonds. [Because bonds are expected to be called before
maturity]
• YTM on par & discount bonds.

• Question:
• From where to get money to call (buyback or repurchase) bonds?

60
When is a call more likely to occur?
• In general, if a bond sells at a premium, then (1) coupon > rd, so (2) a
call is more likely.
• As an investor, expect to earn:
• YTC on premium bonds. [Because bonds are expected to be called before
maturity]
• YTM on par & discount bonds.

• Question:
• From where to get money to call (buyback or repurchase) bonds?
• Answer:
• Sinking Fund

61
Investor’s
perspective Putable Bonds

Additional features Convertibles

Warrants
For Investor

Yield to maturity = YTM = Current

Held up-to-maturity Yield + Capital Gain Yield
Return known as
Reward
Yield
Called by firm before
Yield to Call = YTC
maturity

Price or Interest rate

Risk
Market-related
Reinvestment Risk
Risk

Firm-specific Default risk

62
 Risks Associated with Bond Investing
Interest rate risk the risk that interest rates will rise, thereby reducing a bond’s price (also called market risk)

Reinvestment risk the risk that the interest rate at which intermediate cash flows can be reinvested will fall.

Call risk the risk the issuer may “call” or retire all or part of the issue before the maturity date.
Risks in Bonds

Default risk risk the issuer does not repay part or all of its financial obligation. [Credit Ratings]

the risk that the purchasing power of a bond’s cash flows may decline. Floating rate bonds have a
Inflation risk lower level of inflation risk than coupon bonds.

if a bond is denominated in a foreign currency (e.g., the euro), the value of the cash flows in US$
Exchange risk will be uncertain.

Liquidity risk the risk that the bond cannot be sold with ease at (or near) its current value

Volatility risk the value of embedded options is determined partly by the volatility of interest rates.

The risk/return characteristics of innovative securities are not always understood. Risk risk is “not
Risk risk knowing what the risk of a security is.”
63
 Market-related Risks in Bond Investment
• Price or Interest Rate Risk
• If interest rates increase → Price of bond would fall
• Reinvestment risk
• If interest rates decrease → Reinvestment of received
interest rates would be made at lower rates.

• Increase in interest rate

• Prices would fall → Capital Loss
• The received coupon (Interest) would be reinvested at
new higher rates [Gain]
• Decrease in interest rate
• Prices would increase → Capital Gain
• The received coupon (Interest) would be reinvested at
new lower rates [Loss]

64
Firm-specific (Default) Risk in Bond Investment
• Default risk is the risk that a lender takes on in the chance that a
borrower will be unable to make the required payments on their debt
obligation.

65
• https://www.infomerics.com/rating-methodology 66
Evaluating default risk:
Bond ratings
Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

• Bond ratings are designed to reflect the

probability of a bond issue going into default.

67
Factors affecting Debt ratio

default risk and Financial performance TIE ratio

bond ratings Current ratio

Determinants of Default risk

Secured vs. Unsecured debt

Senior vs. subordinated debt

Bond contract provisions
Guarantee and sinking fund provisions

Debt maturity

Earnings stability

Regulatory environment

Potential antitrust or product liabilities

Other Factors can result in
Product liability is the legal liability a penalties
manufacturer or trader incurs for Pension liabilities
producing or selling a faulty product.

Antitrust laws are regulations that

Potential labor problems
encourage competition by limiting the
market power of any particular firm. Accounting policies 68
 Private • Par
• Coupon – (Fixed, Floating, Zero)
Issuer • Maturity
Net-saver Public • Yield to maturity
• Call Provision
• Sinking Fund Provision [Retire early]
Investment • Through Call
Key • Buy from market

Features • Convertible
Human Financial Real • Warrant
Others
• Puttable
Equity Debt • Income Bond
• Index Bond
CFs Interest + Par
• Interest = f (Inflation)
Discount Rd = Rf + Risk Selling at:
Valuation Rate premium
Bond • Par (rd = CR)
• Discount (rd > CR)
Bond Yield • Premium (rd < CR)
• Current Yield (CY)
Equity Debt • Yield to Maturity (YTM)
• Yield to Call (YTC)
• Capital Gain Yield (CGY)
Financing
Δ in Bond’s Price
Overtime
Net Borrowers Price (Interest rate) risk
Bond’s Riskiness
Reinvestment risk
Default Risk 69
Problems and Solutions

70
Topics
• Bond Valuation
• Yields
• Bond Valuation and Yields
• Interest Rate Sensitivity

71
Formulas
• Price of Bond

72
Formulas
• Yield to Maturity
• The rate of return earned on a bond if it is held to
maturity.
• Finding rd = ytm = y; when Price of Bond, Interest
payments, Maturity and Par value are given.
• Trial and Error Method

• Approximation Formula

73
Formulas
• Yield to Call
• The rate of return earned on a bond when it is
called before its maturity date.
• Finding rd = ytc = y; when Price of Bond, Interest payments,
Maturity and Call Price are given.
• Trial and Error Method

• Call Price = Par x (1+Call Premium)

74
Formulas
• Current Yield = CY

• Capital Gain Yield

• Total Yield = ytm = Current Yield + Capital Gain Yield

75
Bond valuation

76
77
Years 23
m 1
Par 1000
CR 9%
YTM 11%
Price ?
Periodic
N 23
I 90
YTM 11.00%

PVF 0.091
PVFA 8.266

PV (Interest) 743.979
PV (Par) 90.693
Price 834.671
78
79
Years 14
m 2
Par 1000
CR 8%
YTM 11%
P ?
Periodic
N 28
I 40
YTM 5.50%

PVF 0.223
PVFA 14.121

PV (Interest) 564.857
PV (Par) 223.322
Price 788.179

80
81
82
 Bond L Bond S
N 12 12 12 N 1 1 1
m 1 1 1 m 1 1 1
Par 1000 1000 1000 Par 1000 1000 1000
CR 11% 11% 11% CR 11% 11% 11%
YTM 6% 8% 12% YTM 6% 8% 12%
Price ? ? ? Price ? ? ?
Periodic Periodic
N 12 12 12 N 1 1 1
I 110 110 110 I 110 110 110
YTM 0.06 0.08 0.12 YTM 0.06 0.08 0.12

PVF 0.497 0.397 0.257 PVF 0.943 0.926 0.893

PVFA 8.384 7.536 6.194 PVFA 0.943 0.926 0.893

PV (Interest) 922.223 828.969 681.381 PV (Interest) 103.774 101.852 98.214

PV (Par) 496.969 397.114 256.675 PV (Par) 943.396 925.926 892.857
Price 1419.192 1226.082 938.056 Price 1047.170 1027.778 991.071

Change -13.61% -23.49% Change -1.85% -3.57%

83
84
85
 Par 1000 1000
CR 11.50% 0%
YTM 8.20% 8.20%
I 115 0

Years to Maturity Price C Price Z

4 1108.82 729.61
3 1084.74 789.44
2 1058.69 854.17
1 1030.50 924.21
86
0 1000 1000
87
88
89
 Step 1: Amount of Money at which bond would be sold in 5 years
N 15
Our Problem: Price today based on m 1 Step 2: Maximum Price willing to pay
the next 5 years of CFs Par 1000 Rd 9%
CR 8% CF DF
CFs 0 1 2 3 4 5
Coupon 80 80 80 80 80
YTM 7.50% 0
Price Price P ? 1 80 0.917 73.394
2 80 0.842 67.334
First Step: Find Price of bond at year 5
• We must find the Price at year 5 at which bond N 15 3 80 0.772 61.775
would be sold. I 80 4 80 0.708 56.674
• In 5 years time, years remaining to maturity = N = 15 YTM 0.075 5 1124.136 0.650 730.611
• CFs would be 80 for 15 years and 1000 at the end of
last year 989.789
• YTM (discount rate) for 15 years bond = 7.5% PVF 0.338
PVFA 8.827 CF at year 5:
Coupon 80
PV (Interest) 706.170 Price at 5 1044.136
PV (Par) 337.966 1124.136
Price 1044.136
90
Yields

91
Steps to follow
• For YTM first use approximation formula
• For example if ytm with approximation formula is 7.58%
• Find price of bond when rd = 7%
• Find price of bond when rd = 8%
• Make sure that given price lie between two prices
• Use formula to calculate ytm

• For YTC – same process but Actual Price = Call Price and years to
maturity would be replaced with years to call.
92
93
 Part A Part B
N 12 N 9 Approximation Formula
m 1 m 1 YTM 9.26%
Par 1000 Par 1000
CR 9% CR 9%
YTM 9.283% YTM 9.283%
P ? P ?

N 12 N 9
I 90 I 90
YTM 0.093 YTM 0.093

PVF 0.345 PVF 0.450

PVFA 7.060 PVFA 5.927

PV (Interest) 635.369 PV (Interest) 533.413

PV (Par) 344.631 PV (Par) 449.796
Price 980 Price 983.209
94
95
 Part A (YTM) Part B (YTC)
N 8 N 4 Approximation Formula
m 2 m 2 YTM 3.27%
Par 1000 Par 1000 YTM (annum) 6.54%
CR 11% CR 11%
YTM 6.420% YTC 6.32%

Periodic Periodic
N 16 N 8
I 55 I 55
YTM 3.21% YTC 3.16%

PVF 0.603 PVF 0.780

PVFA 12.362 PVFA 6.972

PV (Interest)679.900 PV (Interest) 383.465

PV (Par) 603.190 PV (Par) 899.625
Price 1283.090 Price 1283.090
Price 1283.090 Call Price 1154.000

96
97
 YTC Time CFs PVF PV
• Normal Assumption: N 7 0 -1000
• Bonds are issued at par m 1 1 110 0.895 98.435
• Realized Rate of Return Par 1000 2 110 0.801 88.085
= YTC CR 11% 3 110 0.717 78.824
YTC 11.75% 4 110 0.641 70.537
Call Premium 7.50% 5 110 0.574 63.121
Periodic 6 110 0.513 56.484
N 7 7 1185 0.460 544.514
I 110 11.75% 1000.00
YTC 11.75% Realized Return 11.75%
Despite a 11.75% return on the bonds, investors
PVF 0.46 are not likely to be happy that they were called.
PVFA 4.60 Because if the bonds have been called, this
indicates that interest rates have fallen sufficiently
that the YTC is less than the YTM. (Since they were
PV (Interest) 506.03
originally sold at par, the YTM at issuance= 11%.)
PV (Par) 493.97 Rates are sufficiently low to justify the call. Now
Price 1000.00 investors must reinvest their funds in a much
Call Price 1075.00 lower interest rate environment
98
99
 Part A (P=865) Part A (P=1166)
N 6 N 6
m 1 m 1
Par 1000 Par 1000
CR 10% CR 10%
YTM 13.416% YTM 6.564%
P ? P ?
Periodic Periodic
N 6 N 6
I 100 I 100
YTM 13.416% YTM 6.564%

PVF 0.47 PVF 0.68

PVFA 3.95 PVFA 4.83

PV (Interest) 395.16 PV (Interest) 483.14

PV (Par) 469.84 PV (Par) 682.86
Price 865.00 Price 1166.00
100
Price 865 Price 1166
101
 Part A Part B [Price when N=8] Current and Capital Gain Yield
• Current yield = Interest / Price N 9 N 8
m 1 m 1 Current Yield
• Capital Gain Yield = Par 1000 Par 1000 Interest 90
CR 9% CR 9% Price 910.3000
• YTM = CGY [t] + [CY[t-1]]
YTM 10.595% YTM 10.595% CY = I / P0 9.89%
P ? P ?
Periodic Periodic Capital Gain Yield
N 9 N 8 Current Price 916.74
I 90 I 90 Purchase Price 910.30
Part C YTM 10.595% YTM 10.595% CGY = P1/ P0 - 1 0.708%
The change in interest rates would
change the end-of-year price and PVF 0.404 PVF 0.447 Verification [YTM = CY+CGY]
consequently the realized capital gains PVFA 5.625 PVFA 5.221 YTM 10.595%
yield would change. This means that
PV (Interest) 506.286 PV (Interest) 469.925 Alternative Way
the realized return to investors will PV (Par) 404.014 PV (Par) 446.817 YTM = CGY + CY
differ from the YTM. Price 910.3 Price 916.742 CGY = YTM - CY 0.708%
Price 910.3 102
103
 Part A Part B Part C
• Company wants to pay less YTM YTC Current Yield YTM = CGY + CY
• Compares YTM with YTC N 9 N 6 Interest 130 YTM 9.628%
• If YTC < YTM – Company m 2 m 2 Price 1200 CY 10.83%
Calls the bonds Par 1000 Par 1000 CY 10.83% CGY -1.206%
CR 13% CR 13%
Company wants to pay
YTM 9.628% YTC 9.395% less yield. Calling bond But we know that bond would be called
P ? would reault in paying YTC = CGY + CY
Periodic Periodic less. So bonds likely to YTC 9.395%
N 18 N 12 be called CY 10.83%
I 65 I 65 CGY -1.439%
YTM 4.81% YTC 4.70%

PVF 0.429 PVF 0.576

PVFA 11.861 PVFA 9.016

PV (Interest) 770.995 PV (Interest) 586.070

PV (Par) 429.005 PV (Par) 613.929
Price 1200 Price 1200
104
Price 1200 Call Price 1065
105
 YTM YTC Part B:
N (Jan 1, 2018 to Dec 31, 2045) 28 N (Jan 1, 2018 to Dec 31, 2020) 3 Knowledgeable Investors would
m 1 m 1 expect the return closer to 3.72%
Par 1000 Par 1000 than 6.5%. If Interest rates remain
CR 8% CR 8% lower than 8% (CR), the company
can be expected to call the issue at
YTM 6.500% YTC 3.72%
the call date.
P ? Call Price (% of Par) 108.00%
Periodic Periodic
N 28 N 3 Part C:
I 80 I 80 If the bond had sold at a discount,
YTM 6.500% YTC 3.717% this would imply that current
interest rates are above the
PVF 0.171 PVF 0.896 coupon rate (i.e., interest rates have
PVFA 12.746 PVFA 2.790 risen). Therefore, the company
would not call the bonds, so
the YTM would be more relevant
PV (Interest) 1019.720 PV (Interest) 223.205
than the YTC.
PV (Par) 171.480 PV (Par) 967.995
Price 1191.200 Price 1191.200
Price 1191.200 Call Price (Par x Call Price) 1080
106
Selling Price 1191.2
Bond valuation and yields

107
108
 Price YTM Approximation Formula
N 5 N 5 YTM (Periodic) 4.37%
m 2 m 2 YTM (Annual) 8.75%
Par 1000 Par 1000
CR 7% CR 0.07
YTM 8.802%
Current Yield 7.54% P ?
I 70 Periodic
N 10
Price 928.370 I 35
CY = I/Price --> Price = I / CY YTM 4.40%

PVF 0.650
PVFA 7.951

PV (Interest) 278.300
PV (Par) 650.069
Price 928.370
Price 928.370
109
Interest rate sensitivity

110
111
 Bond Price @ Bond Price @ % Change
Par Years CR Interest 8% Par Years CR Interest 7%
1000 10 10% 100.00 1134.20 1000 10 10% 100.00 1210.71 6.75%
1000 10 0% 0.00 463.19 1000 10 0% 0.00 508.35 9.75%
1000 5 0% 0.00 680.58 1000 5 0% 0.00 712.99 4.76%
1000 30 0% 0.00 99.38 1000 30 0% 0.00 131.37 32.19%
1000 Infinity 100 1250.00 1000 Infinity 100 1428.57 14.29%
112