INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Chapter 7

Bonds and Their Valuation

Key Features of Bonds

Bond Valuation
Measuring Yield
Assessing Risk

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 DRILL

1. If a company performs very well, investors

in that company's bonds are likely to receive a
higher coupon payment than the coupon
payment indicated by the bond's coupon rate,
face value, and frequency of coupon
payments (annual or semi-annual).

2. Bonds with call provisions are more

desirable than noncallable and generally
higher priced.
7-2
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 DRILL

3. The price of a semi-annual or an annual

coupon paying bond will be the same if their
coupon rate is the same as yield to maturity
regardless of differences in maturity.

4. If I invest P100 in a 10% coupon, 2-year

bond at par, I will certainly get P121 at the
end of the two years.

7-3
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 DRILL

What is the yield-to-maturity for a bond

with a coupon rate of 6.40 percent, 3
years to maturity, and a face value of
P1,000, if the price of the bond today
is P988.24 and coupons are paid
semi-annually with the next coupon
due in 6 months?

7-4
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Definitions

Annual coupon payment

Current yield (CY) 
Current price

Change in price
Capital gains yield (CGY) 
Beginning price

Expected total return  YTM  Expected CY  Expected CGY

7-5
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Definitions

Consider a P1,000 par value bond

with a 7 percent annual coupon. The bond
pays interest annually. There are 9 years
remaining until maturity. What is the
current yield on the bond assuming that the
required return on the bond is 10 percent?

7-6
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Definitions

A 12-year bond pays an annual coupon of

8.5 percent. The bond has a yield to
maturity of 9.5 percent and a par value of
P1,000. What is the bond’s current yield?

7-7
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

What is price risk? Does a 1-year or 10-year

bond have more price risk?

• Price risk is the concern that rising rd will cause

the value of a bond to fall.
rd 1-year Change 10-year
Change
5% P1,048 + 4.8%
P1,386 +38.6%
10% 1,000 – 4.4% 1,000 –25.1%
15% 956 749

• The 10-year bond is more sensitive to

interest rate changes, and hence has more
price risk.
7-8
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Illustrating Price Risk

Value (P)
1,600
10-Year Bond
1,400
1,200 1-Year Bond
1,000
800
600
400
200
0 YTM(%)
0 5 10 15 20

7-9
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Conclusions about Price Risk and

Reinvestment Risk

Short-term Long-term
AND/OR AND/OR
High-coupon Low-coupon
Bonds Bonds
Price risk Low High
Reinvestment risk High Low

• CONCLUSION: Nothing is riskless!

7-10
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Price risk

Assume that all interest rates in the economy decline

from 10 percent to 9 percent. Which of the following
bonds will have the largest percentage increase in
price?

a. A 10-year bond with a 10 percent coupon.

b. An 8-year bond with a 9 percent coupon.
c. A 10-year zero coupon bond.
d. A 1-year bond with a 15 percent coupon.
e. A 3-year bond with a 10 percent coupon.
7-11
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Price risk

Which of the following Treasury bonds will have the

largest amount of interest rate risk (price risk)?

a. A 7 percent coupon bond that matures in 12 years.

b. A 9 percent coupon bond that matures in 10 years.
c. A 12 percent coupon bond that matures in 7 years.
d. A 7 percent coupon bond that matures in 9 years.
e. A 10 percent coupon bond that matures in 10 years.

7-12
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Price risk

All treasury securities have a yield to maturity of 7

percent--so the yield curve is flat. If the yield to maturity
on all Treasuries were to decline to 6 percent, which of
the following bonds would have the largest percentage
increase in price?
a. 15-year zero coupon Treasury bond.
b. 12-year Treasury bond with a 10 percent annual
coupon.
c. 15-year Treasury bond with a 12 percent annual
coupon.
d. 2-year zero coupon Treasury bond.
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Yield to Call

• 3.568% represents the periodic semiannual

yield to call.
• YTCNOM = rNOM = 3.568% x 2 = 7.137% is the
rate that a broker would quote.
• The effective yield to call can be calculated.
– YTCEFF = (1.03568)2 – 1 = 7.26%
– Excel:=EFFECT(.07137,2)
= 7.26%

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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Yield to Call

A corporate bond matures in 14 years.

The bond has an 8 percent semiannual
coupon and a par value of P1,000.
The bond is callable in five years at a call
price of P1,050. The price of the bond
today is P1,075. What are the bond’s
yield to maturity and yield to call?

7-15
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 INTRO KEY FEATURES BOND VALUATION MEASURING YIELD ASSESSING RISK

Yield to Call

A corporate bond that matures in 12 years

pays a 9 percent annual coupon, has a
face value of P1,000, and a yield to
maturity of 7.5 percent. The bond can first
be called four years from now. The call
price is P1,050. What is the bond’s yield
to call?

7-16
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