PRINCIPLES OF FINANCE

Chapter 7 (BH)

Bonds and Their Valuation

1
Key Concepts

 Key features of bonds

 Bond valuation
 Measuring yield
 Assessing risk
What is a bond?

A long-term debt instrument in which a

borrower agrees to make payments of
principal and interest, on specific dates,
to the holders of the bond.
What is a bond?

Long Term debt(Bond certificate sample)

Key Features of a Bond

 Par value – face amount of the bond, which

is paid at maturity (assume $1,000).
 Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply by
par value to get dollar payment of interest.
 Maturity date – years until the bond must be
repaid.
 Issue date – when the bond was issued.
 Yield to maturity - rate of return earned on
a bond held until maturity (also called the
“promised yield”).
The value of financial assets

0 1 2 n
r%
...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value  1
 2
 ...  n
(1  r) (1  r) (1  r)
What is the value of a 10-year, 10% annual
coupon bond, if rd = 10%?

0 1 2 n
r
...
VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB  1
 ...  10
 10
(1.10) (1.10) (1.10)
VB  $90.91  ...  $38.55  $385.54
VB  $1,000
 Bond Value

 VB = Present Value of Bond

 INT = Coupon payment / Interest paid each period
M = Maturity value / Par Value / Face Value
 rd = Market interest rate
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Example
 A bond has a $1,000 lump sum (the par value) due at maturity
(t = 3), and annual $100 coupon payments beginning at t = 1
and continuing through t = 3 (Coupon rate 10%), market
interest rate is 10%.
 What is the price of this bond?
The same company also has 10-year bonds
outstanding with the same risk but a 13% annual
coupon rate.
Calculate the price of second bond.
 This bond has an annual coupon payment of $130. Since the risk is the
same the bond has the same yield to maturity as the previous bond
(10%). In this case the bond sells at a premium because the coupon
rate exceeds the market rate (rd).

INPUTS 3 10 130 1000

N I/YR PV PMT FV
OUTPUT -1074.61
The same company also has 10-year bonds
outstanding with the same risk but a 7%
annual coupon rate
Calculate the price of second bond.
 This bond has an annual coupon payment of $70. Since the risk is the same
the bond has the same yield to maturity as the previous bonds (10%). In this
case, the bond sells at a discount because the coupon rate is less than the
market rate (rd).

INPUTS 3 10 70 1000
N I/YR PV PMT FV
OUTPUT -925.39
  rd = coupon rate, fixed-rate bond sells at par; hence, it
is a par bond.
  rd  > coupon rate, fixed-rate bond sells below par; hence,
it is a discount bond.
  rd  < coupon rate, fixed-rate bond sells above par; hence,
it is a premium bond.

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 Bond Pricing with a Market Discount Rate

 Trading at Discount
 Calculate the price of bond
Coupon rate : 4%
Maturity : 5 year
Market interest rate: 6%
Face value : 100 AZN
Bond Pricing with a Market Discount Rate

 Trading at Premium
 Calculate the price of bond
 Coupon rate : 8%
 Maturity : 5 year
 Market interest rate: 6%
 Face value : 100 AZN
 Bond Pricing wit a Market Discount Rate
 Trading at Par
 Calculate the price of bond
 Coupon rate : 6%
 Maturity : 5 year
 Market interest rate: 6%
 Face value : 100 AZN
Example
 Identify whether each of the following bonds is trading at a
discount, at par value, or at a premium. Calculate the prices of the
bonds per 100 in par value.

Coupon Number of Market

Payment per Periods to Discount Rate
Bond Period Maturity per Period
A 2 6 3%
B 6 4 4%
C 5 5 5%
D 0 10 2%
 Bond A
 Trading at Discount

 Bond B
 Trading at premium
 Bond C

 Trading at Par

 Bond D
 Bond D is a zero-coupon bond, which always will trade at a
discount below par value (as long as the required yield is
greater than zero)
 What is interest rate (or price) risk?
Does a 1-year or 10-year bond have more
interest rate risk?
 Assume coupon payments is 10% and par value $1,000
 Interest rate risk is the concern that rising rd will cause the
value of a bond to fall.

rd 1-year Change 10-year Change

5% $1,048$1,386 + 4.8% +38.6%
10% 1,000 1,000 – 4.4% –25.1%
15% 956 749

The 10-year bond is more sensitive to interest rate

changes, and hence has more interest rate risk.
1- year Bond (10% coupon)

i/yr= 5%, FV= 1,000, Pmt= 100, PV= 1,047

i/yr= 15%, FV= 1,000, Pmt= 100, PV=956

10- year Bond (10% coupon)

I/ yr= 5%, FV= 1,000, Pmt= 100, PV= 1,386

I/ yr= 15%, FV= 1,000, Pmt= 100, PV= 749

So, the 10-year bond is more sensitive to
interest rate changes, and hence has more
interest rate risk. The relationship between
price of bond and interest rates is inverse
Illustrating interest rate risk

1,600
1,400
1,200
Value ($)

1,000 n=1
800
n = 10
600
400
200
0
0 5 10 15 20
Interest rates (%)
Yield to Maturity

 Yield to maturity (YTM) is the

total return anticipated on a bond if the bond is
held until it matures. Yield to maturity is
considered a long-term bond yield but it is
expressed as an annual rate.

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Yield-to-Maturity

 Ifthe market price is known, yield to maturity

can be calculated easily.
3 main assumption
1. The investor holds the bond to maturity.
2. The issuer makes all of the coupon and principal payments in the
full amount on the scheduled dates.
3. The investor is able to reinvest coupon payments at that same
yield.
Example

 Calculate the yield to maturity

Coupon
Payment per Number of Periods
Bond Period to Maturity Price
A 3.5 4 103.75
B 2.25 6 96.50
C 0 60 22.38
 Bond A

 Bond B
 Bond C
 What is the value of a 10-year, 10%
semiannual coupon bond, if rd = 13%?

1. Multiply years by 2 : N = 2 * 10 = 20.

2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.
3. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

INPUTS 20 6.5 50 1000

N I/YR PV PMT FV
OUTPUT - 834.72
 Reinvestment Risk

CF CF CF CF CF

100 100 100 100 100%

100 +%
+ 1,000

“reinvest(cash(inflow(at(going(market(rates”
“reinvest cash inflow at going market rates”

Thus,&
Thus, if&
if market&
market rates&
rates &&
,,&
may&
may experience&
experience
income&
income reduction
reduction
What is reinvestment rate risk?
 Reinvestment rate risk is the concern that
rd will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.
Default risk
 Ifan issuer defaults, investors receive less
than the promised return.
 The default risk is influenced by the
issuer’s financial strength and the terms of
the bond contract.
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

 Bondratings are designed to reflect the

probability of a bond issue going into
default.
Bond Ratings by Moody’s and S&P’s

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Types (features) of bonds

 Convertible
bond – may be exchanged for
common stock of the firm, at the holder’s option.
 Callable bond – allows issuer to buy back bonds
prior to maturity.
 Putable bond – allows holder to sell the bond
back to the company prior to maturity.
 Income bond – pays interest only when income is
earned by the firm.
 Indexed bond – interest rate paid is based upon
the rate of inflation.
Relationships between the Bond Price
and Bond Characteristics
4 important relationship

 The bond price is inversely related to the market discount rate.

 The convexity effect / For the same coupon rate and time-to-
maturity, the percentage price change is greater when the market
discount rate goes down than when it goes up.
 The coupon effect / For the same time-to-maturity, a lower-coupon
bond has a greater percentage price change than a higher- coupon
bond when their market discount rates change by the same amount
 The maturity effect / Generally, for the same coupon rate, a longer-
term bond has a greater percentage price change than a shorter-term
bond when their market discount rates change by the same amount
Example
CONVENTIONS FOR QUOTES AND
CALCULATIONS
 Flat Price, Accrued Interest, and the Full Price

 PVFull = Full Price / Dirty Price

 PVFlat = Full price minus accrued interest/Dirty Price
 AI = Accrued interest
 Than