Bond Valuation

Econ 181
Corporate Finance
Wadia Haddaji
Department of Economics
Duke University

RK-CH
 Bond Valuation An 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

 The term structure of interest rates

 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)
 Bonds are also called fixed income securities.
 Bonds differ in several respects:
» Repayment type
» Issuer
» Maturity
» Security
» Priority in case of default
 Repayment Schemes

 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.
 Types of Bonds: Issuers

Bonds Issuer
Government Bonds US Treasury, Government
Agencies
Mortgage-Backed Securities Government agencies (GNMA etc)
Municipal Bonds State and local government
Corporate Bonds Corporations
Asset-Back Securities Corporations
 U.S. Government Bonds

 Treasury Bills
» No coupons (zero coupon security)
» Face value paid at maturity
» Maturities up to one year

 Treasury Notes
» Coupons paid semiannually
» Face value paid at maturity
» Maturities from 2-10 years
 U.S. 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
» 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.
 Agency and Municipal Bonds

 Agency bonds: mortgage-backed bonds

» Bonds issued by U.S. Government agencies that are backed by a
pool of home mortgages.
» Self-amortizing bonds. (mostly monthly payments)
» Maturities up to 30 years.
» Prepayment risk.
 Municipal bonds
» Maturities from one month to 40 years.
» Usually exempt from federal, state, and local taxes.
» Generally two types:
– Revenue bonds
– General Obligation bonds
» Riskier than U.S. Government bonds.
 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
 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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 The US Bond Market

Debt Instrument 2006 Q2

Treasury securities 4759.6

Municipal securities 2305.7

Corporate and foreign bonds 8705.3

Consumer Credit 2327.4

Mortgages 12757.7

Corporate equities 18684.5

Amount ($bil.). Source: U.S. Federal Reserve (Table L.4, September/2006) 1

 Bond Valuation: Zero Coupon Bonds
B = Market price of the Bond of bond
F = Face value
R = Annual percentage rate
m = compounding period (annual  m = 1, semiannual  m = 2,…)
i = Effective periodic interest rate; i=R/m
T = Maturity (in years)
N = Number of compounding periods; N = T*m

 Two cash flows to purchaser of bond:

» -B at time 0
» F at time T
 What is the price of a bond?
 Use present value formula:
F
B
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 APR is
R=7.5% with annual compounding? What about quarterly compounding?

 What is the APR on a U.S. Treasury strip that pays $1,000 in exactly 7 years
and is currently selling for $591.11 under annual compounding? Semi-annual
compounding?

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 Interest Rate Sensitivity:
Zero Coupon Bonds

 Consider the following 1, 2 and 10-year zero-coupon

bonds, all with
» face value of F=$1,000
» APR of R=10%, compounded annually.
We obtain the following table for increases and decreases of the
interest rate by 1%:
Interest Rate Bond 1 Bond 2 Bond 3
1-Year 2-Year 10-Year
9.0% $917.43 $841.68 $422.41
10.0% $909.09 $826.45 $385.54
11.0% $900.90 $811.62 $352.18
 Bond prices move up if interest rates drop, decrease if
interest rates rise
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 Bond Prices and Interest Rates
$1,200
 Bond prices are
$1,000 inversely related
to IR
$800  Longer term
$600 bonds are more
sensitive to IR
$400 1-Year changes than
2-Year short term
$200 bonds
10-Year
$0  The lower the
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% IR, the more
sensitive the
price.

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 Measuring Interest Rate Sensitivity
Zero Coupon Bonds

 We would like to measure the interest rate sensitivity of a bond or a

portfolio of bonds.
» How much do bond prices change if interest rates change by a small
amount?
» Why is this important?
 Use “Dollar value of a one basis point decrease” (DV01):
» Basis point (bp): 1/100 of one percentage point =0.01%=0.0001
» Calculate DV01:
– Method 1: Difference of moving one basis point down:
DV01= B(R-0.01%)-B(R).
– Method 2: Difference of moving 1/2bp down minus 1/2pb up:
DV01=B(R-0.005%) -B(R+0.005%).
– Method 3: Use calculus:
B
DV 01    0.0001
R
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 Computing DV01: An Example

 Reconsider the 1, 2 and 10- year bonds discussed before:

Interest Rate Bond 1 Bond 2 Bond 3
1-Year 2-Year 10-Year
9.990% $909.1736 $826.5966 $385.8940
9.995% $909.1322 $826.5214 $385.7186
10.000% $909.0909 $826.4463 $385.5433
10.005% $909.0496 $826.3712 $385.3681
Method 1 $0.082652 $0.150283 $0.350669
Method 2 $0.082645 $0.150263 $0.350494
Method 3 $0.082645 $0.150263 $0.350494

 Method 3:
B $1,000 1
  0.0001  T  0.0001  T * $0.10 *
R 1.10T 1 1.10T 1
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 DV01: A Graphical Approach
10-Year

$1,200.00

$1,000.00

$800.00

$600.00

$400.00

$200.00

$0.00
Interest Rate

 DV01 estimates the change in the Price-Interest rate curve using a

linear approximation.
higher slope implies greater sensitivity
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 Valuing Coupon Bonds
Example 1: Amortization Bonds

 Consider Amortization Bond

» T=2
» m=2
» C=$2,000 c = C/m = $2,000/2 = $1,000
» R=10%  i = R/m = 10%/2 = 5%
 How can we value this security?
» Brute force discounting
» Similar to another security we already know how to value?
» Replication

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 Valuing Coupon Bonds
Example 1: Amortization Bonds

 Compare with a portfolio of zero coupon bonds:

0 1 2 3 4
Buy Coupon Bond -$3,545.95 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Buy 6-Month Zero -$952.38
Buy 1-Year Zero -$907.03
Buy 1.5-Year Zero -$863.84
Buy 2-Year Zero -$822.70
Portfolio -$3,545.95

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 A First Look at Arbitrage

 Reconsider amortization bond; suppose bond

trades at $3,500 (as opposed to computed price of
$3,545.95)
» Can we make a profit without any risk?
– What is the strategy?
– What is the profit?

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 A First Look at Arbitrage

 Reconsider amortization bond; suppose bond trades at $3,500 (as

opposed to computed price of $3,545.95)
» Can make risk less profit
– Buy low: buy amortization bond
– Sell high: Sell portfolio of zero coupon bonds
Time Period
0 1 2 3 4
Buy Coupon Bond -$3,500.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00
Sell 6-Month Zero $952.38 -$1,000.00 $0.00 $0.00 $0.00
Sell 1-Year Zero $907.03 $0.00 -$1,000.00 $0.00 $0.00
Sell 1.5-Year Zero $863.84 $0.00 $0.00 -$1,000.00 $0.00
Sell 2-Year Zero $822.70 $0.00 $0.00 $0.00 -$1,000.00
Portfolio $3,545.95 -$1,000.00 -$1,000.00 -$1,000.00 -$1,000.00
Net Cash Flow $45.95 $0.00 $0.00 $0.00 $0.00

– riskless profit of $45.95

– no riskless profit if price is correct
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 Valuation of Coupon Bonds:
Example 2: Straight Bonds

 What is the market price of a U.S. Treasury bond that has a coupon
rate of 9%, a face value of $1,000 and matures exactly 10 years from
today if the interest rate is 10% compounded semiannually?

0 6 12 18 24 ... 120 Months

45 45 45 45 1045

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 Valuing Coupon Bonds
The General Formula
 What is the market price of a bond that has an annual coupon C, face
value F and matures exactly T years from today if the required rate of
return is R, with m-periodic compounding?
» Coupon payment is: c = C/m
» Effective periodic interest rate is: i = R/m
» number of periods N = Tm

0 1 2 3 4 ... … N
c c c c… … c+F
B  Annuity   Zero 
c 1   F 
 1   N 
i  1  i N   1  i  
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 The Concept of a “Yield to Maturity”
 So far we have valued bonds by using a given interest rate,
then discounted all payments to the bond.
 Prices are usually given from trade prices
» need to infer interest rate that has been used
Definition: The yield to maturity is that interest rate that
equates the present discounted value of all future payments
to bondholders to the market price:
 Algebraic:

c  1  F
B  1 

yield / m  1  yield / m N  1  yield / m N


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 Yield to Maturity
A Graphical Interpretation

$2,500.00

$2,000.00

$1,500.00

$1,000.00

$500.00

$0.00
0%
2%
4%

10%
12%
14%
16%
18%
20%
22%
24%
6%
8%

 Consider a U.S. Treasury bond that has a coupon rate of 10%, a face value of
$1,000 and matures exactly 10 years from now.
» Market price of $1,500, implies a yield of 3.91% (semi-annual
compounding); for B=$1,000 we obviously find R=10%.
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 Interest Rate Sensitivity:
Coupon Bonds

 Coupon bonds can be represented as portfolios of zero-

coupon bonds
» Implication for price sensitivity

 Consider purchasing the US Treasury bond discussed

earlier (10 year, 9% coupon, $1,000 face)
» Suppose immediately thereafter interest rates fall to 8%,
compounded semiannually.
» Suppose immediately thereafter interest rate rises to 12%
compounded semiannually.
» Suppose the interest rate equals 9%, compounded semiannually.

 What are the pricing implications of these scenarios?

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 Implication of Interest Rate Changes on
Coupon Bond Prices
 Recall the general formula:

 c  if the1 APR
What is the price of Bthe bond  is8%Fcompounded

1 N 
 
semiannually? i  1  i    1  i N 

 Similarly:
If R=12%: B=$ 827.95
If R= 9%: B=$1,000.00

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 Relationship Between Coupon Bond
Prices and Interest Rates
 Bond prices are inversely related to interest rates (or yields).

 A bond sells at par only if its interest rate equals the coupon
rate

 A bond sells at a premium if its coupon rate is above the

interest rate.

 A bond sells at a discount if its coupon rate is below the

interest rate.
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 DV01 and Coupon Bonds

 Consider two bonds with 10% annual coupons with maturities of 5

years and 10 years.
 The APR is 8%
 What are the responses to a .01% (1bp) interest rate change?

Yield 5-Year Bond $ Change % Change 10-Year Bond $ Change % Change

7.995% $1,080.06 $0.21019 0.0195% $1,134.57 $0.36585 0.0323%
8.000% $1,079.85 $1,134.20
8.005% $1,079.64 -$0.21013 -0.0195% $1,133.84 -$0.36569 -0.0322%
DV01 $0.42032 $0.73154

 Does the sensitivity of a coupon bond always increase with the term to
maturity?

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Bond Prices and Interest Rates

$2,500.00
5-Year Bond
$2,000.00
10-Year Bond
$1,500.00
Price (P)

$1,000.00

$500.00

$0.00
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%

24%
20%
22%
Interest Rate (R)

Longer term bonds are more sensitive to

changes in interest rates than shorter term bonds, in general.
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 Bond Yields and Prices
 Consider the following two bonds:
» Both have a maturity of 5 years
» Both have yield of 8%
» First has 6% coupon, other has 10% coupon, compounded
annually.
 Then, what are the price sensitivities of these bonds, measured by
DV01 as for zero coupon bonds?
Yield 6%-Bond $ Change % change 10%-Bond $ Change % change
7.995% $920.33 $0.1891 $1,080.06 $0.2102
8.000% $920.15 $1,079.85
8.005% $919.96 ($0.1891) $1,079.64 ($0.2101)
0.0411% 0.0389%
DV01 $0.3782 $0.4203

 Why do we get different answers for two bonds with the same yield
and same maturity?
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 Maturity and Price Risk

 Zero coupon bonds have well-defined relationship

between maturity and interest rate sensitivity:

 Coupon bonds can have different sensitivities for

the same maturity
» DV01 now depends on maturity and coupon

 Need concept of “average maturity” of coupon

bond:
» Duration
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 Duration

 Duration is a weighted average term to maturity where the

weights are relative size of the contemporaneous cash flow.
PV(c ) PV(c ) PV(c )
Duration  T  1 T  2  T  N  T  PV(F)
1 B 2 B N B N B

 Duration is a unitless number that quantifies the percentage

change in a bond’s price for a 1 percentage change in the
interest rate.  B 
 
B 1  R  B 
Duration    
R B  R 
 
1 R 
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 Duration (cont.)

 The duration of a bond is less than its time to maturity (except for
zero coupon bonds).
 The duration of the bond decreases the greater the coupon rate.
This is because more weight (present value weight) is being given
to the coupon payments.
 As market interest rate increases, the duration of the bond
decreases. This is a direct result of discounting. Discounting at a
higher rate means lower weight on payments in the far future.
Hence, the weighting of the cash flows will be more heavily
placed on the early cash flows -- decreasing the duration.
 Modified Duration = Duration / (1+yield)
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 A Few Bond Markets Statistics
U.S. Treasuries, May 20th 2007.

Bills
MATURITY DISCOUNT/YIELD DISCOUNT/YIELD TIME
DATE CHANGE
3-Month 08/16/2007 4.72 / 4.84 0.01 / .010 13:41
6-Month 11/15/2007 4.78 / 4.98 0.01 / .015 13:41

Notes/Bonds
COUPON MATURITY CURRENT PRICE/YIELD TIME
DATE PRICE/YIELD CHANGE
2-Year 4.500 04/30/2009 99-121⁄4 / 4.84 -0-02 / .035 14:08
3-Year 4.500 05/15/2010 99-081⁄2 / 4.77 -0-031⁄2 / .040 14:06
5-Year 4.500 04/30/2012 98-281⁄2 / 4.75 -0-06 / .043 14:07
10-Year 4.500 05/15/2017 97-15 / 4.82 -0-091⁄2 / .038 14:07
30-Year 4.750 02/15/2037 96-17+ / 4.97 -0-17 / .035 14:07

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 Spot Rates

 A spot rate is a rate agreed upon today, for a loan that is to be

made today
» r1=5% indicates that the current rate for a one-year loan is 5%.
» r2=6% indicates that the current rate for a two-year loan is 6%.
» Etc.
 The term structure of interest rates is the series of spot rates
r1, r2, r3,…
» We can build using STRIPS or coupon bond yields.
» Explanations of the term structure.

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The Term Structure of Interest Rates
An Example

Yield

6.00

5.75

5.00

1 2 3 Maturity

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Term Structure, July 1st 2005.

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Term Structure, September 12th, 2006

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Term Structure, May 20th, 2007

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Term Structure of Interest Rates

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 Summary
 Bonds can be valued by discounting their future cash
flows
 Bond prices change inversely with yield
 Price response of bond to interest rates depends on term
to maturity.
» Works well for zero-coupon bond, but not for coupon bonds
 Measure interest rate sensitivity using ‘DV01’ and
duration.
 The term structure implies terms for future borrowing:
» Forward rates
» Compare with expected future spot rates
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