BONDS AND THEIR

VALUATION
 WHAT IS A BOND
 A bond is a Security that pays a stated amount of Interest to the Investor Period
after period, until it is finally retired by the issuing company.
 In othe words Bond is defined as:
“A long term debt Instrument issued by a corporation or Government”
 A Bond has a FACE VALUE:
“The stated value of an asset”
 The bond has stated values let us say a Government issue a bond with a face value
of Rs. 1,000/-
 A bond has MATURITY:
“The time the company obligated to pay the bond holder the face value
of the Instrument”
 WHAT IS A BOND
 A Bond has a Coupon Rate
 A nominal annual rate of Interest is stated on the bond’s face value So Coupon rate is
defined as:
 “The stated Interest rated on the bond; the annual interest payment divided by the
bond’s face value”
 For example the Coupon Rate is 12% on a bond having face value of Rs. 1,000, the
company pays the bond holder Rs. 120 each year until the bond maturity.
 The terms of the bond establish a legal binding payment pattern at the time bond
is originally issued
 This pattern consist of a stated amount of interest over a given number of years
coupled with a final payment (Interest + Final Payment) when the bond matures
equal to bond’s face value.
 The discount, or capitalization rate applied to the cash flow streams will differ among
various kinds of bonds depending upon the risk structure of bonds issue.
 In general coupon rate is being composed of the Risk FREE RATE + PREMIUM FOR RISK
 Basic Terms

 Par Value. Par value for a bond represents the amount to be paid to the
lender at the bond’s maturity. It is also called face value or principal. Par
value is usually $1,000 per bond (or some multiple of $1,000). With the major
exception of a zero-coupon bond, most bonds pay interest that is calculated
on the basis of the bond’s par value.
 Coupon Rate. The stated rate of interest on a bond is referred to as the
coupon rate. For example, a 13 percent coupon rate indicates that the issuer
will pay bondholders $130 per annum for every $1,000-par-value bond that
they hold.
 Maturity. Bonds almost always have a stated maturity. This is the time
when the company is obligated to pay the bondholder the par value of the
bond.
Bond Ratings

 The creditworthiness of a publicly traded debt instrument is often judged in terms of the
credit ratings assigned to it by investment rating agencies.
 The principal rating agencies are Moody’s Investors Service (Moody’s) and Standard & Poor’s
(S&P).
 The issuer of a new corporate bond contracts with the agency to evaluate and rate the
bond, and to update the rating throughout the bond’s life.
 For this service, the issuer pays a fee. In addition, the rating agency charges subscribers to
its rating publications.
 Based on their evaluations of a bond issue, the agencies give their opinion in the form of
letter grades, which are published for use by investors.
 In their ratings, the agencies attempt to rank issues according to the perceived probability
of default.
 The highest grade issues, whose risk of default is felt to be negligible, are rated triple-A,
followed by double-A, single-A, B-double-A (Moody’s) or triple-B (S&P), and so forth through
C and D, which are the lowest grades of Moody’s and S&P, respectively. The first four grades
mentioned are considered to represent investment-quality issues, whereas the other rated
bonds are considered speculative.. The ratings by the two agencies are widely respected as
measures of default risk. In fact, many investors do not separately analyze the default risk
of a company.
Bond Ratings by Moody’s and S&P
TYPES OF BONDS

Income Bonds:
 A company is obligated to pay interest on an income bond only when the interest is
earned.
Or
 A bond where the payment of interest is contingent on sufficient earnings of the
firm.
 There may be a cumulative feature where unpaid interest in a particular year
accumulates. It promise rather weak promise to fixed returns to Investor.
TYPES OF BONDS
Junk Bonds:
 These are bonds with a rating of Ba (Moody’s) or less, and they are called “junk” or
“high-yield” bonds.
Or
 A high-risk, high-yield (often unsecured) bond rated below investment grade.
 High risk bonds
 Principal investors in junk bonds include pension funds, high-yield bond mutual
funds,and some individuals who invest directly. A secondary market of sorts exists,
 but in any kind of financial panic or “flight to quality” by investors in the bond
markets, such liquidity dries up.
TYPES OF BONDS
 Mortgage Bonds
 A mortgage bond issue is secured by a lien (creditor claim) on specific assets of the corporation--
usually fixed assets
 As with other secured lending arrangements, the market value of the collateral should exceed the
amount of the bond issue by a reasonable margin of safety
 A bond issue secured by a mortgage on the issuer’s property.

 The trustee of bond foreclose (Sold/liquidate) property of issuer to pay

bond holder
 There are 2nd mortgage bondholder where first mortgage bondholder
were paid full amount then residual amount will be paid to 2 nd mortgage
bondholder
Retirement of Bonds

 The retirement (repayment) of bonds may be accomplished in a number of

different ways.
 For example, bonds may be retired by making a single-sum payment at final
maturity, by conversion (an exchange for common stock) if the bonds are
convertible, by calling the bonds if there is a call feature, or by periodic
repayment.
 INTERNATIONAL BONDS

EuroBond
Sukuk (Islamic Bond)
 PERPETUAL BOND
A unique class These bonds
of bonds that were once
never matures. issued by
These are very British This bond
PERPETUAL
rare bond Government in carries
BOND IS A
Napoleonic obligation to
BOND THAT
wars to pay a fixed
NEVER
consolidate interest
MATURES I-E
debt issues. payments in
PERPUITY IN
perpetuity.
THE FORM OF
BOND
 PRESENT / INTRINSIC VALUE OF
PERPETUAL BOND
 The Present value of perpetual bond would simply be equal to the capitalized
value of infinite stream of interest payment.
 If a bond promises fixed annual payment of “I” forever, its present (Intrinsic)
value V, at the investors required rate of return for the debt issue Kd

V = I /kd or V=I*(PVIFAkd,∞)
 Thus the present value of a perpetual bond is simply the periodic interest
payment divided by the appropriate discount rate per period. Suppose you could
buy a bond that paid $50 a year forever. Assuming that your required rate of
return for this type of bond is 12 percent, the present value of this security would
be
 V = $50/0.12 = $416.67
 This is the maximum amount that you would be willing to pay for this bond. If the
market price is greater than this amount, however, you would not want to buy it.
 BOND WITH FINITE MATURITY
 Nonzero Coupon Bonds. If a bond has a finite maturity, then we must consider not only
the interest stream but also the terminal or maturity value (face value) in valuing the
bond.
 The valuation equation for such a bond that pays interest at the end of each year is

 where n is the number of years until final maturity and MV is the maturity value of the
bond.
 We might wish to determine the value of a $1,000-par-value bond with a 10 percent
coupon and nine years to maturity. The coupon rate corresponds to interest payments
of $100 a year. If our required rate of return on the bond is 12 percent, then
BOND WITH FINITE MATURITY

Referring to Table IV in the Appendix at the back of the book, we find that the present
value interest factor of an annuity at 12 percent for nine periods is 5.328. Table II in the
Appendix reveals under the 12 percent column that the present value interest factor for a
single payment nine periods in the future is 0.361. Therefore the value, V, of the bond is

V = $100(5.328) + $1,000(0.361)
= $532.80 + $361.00 = $893.80
BOND WITH FINITE MATURITY
 In this case, the present value of the bond is in excess of
its $1,000 par value because the required rate of return is
less than the coupon rate. Investors would be willing to
pay a premium to buy the bond. In the previous case, the
required rate of return was greater than the coupon rate.
As a result, the bond has a present value less than its par
value. Investors would be willing to buy the bond only if it
sold at a discount from par value. Now if the required rate
of return equals the coupon rate, the bond has a present
value equal to its par value, $1,000.
BOND WITH FINITE MATURITY
 ZERO COUPON BOND
 Zero-Coupon Bonds. A zero-coupon bond makes no periodic interest
payments but instead is sold at a deep discount from its face value.
 Why buy a bond that pays no interest? The answer lies in the fact that the
buyer of such a bond does receive a return.
 This return consists of the gradual increase (or appreciation) in the value of
the security from its original, below-face-value purchase price until it is
redeemed at face value on its maturity date.
 The valuation equation for a zero-coupon bond is a truncated version of that
used for a normal interest-paying bond. The “present value of interest
payments” component is lopped off, and we are left with value being
determined solely by the “present value of principal payment at maturity,” or
 ZERO COUPON BOND
 Suppose that Espinosa Enterprises issues a zero-coupon bond having a 10-year
maturity and a $1,000 face value. If your required return is 12 percent, then

 Using Table II in the Appendix, we find that the present value interest factor
for a single payment 10 periods in the future at 12 percent is 0.322.
Therefore:
 V = $1,000(0.322) = $322
 If you could purchase this bond for $322 and redeem it 10 years later for
$1,000, your initial investment would thus provide you with a 12 percent
compound annual rate of return.
 SEMI ANNUAL COMPOUNDING INTEREST
 Semiannual Compounding of Interest. Although some bonds (typically those issued
in European markets) make interest payments once a year, most bonds issued in
the United States pay interest twice a year. As a result, it is necessary to modify
our bond valuation equations to account for compounding twice a year.

 where kd is the nominal annual required rate of interest, I/2 is the semiannual
coupon payment, and 2n is the number of semiannual periods until maturity.
 SEMI ANNUAL COMPOUNDING INTEREST
 To illustrate, if the 10 percent coupon bonds of US Blivet Corporation have 12
years to maturity and our nominal annual required rate of return is 14
percent, the value of one $1,000-par-value bond is
 V = ($50)(PVIFA7%,24) + $1,000(PVIF7%,24)
 = ($50)(11.469) + $1,000(0.197) = $770.45
 Rather than having to solve for value by hand, professional bond traders
often turn to bond value tables. Given the maturity, coupon rate, and
required return, one can look up the present value. Similarly, given any three
of the four factors, one can look up the fourth. Also, some specialized
calculators are programmed to compute bond values and yields, given the
inputs mentioned. In your professional life you may very well end up using
these tools when working with bonds.
 Remember, when you use bond Eqs, the variable MV is equal to the bond’s maturity
value, not its current market value.
 RATE OF RETURNS OR YIELDS
 If we replace intrinsic value (V) in our valuation equations with the market price (P0)
of the security, we can then solve for the market required rate of return.
 This rate, which sets the discounted value of the expected cash inflows equal to the
security’s current market price, is also referred to as the security’s (market) yield.
 Depending on the security being analyzed, the expected cash inflows may be
interest payments, repayment of principal, or dividend
payments.
 It is important to recognize that only when the intrinsic value of a security to an
investor equals the security’s market value (price) would the investor’s required rate
of return equal the security’s (market) yield.
 Market yields serve an essential function by allowing us to compare, on a
uniform basis, securities that differ in cash flows provided, maturities, and
current prices
 Yield to Maturity (YTM) on Bonds
 Yield to maturity (YTM) The expected rate of return on a bond if bought at its
current market price and held to maturity. it is also known as the bond’s internal
rate of return (IRR).
 The market required rate of return on a bond (kd) is more commonly referred to
as the bond’s yield to maturity
 Mathematically, it is the discount rate that equates the present value of all
expected interest payments and the payment of principal (face value) at
maturity with the bond’s current market price.

 If we now substitute actual values for I, MV, and P0, we can solve for kd, which
in this case would be the bond’s yield to maturity.
Yield To Maturity (YTM) On Bonds- Trial And
Error Method
 we can still determine an approximation of the yield to maturity by making
use of a trial-and-error procedure.
 To illustrate, consider a $1,000-par-value bond with the following
characteristics: a current market price of $761, 12 years until maturity, and
an 8 percent coupon rate (with interest paid annually).
 We want to determine the discount rate that sets the present value of the
bond’s expected future cash-flow stream equal to the bond’s current market
price
 Suppose that we start with a 10 percent discount rate and calculate the
present value of the bond’s expected future cash flows. For the appropriate
present value interest factors, we make use of Tables II and IV.
 V = $80(PVIFA10%,12) + $1,000(PVIF10%,12)
 = $80(6.814) + $1,000(0.319) = $864.12
Yield To Maturity (YTM) On Bonds- Trial And Error
Method
 A 10 percent discount rate produces a resulting present value
for the bond that is greater than the current market price of
$761. Therefore we need to try a higher discount rate to
handicap the future cash flows further and drive their present
value down to $761. Let’s try a 15 percent discount rate.
 V = $80(PVIFA15%,12) + $1,000(PVIF15%,12)
 = $80(5.421) + $1,000(0.187) = $620.68
 For example, had we used 11 and 12 percent, we would have
come even closer to the “true” yield to maturity.
 Behavior of Bond Prices
 On the basis of an understanding of Eq. of Yield to maturity a number of
observations can be made concerning bond prices:
 1. When the market required rate of return is more than the stated coupon rate, the
price of the bond will be less than its face value. Such a bond is said to be selling at
a discount from face value. The amount by which the face value exceeds the current
price is the bond discount.
 2. When the market required rate of return is less than the stated coupon rate, the
price of the bond will be more than its face value. Such a bond is said to be selling
at a premium over face value. The amount by which the current price exceeds the
face value is the bond premium.
 3. When the market required rate of return equals the stated coupon rate, the price
of the bond will equal its face value. Such a bond is said to be selling at par.
 4. If interest rates rise so that the market required rate of return increases, the
bond’s price will fall. If interest rates fall, the bond’s price will increase. In short,
interest rates and bond prices move in opposite directions
 The variation in the market price of a security caused by changes in interest
rates is referred to as interest-rate (or yield) risk
 Behavior of Bond Prices

 5. For a given change in market required return, the price of a bond will
change by a greater amount, the longer its maturity
 The longer the maturity of bond the greater will be the price fluctuation of
bond with the given market rate of return the greater the risk of price change
to the investor when changes occur with overall level of interest rates
 Figure 4.1 illustrates our discussion by comparing two bonds that differ only
in maturity. The price sensitivities of a 5-year bond and a 15-year bond are
shown relative to changes in market required rate of return. As expected, the
bond with the longer term to maturity shows a greater change in price for any
given change in market yield
Examples Of Behavior of Bond Prices
Behavior of Bond Prices----Coupon Effect
 One last relationship also needs to be addressed separately, and it is known
as the coupon effect.
 6. For a given change in market required rate of return, the price of a bond
will change by proportionally more, the lower the coupon rate.
 In other words, bond price volatility is inversely related to coupon rate.
 It means if market rate of return is higher than coupon rate of bond the
bond price would be higher and if market rate is lower than coupon rate
than bond price would be lower.

 The reason for this effect is that the lower the coupon rate, the more return
to the investor is reflected in the principal payment at maturity as opposed to
interim interest payments
YTM and Semiannual Compounding.

 Some bonds pay interest twice a year.

 We can take semiannual interest payments into account, however, when
determining yield to maturity by replacing intrinsic value (V) with current market
price (P0) in bond valuation in the previous Equation
TABLES