Financial Management 2A

Unit 6a – Bond valuation and interest rates

(Chapter 8)
FMN22A2
 LEARNING OUTCOME

Describe what a bond is, its characteristics, its valuation,

and its relationship with interest rates and inflation.

UNIT 6a : Bond valuation and interest rates

 ASSESSMENT CRITERIA

1. Explain what a bond is;

2. Explain bond characteristics;
3. Calculation/determine the value of a bond;
4. Differentiate various types of bonds and bond markets; and
5. Explain the relationship between bonds, interest rates and
inflation.

UNIT 6a : Bond valuation and interest rates

 RESOURCES

• Textbook:
• Chapter 8
• Study Guide
• Unit 6a: Bond valuation and interest rates
• Financial calculator

UNIT 6a : Bond valuation and interest rates

 INTRODUCTION

• Bonds are an alternative form of debt capital available to

companies who need funding.

• A bond is similar to a term loan (or long-term loan) but is

distinguished from the latter by some unique terms and/or
characteristics used in the bond agreement (or contract).

• Two parties involved:

- the issuer (borrower – company in need of funding),
- bondholder (lender – public, other companies etc).

• The valuation of bonds must be preferably performed using a

financial calculator (similar approach to TVM).

UNIT 6a : Bond valuation and interest rates

 BONDS

A bond is a form of debt financing used by

• Governments, or
• The corporate sector…
…usually to finance expansion.

A bond is used to borrow money on a long-term basis (capital markets)

from the public.

https://secure.rsaretailbonds.gov.za/Rates.aspx

UNIT 6a : Bond valuation and interest rates

 TYPES OF BONDS page 269 - 272

• Government bonds (or treasury bills)

- Treasury bills, treasury notes and treasury bonds
- Classified according to length of maturity
- RSA Retail Savings Bonds

• Municipal bonds
- Issued by municipalities
- Interest is tax-free, yield lower than corporate bonds.

• Corporate bonds
- Issued by companies
- Higher yield accompanied with higher risk
- Short term, intermediate term and long-term bonds

UNIT 6a : Bond valuation and interest rates

 TYPES OF BONDS

• Convertible bonds
- Owner can convert the bond to ordinary shares
- Conversion done at conversion ratio or conversion
price
- Example 8.6 & 8.7

• Junk bonds
- Also called high-yield bonds
- Highly risky & speculative

• Zero coupon bonds

- No coupon payments, bonds trading at discount
- Income tax vs capital gains tax
- Eliminates re-investment risk
- Yields are usually better
UNIT 6a : Bond valuation and interest rates
 TYPES OF BONDS

• Extendable and retractable bonds

- Lower coupon rate
- Have more than one maturity date to take the effects of
inflation into account
- Extendable – Extend maturity
- Retractable – Shorten maturity

• Foreign currency bonds

- Issued in a currency other than in the borrower’s
currency
- Coupons paid in foreign currency
- Yankee bonds, Samurai bonds, Bulldog bonds, Kiwi
bonds.

• Inflation linked bonds

- Provides protection against inflation
- Coupon & Coupon rate linked to inflation
UNIT 6a : Bond valuation and interest rates
 INTEREST RATES, INFLATION AND BOND VALUES page 263

• Two kinds of interest rates

• Nominal interest rate – includes inflation
• Real interest rate – excludes inflation

• Inflation definition:
• Sustained, rapid increase in price levels
• Decreased purchasing power of currency (money)

• Fisher effect explains the relationship of the 3 variables:

Nominal interest rate, real interest rate and inflation rate.

UNIT 6a : Bond valuation and interest rates

 BOND MARKETS AND BOND RATINGS page 260 - 262

Bond Markets
• Mostly OTC (dealer) markets
• Bond markets are often listed on the stock exchanges (NYSE &
JSE)

Bond Ratings
• A bond is rated according to the creditworthiness of the issuing
entity
• Ratings agencies: Standard and Poor’s (S&P), Moody’s and Fitch
• See table on page 274

• Credit ratings of different countries:

http://www.tradingeconomics.com/south-africa/rating

UNIT 6a : Bond valuation and interest rates

 BONDS

Bond Characteristics Description TVM

Characteristics
Nominal value/ of a bond:
amount to be repaid at the end of the bond period FV
Par value/
Principle value
• Nominal value (also called par value or capital value or principal
Coupon Rate (%)= amount
amount) Fixed to
interest rate calculated
be repaid on the
at the end ofnominal value
the bond (used to
period
calculate the coupon)
• Coupon = period payments
Coupon (Rand) Period payments made to the bondholder. Amount is PMT
• Coupon rate (also called interest rate)
determined by the coupon rate
• Maturity = time left until the bond reaches the end of its term (p.a.)
Maturity Time left until the bond reaches the end of its term (p.a) N
• Yield to maturity (YTM) = market interest rate for similar instrument
(NACA)
Yield to maturity Market interest rate for similar instruments (NACA) i/y
(YTM)
Bond value Amount that bond exchanges hands at the time of trade PV
(price of the bond).

Fixed payments for specific

period of time………
UNIT 6a : Bond valuation and interest rates

= ANNUITY
 CHARACTERISTICS OF A BOND

Nominal Value / Par Value / Principal Value

• Amount being borrowed
• Amount paid back at the end of the borrowing period (at maturity)

Coupon Rate
• % interest paid (on nominal value) at regular intervals
• Fixed rate
• NOT the market rate

Coupon
• Rand-amount paid every period
• Nominal value x Coupon rate = Coupon

UNIT 6a : Bond valuation and interest rates

 CHARACTERISTICS OF A BOND

Maturity
• Time left for the par value to be paid back

Yield to Maturity (YTM)

• Interest rate required for similar instruments in the market (similar
risk)
• When the market interest rate is higher than the coupon rate:
- Bond will be sold at a cheaper price than par value
- Trading at a Discount
• When the market interest rate is lower than the coupon rate:
- Bond will be sold at a higher price than par value
- Trading at a Premium
• YTM = coupon rate:
- Bond sold at par (nominal value)

UNIT 6a : Bond valuation and interest rates

 BONDS (p. 261)

• The coupon rate is fixed, and it does not go up and down - (refer to
the diagram below).
• However, the yield-to-maturity (YTM) varies as it is dictated by the
market. If the YTM increases, the value of a bond will decrease and
vice versa.

UNIT 6a : Bond valuation and interest rates

 DETERMINANTS OF BOND RETURNS (COUPON)

Coupon is the bond return

Coupon rate is dependent on the following:

• Real interest rate and expected inflation rate

- Inflation premium

• Interest rate risk and time to maturity

- Interest rate premium

• Default risk
- Credit risk premium

• Lack of liquidity
- Liquidity premium
UNIT 6a : Bond valuation and interest rates
 VARIABLES ON FINANCIAL CALCULATOR

TVM Bond Characteristics

FV Nominal value (R1 000 unless specified otherwise)

Coupon Rate (fixed %)

PMT Coupon (fixed Rand amount based on coupon rate)

N Maturity

i/y Yield to maturity (YTM) (current interest rates in the market)

PV Value of the bond (What we are paying for the bond)

UNIT 6a : Bond valuation and interest rates

 EXAMPLE 1: BONDS

Michael wants to invest in a bond with a nominal value of R1 000. The

price of the bond is currently R1 090 and pays 6% coupons. The
current market interest rate on bonds is 5.5%.

REQUIRED:

• How much time is left to maturity?

UNIT 6a : Bond valuation and interest rates

 BONDS

Financial Calculator:

• PV (Bond value) = R1 090

Cash INFOW vs Cash OUTFLOW:
• Company perspective
• I/Y (yield to maturity) = 5.5%

• PMT (Coupon) = R1 000 x 6% = (R60)

• FV (par value) = (R1 000)

• [COMP] N (Time to maturity) = 86.01 years

UNIT 6a : Bond valuation and interest rates

 EXAMPLE 2: BONDS

Imagine’s bond is currently selling for R1 123. The nominal value of the
bonds is R1 000, the YTM is 10% and the time to maturity is 13 years.

REQUIRED:

What is the coupon rate of the bond?

First: Calculate the PMT in rand value (Coupon)

Second: Convert to % of nominal value

UNIT 6a : Bond valuation and interest rates

 BONDS

• Financial Calculator:
Step 1: calculate the PMT in Rand values:

• PV = R1 123

• FV = (R1 000)

• I/Y = 10%

• N = 13

• [COMP] PMT = (R117.32)

UNIT 6a : Bond valuation and interest rates

 BONDS

Step 2: We need to convert the PMT into a coupon rate:

Coupon rate = Coupon / par value x 100

Coupon rate = R117.32 / 1 000 X 100
Coupon Rate = 11.73%

UNIT 6a : Bond valuation and interest rates

 EXAMPLE 3: BONDS

Sam wants to buy a bond with a R10 000 nominal value payable in ten
years’ time. The bond pays 10% coupons and is currently selling for
R9000.

REQUIRED:

• What is the YTM?

UNIT 6a : Bond valuation and interest rates

 BONDS

Financial Calculator:

• PV = R9 000

• FV = (R10 000)

• PMT = (R1 000)

• N = 10

• [COMP] I/YR = 11.75%

UNIT 6a : Bond valuation and interest rates

 EXAMPLE 4: BONDS

Dumisani is interested in buying a bond from Company Y. The bond

has a maturity of 12 years, a coupon rate of 7% and the YTM is 8%. If
the nominal value of the bond is R15 000 and makes semi-annual
payments.

REQUIRED:

• What is the price (or value) of bond?

UNIT 6a : Bond valuation and interest rates

 BONDS

Financial Calculator:

• N = 24 = (12 years x 2)

• I/Y = 4% = (8% / 2)

• PMT = (R525) = (1050 / 2)

• FV = (R15 000)

• [COMP] PV = R13 856.48

UNIT 6a : Bond valuation and interest rates

 HOMEWORK

• MCQ at the end of Chapter 8 in the prescribed textbook

(Q1,2,3,4,7,9,10,11)

UNIT 6a : Bond valuation and interest rates

Thank you