Brooks FM PPT Ch06 BB

Chapter 6
Bonds and
Bond Valuation
Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Learning Objectives
• Understand basic bond terminology

and apply the TVM equation in pricing bonds.
• Understand the difference between annual and
semiannual bonds and note the key features of zero-
coupon bonds.
• The relationship between the coupon rate and the
yield to maturity.
• Delineate bond ratings and why ratings affect bond
prices.
• Appreciate bond history and understand the rights and
obligations of buyers and sellers of bonds.
• Pricing government bonds, notes, and bills.
6-2
6.1 Application of the TVM Tool:
Bond Pricing
• Bonds: Debt instruments
• Provide periodic interest income (annuity stream)
and return of the principal amount at maturity

(future lump sum)
• Prices can be calculated by using PV techniques

(discounting of future cash flows)
• Combination of PV of an annuity stream

and of a lump-sum repayment
6-3
6.1.1 Key Components of a Bond
• Par value: Principal or face value

(typically $1000)
• Price (% of par): Price in relation

to $100
• Coupon rate (rc): Annual interest

rate for the coupons
• Coupon (C): Regular interest

payment received by
holder per year
[FIG 6.1] Merrill Lynch corporate bond
6-4
• Maturity date: Expiration date of

bond when par
value is repaid
• Yield to maturity (YTM):

Expected rate of return from
holding the bond until the maturity
• Current yield: C/Price
• Rating: Credit quality of bond
• Coupon payment frequency

• First coupon date
[FIG 6.1] Merrill Lynch corporate bond
• Type
6-5
[Tab 6.1]
Components of a Merrill Lynch Corporate Bond
Price quote for a corporate bond: As of 15-Jul-2008,
Issue Price Coupon(%) Maturity YTM% Current Yield Rating

Merrill L. 109.13 6.50 15-Jul-2018 5.30 5.96 AA
Price = 109.13% of $1000 = $1,091.30

Annual coupon = 6.50%x1000 = $65.00
Maturity date = July 15, 2018
YTM = 5.30% if i bought and held to maturity
Current Yield = C/Price = $65/$1091.3 = 5.96%
6-6
6.1.2 Pricing a Bond in Steps
A bond involves a combination of an annuity (coupons)

and a lump sum (par value)
⇒ An interest-only loan
[Fig 6.2] Pricing bonds
[Fig 6.3] Future Cash Flow of a Merrill Lynch Bond
Step 1: C = $1000x0.065 = $65.00 = PMT
Step 2: YTM = 0.053 = r

6-7
6.1.2 Pricing a Bond in Steps
Step 3:
 1 
1
 1 r 
n

PV of coupons = PMT    =
 r 

 

1
PV of par value = FV  =
1 r n
=
Step 4: Price (of bond) =

6-8
6.2 Semiannual Bonds
and Zero-Coupon Bonds
•Most corporate and government bonds pay coupons

on a semiannual
basis.
•Some companies issue zero-coupon bonds

by selling them at a deep discount.
•For computing the price of bonds, the values of the inputs

have to be adjusted according to the frequency of the
coupons.
(Ex) For semiannual bonds, the annual coupon is divided by 2,

the number of years is multiplied by 2,
and the YTM is divided by 2.
6-9
Semiannual coupon = C/2

=
Issuance date:
PIR = YTM/2 =
n = years x m =
[FIG 6.4] Coca-Cola semiannual corporate bond

6-10
[Fig 6.5]

6-11
6.2.1 Pricing Bonds after Original Issue
The price of a bond is a function of the remaining cash flows

(coupons and par value)
that would be paid on it until
expiration.
As of Aug 1, 2008, Coca-Cola bond has only 27 coupons

left to be paid until it matures
on Feb 1,
2022.
[Fig 6.6] Remaining cash flow of the Coca-cola bond 6-12

r = 0.05473/2 = 0.027365, n = 27, C/2 = 42.5
Bond price on Aug 1, 2008

6-13
Ex1: Pricing a Semiannual Coupon Bond

after Original Issue
Four years ago, the XYZ Corporation issued an 8%

coupon (paid semiannually), 20-year, AA-rated bond
at its par value of $1000. Currently, the yield to
maturity on these bonds is 10%.
Calculate the price of the bond today.

6-14
6.2.2 Zero-Coupon Bonds
•Known as “pure” discount bonds

and sold at a discount from face value
•Do not pay any interest over the life of the bond.
•At maturity, the investor receives the par value

(usually $1000).
•Price of a zero-coupon bond is calculated

by merely discounting its par value
at the prevailing YTM.
6-15
6.2.2 Zero-Coupon Bonds
Zero-coupon bond price = par value × + 0
[Example 6.1] Kentucky state bond (Tab 6.1)

Maturity date = Oct 1, 2027
Issuance date = Oct 1, 2007
Initial YTM = 4.3%, n = 40, r = 0.043/2 = 0.0215

6-16
6.2.3 Amortization of a Zero-Coupon
Bond
The discount on a zero-coupon bond is amortized over its life.
Interest is added to bond price to compute ending price.
Zero-coupon bond holders have to pay tax on annual price

appreciation, even though no cash is received.
[Example] Amortized interest on a 3-year-zero-

coupon bond with YTM = 8%, par value = $1,000
6-17
Copyright © 2010 Pearson Prentice Hall. All rights reserved. [Tab 6.2]
6.2.3 Amortization of a Zero-Coupon
Bond
Ex2: Price of and Taxes Due

on a Zero-Coupon Bond
John wants to buy a 20-year, AAA-rated, $1000 par value,

zero-coupon bond being sold by Diversified Industries, Inc.
The yield to maturity on similar bonds is estimated to be 9%.
A) How much will he have to pay for it?
B) How much will he be taxed on the investment

after 1 year, if his marginal tax rate is 30%?

6-18
6.3 Yields and Coupon Rates
•A bond’s coupon rate differs from its YTM.
•Coupon rate is set by the company at the time of

issue. (Fixed except for ones with variable coupon
rates)
•YTM used to discount the future cash flow of the bond

depends on market, economic, and
company-specific factors. (Variable)

6-19
6.3.1 The First Interest Rate: YTM
• YTM: Expected rate of return on a bond

(if held to maturity)
• The price that willing buyers and sellers settle at

determines a bond’s YTM at any given point.
• Changes in economic conditions and risk factors will cause

bond prices and their corresponding YTMs to change.
• YTM can be calculated by entering the coupon amount (C)

price (PV), remaining number of
coupons (n), and par value (FV)
into the TVM equation, financial calculator, or spreadsheet.
6-20
6.3.1 The First Interest Rate: YTM
20 years semiannual bond

Issue date: Mar 1, 2008
Initial price = $905.00
Par value = $1,000
n = 20 x 2 = 40
C = 1000 x (0.07/2) = $35
↓
The equation
↓
r = YTM =
[Fig 6.7] Goodyear Semiannual
Corporate Bond 6-21
6.3.2 The “Other” Interest Rate:
Coupon Rate
•The coupon rate (rc) on a bond is set

by the issuer at the time of issue.
•The annual rate of interest that the firm is committed

to pay over the life of the bond.
(Ex) If rc = 7%, C = 0.07 x $1000 = $70 per year
Semiannual C = 70/2 = $35

6-22
6.3.3 Relation of YTM and Coupon Rate
• Based on the rating and maturity of the bond,

the coupon rate is set to equal the expected yield,
and the bond is initially sold at par value ($1000).
• Once issued, if investors expect a higher yield on the

bond, its price will go down and the bond will sell below
par (as a discount bond).
• Premium bond: > >

Par value bond: rc = YTM → PB = Par [Tab 6.3]
Discount bond: < <
[Fig 6.8] Negative relationship between YTM and PB

6-23
6.3.3 Relation of YTM and Coupon Rate
Ex3: Computing YTM
Last year, The ABC Corporation had issued 8% coupon

(semiannual), 20-year, AA-rated bonds (Par = $1000)
to finance its business growth. If investors are
currently offering $1200 on each of these bonds,
what is their expected YTM on the investment?
If you are willing to pay no more than $980,

what is your expected YTM?
Remaining number of coupons = n =

Semiannual coupon amount =
6-24
6.4 Bond Ratings
•Ratings by Moody’s, Standard and Poor’s, and Fitch:
AAA ~ BBB- (Investment grade)

BB+ ~ B- (Speculative grade; junk bonds)
CCC+ ~ (Extremely speculative); D (default)
☞ Likelihood of default by issuer [Tab 6.4]
•Ratings help issuers establish a yield on new bonds.
Junk bonds: Considered to be speculative in nature,

carry higher yields than investment grade bonds
Fallen angels: Investment grade bonds

downgraded to speculative bonds
6-25
6.5 Some Bond History
and More Bond Features
– Bearer bonds / Registered bonds
– Indenture (deed of trust): Written contract between

issuer and holder, spelling out details
of the bond agreement
– Collateral (security of a bond): Assets pledged as security

for the payment by the bond issuer
– Mortgaged security: Bond with real property as collateral
– Debentures: Bonds without collateral

6-26
–Senior debt (older bonds) and junior debt (newer bonds):
Priority to senior debt in coupon payment, principal

repayment, or liquidation
–Sinking fund: Built for principal repayment

Managed by a trustee (bank)
–Protective covenants: Required and prohibited actions

of the issuer

6-27
–Callable bond: With call option at a preset price,

the issuer can call in the bond before maturity
and the holder must sell it to the issuer.
–Yield to call: YTM to compute the (preset) call price
–Putable bond: With put option, the holder can sell back
to the issuer before maturity at a preset (discount) price.
–Convertible bond: With conversion option, the holder can

convert bonds to other assets (common stocks)
at preset conversion ratio.
6-28
– Floating-rate bond: Coupon rate varying with a benchmark

rate
– Income bonds: Coupons based on net income of the issuer
– Exotic bonds: Bonds with special features

6-29
6.6 U.S. Government Bonds
• U.S. government (Department of the Treasury):
Treasury bills (zero-coupon, pure discount securities,

1-, 3-, and 6-months, up to 1 year)
Treasury notes (2- to 10-year)
Treasury bonds (longer than 10-years)
• State bonds, by state governments
• Municipal bonds, by county, city, or

local government agencies
• Foreign bonds by foreign corporate or government

6-30
6.6.1 Pricing a U.S. Government Note or Bond
Same as corporate (coupon) bond
6.6.2 Pricing a Treasury bill
The price is calculated by discounting the face value
for the number of days to maturity (DTM)
at the prevailing bank discount rate (BDR)
Price of T-bill = Face value x [1 - (BDR x (DTM/360))]

Copyright © 2010 Pearson Prentice Hall. All rights reserved. [Tab 6.7] 6-31
Bond equivalent yield (BEY): the APR equivalent of

the bank discount rate
BEY = HPR x (365/DTM)
where HPR = holding period return

= (Face - PB) / PB
_____365 x BDR___
BEY =
360 - (DTM x BDR)

6-32
Ex5: The Price and BEY of a T-Bill
Calculate the price and BEY of a treasury bill that
matures in 105 days, has a face value of $10,000,
and is quoted at a bank discount rate of 2.62%.

6-33

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Chapter 6

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• Understand basic bond terminology

• Bonds: Debt instruments

• Provide periodic interest income (annuity stream)

and return of the principal amount at maturity

• Prices can be calculated by using PV techniques

• Combination of PV of an annuity stream

• Par value: Principal or face value

• Price (% of par): Price in relation

• Coupon rate (rc): Annual interest

• Coupon (C): Regular interest

• Maturity date: Expiration date of

• Yield to maturity (YTM):

• Current yield: C/Price

• Rating: Credit quality of bond

• Coupon payment frequency

Components of a Merrill Lynch Corporate Bond

Price quote for a corporate bond: As of 15-Jul-2008,

Issue Price Coupon(%) Maturity YTM% Current Yield Rating

Price = 109.13% of $1000 = $1,091.30

A bond involves a combination of an annuity (coupons)

[Fig 6.2] Pricing bonds

[Fig 6.3] Future Cash Flow of a Merrill Lynch Bond

Step 1: C = $1000x0.065 = $65.00 = PMT

Step 2: YTM = 0.053 = r

Step 4: Price (of bond) =

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

•Most corporate and government bonds pay coupons

•Some companies issue zero-coupon bonds

•For computing the price of bonds, the values of the inputs

(Ex) For semiannual bonds, the annual coupon is divided by 2,

Semiannual coupon = C/2

[FIG 6.4] Coca-Cola semiannual corporate bond

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

The price of a bond is a function of the remaining cash flows

As of Aug 1, 2008, Coca-Cola bond has only 27 coupons

[Fig 6.6] Remaining cash flow of the Coca-cola bond 6-12

r = 0.05473/2 = 0.027365, n = 27, C/2 = 42.5

Bond price on Aug 1, 2008

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Ex1: Pricing a Semiannual Coupon Bond

Four years ago, the XYZ Corporation issued an 8%

Calculate the price of the bond today.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

•Known as “pure” discount bonds

•At maturity, the investor receives the par value

•Price of a zero-coupon bond is calculated

Zero-coupon bond price = par value × + 0

[Example 6.1] Kentucky state bond (Tab 6.1)

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

The discount on a zero-coupon bond is amortized over its life.

Interest is added to bond price to compute ending price.

Zero-coupon bond holders have to pay tax on annual price

[Example] Amortized interest on a 3-year-zero-

Ex2: Price of and Taxes Due

John wants to buy a 20-year, AAA-rated, $1000 par value,

A) How much will he have to pay for it?

B) How much will he be taxed on the investment

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

•A bond’s coupon rate differs from its YTM.

•Coupon rate is set by the company at the time of

•YTM used to discount the future cash flow of the bond