Bond Valuation

Chapter Outline

• Bonds and Bond Valuation

• Government and Corporate Bonds
• Inflation and Interest Rates
 Learning Objectives
• LO1 Important bond features and types of
bonds;
• LO2 Bond values and yields and why they
fluctuate;
• LO3 Bond ratings and what they mean;
• LO4 The impact of inflation on interest
rates.
 Bonds and Bond Valuation
• A bond is a legally binding agreement
between a borrower and a lender that
specifies the:
– Par (face) value
– Coupon rate
– Coupon payment
– Maturity Date
• The yield to maturity (YTM) is the required
market interest rate on the bond.
 Example
• The Beck Corporation wants to borrow $1,000 for
30 years. The interest rate on similar debt issued by
similar corporations is 12%. Beck will thus pay
0.12*1,000=$120 in interest every year for 30 years.
At the end of 30 years, Beck will repay the $1,000.
– Par (face) value
– Coupon rate
– Coupon payment: a level coupon bond (the coupon is
constant and paid every year)
– Maturity Date
 Bond Valuation

• Primary Principle:
– Value of financial securities = PV of expected
future cash flows
• Bond value is, therefore, determined by the
present value of the coupon payments and
par value.
• Discount rates are inversely related to present
(i.e., bond) values.
 The Bond-Pricing Equation
Bond Value = Present value of the coupons +
Present value of the face amount

T
C F
Bond Value = ෍ t
+
(1 + r) (1 + r)T
t=1
1
1−
(1 + r)T F
Bond Value = C +
r (1 + r)T
 Bond Example

• Consider a U.S. government bond with as 6.375%

coupon that expires in December 2023.
– The Par Value of the bond is $1,000.
– Coupon payments are made semiannually (June 30 and
December 31 for this particular bond).
– Since the coupon rate is 6.375%, the payment is $31.875.
– On January 1, 2019 the size and timing of cash flows are:
$31.875 $31.875 $31.875 $1,031.875

1/1/19 6/30/19 12/31/19 6/30/23 12/31/23

 Bond Example

• On January 1, 2019, the required yield is 5%.

• The current value is:

$31.875 1 $1,000
𝑃𝑉 = 1− 10
+
.05Τ2 (1.025) (1.025)10
= $1,060.17
 Bond Example

• Now assume that the required yield is 11%.

• How does this change the bond’s price?

$31.875 1 $1,000
𝑃𝑉 = 1− 10
+
.11Τ2 (1.055) (1.055)10
= $825.69
 YTM and Bond Value
When the YTM < coupon, the
1300 bond trades at a premium.
Bond Value

1200

1100 When the YTM = coupon, the

bond trades at par.
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6.375 Discount Rate
When the YTM > coupon, the bond trades at a discount.
 Bond Concepts

❑ Bond prices and market interest rates move

in opposite directions.
❑ When coupon rate = YTM, price = par value
❑ When coupon rate > YTM, price > par value
(premium bond)
❑ When coupon rate < YTM, price < par value
(discount bond)
 Interest Rate Risk
• The risk that arises for bond owners from fluctuating
interest rates is called interest rate risk.
• How much interest rate risk a bond has depends on how
sensitive its price is to interest rate changes.
• The sensitivity directly depends on two things: the time to
maturity and the coupon rate.
• All other things being equal, the longer the time to
maturity, the greater the interest rate risk.
• All other things being equal, the lower the coupon rate,
the greater the interest rate risk.
 Maturity and Bond Price Volatility
Bond Value

Consider two otherwise identical bonds.

The long-maturity bond will have much
more volatility with respect to changes in
the discount rate.

Par

Short Maturity Bond

C Discount Rate
Long Maturity Bond
 Coupon Rates and Bond Prices
Bond Value

Consider two otherwise identical bonds.

The low-coupon bond will have much
more volatility with respect to changes in
the discount rate.

Par

High Coupon Bond

C Low Coupon Bond Discount Rate

 Computing Yield to Maturity
• Yield to maturity is the rate implied by the
current bond price.
• Finding the YTM requires trial and error if you
do not have a financial calculator and is similar
to the process for finding IRR.
• If you have a financial calculator, enter N, PV,
PMT, and FV, remembering the sign
convention (PMT and FV need to have the
same sign, PV the opposite sign).
 YTM with Annual Coupons
• Consider a bond with a 10% annual coupon
rate, 15 years to maturity, and a par value of
$1,000. The current price is $928.09.
– Will the yield be more or less than 10%?
– N = 15; PV = 928.09; FV = 1,000; PMT = 100
– CPT I/Y = 11%
 YTM with Semiannual Coupons
• Suppose a bond with a 10% coupon rate and
semiannual coupons has a face value of
$1,000, 20 years to maturity, and is selling for
$1,197.93.
– Is the YTM more or less than 10%?
– What is the semi-annual coupon payment?
– How many periods are there?
– N = 40; PV = 1,197.93; PMT = 50; FV = 1,000; CPT
I/Y = 4% (Is this the YTM?)
– YTM = 4%*2 = 8%
 Current Yield vs. Yield to Maturity
• Current Yield = annual coupon / price
• Yield to maturity = current yield + capital gains yield
• Example: 10% coupon bond, with semi-annual
coupons, face value of 1,000, 20 years to maturity,
$1,197.93 price
– Current yield = 100 / 1,197.93 = .0835 = 8.35%
– Price in one year, assuming no change in YTM = 1,193.68
– Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 =
-.0035 = -.35%
– YTM = 8.35 - .35 = 8%, which is the same YTM computed
earlier
 Zero Coupon Bonds
• Make no periodic interest payments (coupon rate =
0%)
• The entire yield to maturity comes from the
difference between the purchase price and the par
value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
• Treasury Bills and principal-only Treasury strips are
good examples of zeroes
 Pure Discount Bonds

Information needed for valuing pure discount bonds:

– Time to maturity (T) = Maturity date - today’s date
– Face value (F)
– Discount rate (r)

$0 $0 $0 $𝐹

0 1 2 𝑇−1 𝑇

Present value of a pure discount bond at time 0:

𝐹
𝑃𝑉 =
(1 + 𝑟)𝑇
 Pure Discount Bonds: Example
Find the value of a 15-year semiannual zero-
coupon bond with a $1,000 par value and a
YTM of 12%.
$0 $0 $0 $1,000
$0
$1,000
⋯
0
1
2
29
30

0 1 2 29 30

𝐹 $1,000
𝑃𝑉 = = = $174.11
(1 + 𝑟)𝑇 (1.06)30
 Bond Pricing with a Spreadsheet
• There are specific formulas for finding bond
prices and yields on a spreadsheet.
– PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)
– YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
– Settlement and maturity need to be actual dates
– The redemption and Pr need to given as % of par value
• Click on the Excel icon for an example.
 Questions
• What are the cash flow associated with a
bond?
• What is the general expression for the
value of a bond?
 Government and Corporate Bonds

• Treasury Securities
– Federal government debt
– T-bills – pure discount bonds with original maturity less
than one year
– T-notes – coupon debt with original maturity between one
and ten years
– T-bonds – coupon debt with original maturity greater than
ten years
• Municipal Securities
– Debt of state and local governments
– Varying degrees of default risk, rated similar to corporate
debt
– Interest received is tax-exempt at the federal level
 After-tax Yields
• A taxable bond has a yield of 8%, and a
municipal bond has a yield of 6%.
– If you are in a 40% tax bracket, which bond do you
prefer?
• 8%(1 - .4) = 4.8%
• The after-tax return on the corporate bond is 4.8%,
compared to a 6% return on the municipal
– At what tax rate would you be indifferent between
the two bonds?
• 8%(1 – T) = 6%
• T = 25%
 Corporate Bonds

• Greater default risk relative to government

bonds
• The promised yield (YTM) may be higher than
the expected return due to this added default
risk
Bond Ratings – Investment Quality
• High Grade
– Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
– Moody’s Aa and S&P AA – capacity to pay is very
strong
• Medium Grade
– Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
– Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more impact
on the firm’s ability to pay
 Bond Ratings - Speculative
• Low Grade
– Moody’s Ba and B
– S&P BB and B
– Considered speculative with respect to capacity to
pay.
• Very Low Grade
– Moody’s C
– S&P C & D
– Highly uncertain repayment and, in many cases,
already in default, with principal and interest in
arrears.
• Junk bonds are bonds that carry a higher risk of
default.
 Questions
• What is the junk bond?
 Inflation and Interest Rates
• Real rate of interest – have been adjusted for
inflation
• Nominal rate of interest – quoted rate of
interest and have not been adjusted for
inflation.
• The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation.
 Real versus Nominal Rates:
The Fisher Effect
• (1 + R) = (1 + r)(1 + h), where
– R = nominal rate
– r = real rate
– h = expected inflation rate
• Approximation
–R=r+h
 Inflation-Linked Bonds
• Most government bonds face inflation risk
• TIPS (Treasury Inflation-Protected Securities),
however, eliminate this risk by providing
promised payments specified in real, rather
than nominal, terms
 The Fisher Effect: Example
• If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
• R = (1.1)(1.08) – 1 = .188 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because the real return and expected inflation
are relatively high, there is a significant
difference between the actual Fisher Effect
and the approximation.
 Questions
• What is the different between a nominal
and a real return? Which is more important
to a typical investor?
• What is the Fisher effect?