CHAPTER

3 3-1

VALUING BONDS

Brealey, Myers, and Allen

Principles of Corporate
Finance
13th Edition
Topics Covered
3-2

• Using the Present Value Formula to Value

Bonds
• How Bond Prices Vary with Interest Rates
• The Term Structure of Interest Rates
• Explaining the Term Structure
• Real and Nominal Rates of Interest
• The Risk of Default
 3-3

• Investment in new plant and equipment requires

money.
• Sometimes firms can retain and accumulate
earnings to cover the cost of investment, but often
they need to raise extra cash from investors. If
they choose not to sell additional shares of stock,
the cash has to come from borrowing.
• If cash is needed for only a short while, firms may
borrow from a bank. If they need cash for long-
term investments, they generally issue bonds,
which are simply long-term loans.
 3-4

• Companies are not the only bond issuers.

Municipalities also raise money by selling bonds.
So do national governments.
• Do not confuse interest rate that the government
pays when it borrows with the cost of capital for
a corporation.
• The markets for government bonds are huge. At
the start of 2018, investors held $14.8 trillion of
U.S. government securities, and U.S.
government agencies held a further $5.7 trillion.
 3-5

• Companies can’t borrow at the same low interest

rates as governments. The interest rates on
government bonds are benchmarks for all
interest rates, however. When government
interest rates go up or down, corporate rates
follow more or less proportionally. Therefore,
financial managers had better understand how
the government rates are determined and what
happens when they change.
 3-6

• Corporate bonds are more complex securities

than Government bonds.
• It is more likely that a corporation may be
unable to come up with the money to pay its
debts, so investors have to worry about default
risk.
• Corporate bonds are also less liquid than
government bonds: They are not as easy to
buy or sell, particularly in large quantities or on
short notice.
Terminology
3-7

• Bond
o Security that obligates the issuer to make specified
payments to the bondholder.
• Face value (par value or principal value)
o Payment at the maturity of the bond.
• Coupon
o The interest payments made to the bondholder.
• Coupon rate
o Annual interest payment, as a percentage of face
value.
 3-8

• The coupon rate IS NOT the discount rate used

in the present value calculations.
• The coupon rate merely tells us what cash flow
the bond will produce.
• Since the coupon rate is listed as a %, this
misconception is quite common.
 3-9

• Suppose that in October 2017 you decide to buy

€100 face value of the 6.00% a French bond
maturing in October 2025. Each year until the
bond matures, you are entitled to an interest
payment of .06 × 100 = €6.00. This amount is the
bond’s coupon.
• When the bond matures in 2025, the government
pays you the final €6.00 interest, plus the principal
payment of €100. Your first coupon payment is in
one year’s time, in October 2018. So the cash
payments from the bond are as follows:
 3-10

What is the present value of these payments?

It depends on the opportunity cost of capital, which in this
case equals the rate of return offered by other government
debt issues denominated in euros.
In October 2017, other medium-term French government
bonds offered a return of just .3%.
That is what you were giving up when you bought the 6.00%
bond.
 3-11

• Bond prices are usually expressed as a

percentage of face value. Thus the price of
your 6.00%

• Bond prices are usually expressed as a

percentage of face value. Thus the price of
your 6.00% Bond was quoted as 144.99%.
 3-12

• The bond amounts to a package of two

investments. The first investment gets the eight
annual coupon payments of €6.00 each. The
second gets the €100 face value at maturity. You
can use the annuity formula from Chapter 2 to
value the coupon payments and then add on the
present value of the final payment.
 3-13

• Now we turn the valuation around: If the price

of the OAT is 144.99%, what is the interest
rate? What return do investors get if they buy
the bond and hold it to maturity? To answer this
question, you need to find the value of the
variable y that solves the following equation:
 3-14

• The rate of return y is called the bond’s yield to

maturity.

• In this case, we already know that the present

value of the bond is 144.99% at a .3% discount
rate, so the yield to maturity must be .3%. If
you buy the bond at 144.99% and hold it to
maturity, you will earn a return of .3% per year.
 3-15

• A bond that is priced above its face value is said

to sell at a premium.
• Investors who buy a bond at a premium face a
capital loss over the life of the bond, so the yield
to maturity on these bonds is always less than
the current yield.
• A bond that is priced below face value sells at a
discount. Investors in discount bonds look
forward to a capital gain over the life of the bond,
so the yield to maturity on a discount bond is
greater than the current yield.
 3-16

• The only general procedure for calculating the

yield to maturity is trial and error. You guess at
an interest rate and calculate the present value
of the bond’s payments. If the present value is
greater than the actual price, your discount rate
must have been too low, and you need to try a
higher rate. The more practical solution is to
use a spreadsheet program or a specially
programmed calculator to calculate the yield.
PV Formula to Value a Bond
3-17

The price of a bond is the present value of all

cash flows generated by the bond (i.e. coupons
and face value) discounted at the required rate
of return

cpn cpn (cpn  par )

PV  1
 2
 .... 
(1  r ) (1  r ) (1  r ) t

Note: “cpn” is commonly used as an abbreviation for “coupon”

PV Formula to Value a Bond Continued
3-18

Example: France
In October 2014 you purchase 100 euros of bonds in
France that pay a 4.25% coupon every year. If the bond
matures in 2018 and the YTM is 0.15%, what is the value
of the bond?

4.25 4.25 4.25 104.25

PV    
1.0015 1.0015 1.0015 1.00154
2 3

116 .34 euros

PV Formula to Value a Bond Continued 2
3-19

PV(bond) = PV(annuity of coupons) + PV(principal)

PV (bond) (cpn PVAF)  (final payment discount factor)

 1 1  100
4.25   4

 .0015 . 00151  .0015   
1  . 0015 4

116 .34
PV Formula to Value a Bond Continued 3
3-20

Example
If today is October 1, 2015, what is the value of the
following bond? An IBM bond pays $115 every
September 30 for 5 years. In September 2020 it pays an
additional $1000 and retires the bond. The bond is rated
AAA (WSJ AAA YTM is 7.5%)

115 115 115 115 1,115

PV     
1.075 1.075 1.075 1.075 1.0755
2 3 4

$1,161.84
PV Formula to Value a Bond Continued 4
3-21

Example
What is the price of a 7.25% annual coupon bond with a
$1,000 face value that matures in three years? Assume
a required return of 0.35%.

72.50 72.50 1,072.50

PV  1
 2
 3
(1.0035) (1.0035) (1.0035)
PV $1,205.56
PV Formula to Value a Bond Continued 5
3-22

Example continued
What is the price of a 7.25% annual coupon bond with a
$1,000 face value that matures in 3 years? Assume a
required return of 0.35%.

Bond prices are quoted as a percentage of par.

PV Formula to Value a Bond Concluded
3-23

Example: United States

In November 2014 you purchase a three-year U.S.
government bond. The bond has an annual coupon rate
of 4.25%, paid semiannually. If investors demand a
0.965% semiannual return, what is the price of the bond?

21.25 21.25 21.25 21.25 21.25 1021.25

PV      
1.004825 1.0048252 1.0048253 1.0048254 1.0048255 1.0048256

$1,096.90
Figure 3.1 The Interest Rate on 10-Year U.S.
Treasury Bonds
3-24

2012
Figure 3.2 Bond Prices Vary with Interest Rates
3-25
 3-26

• Plot of bond prices as a function of the interest

rate.
• The price of long-term bonds is more sensitive
to changes in the interest rate than is the price
of short term bonds.
How Bond Prices Vary with Interest Rates
3-27

Rate of Return: Total income per period per

dollar invested

total income
Rate of return =
investment

coupon income + price change

Rate of return =
investment
How Bond Prices Vary with Interest Rates
Continued
3-28

Example
A bond increases in price from $963.80 to
$1,380.50 and pays a coupon of $21.875 during the
same period. What is the rate of return?

21.875  (1380.50  963.80)

Rate of return  .455
963.80

ROR = 45.5%
 3-29

• A change in interest rates has only a modest impact

on the value of near-term cash flows but a much
greater impact on the value of distant cash flows.
Thus the price of long-term bonds is affected more
by changing interest rates than the price of short-
term bonds.
• For example, compare the two curves in Figure 3.2.
The brown line shows how the price of the four-year
8% bond varies with the interest rate. The blue line
shows how the price of a 30-year 8% bond varies.
You can see that the 30-year bond is much more
sensitive to interest rate fluctuations than the four-
year bond.
Duration and Volatility
3-30

• Changes in interest rates have a greater

impact on the prices of long-term bonds than
on those of short-term bonds.
• But what do we mean by “long term” and “short
term”? A coupon bond that matures in year 30
makes payments in each of years 1 through
30. It’s misleading to describe the bond as a
30-year bond; the average time to each cash
payment is less than 30 years.
 3-31

• Table 3.2 calculates the prices of two seven-year

bonds. We assume annual coupon payments and a
yield to maturity of 4% per year. Take a look at the
time pattern of each bond’s cash payments and
review how the prices are calculated:
• Which of these two bonds is the longer-term
investment? They both have the same final maturity,
of course. But the timing of the bonds’ cash
payments is not the same. In the case of the 3s, the
average time to each cash flow is longer, because a
higher proportion of the cash flows occurs at
maturity, when the face value is paid off.
3-32
 3-33

• Suppose now that the yield to maturity on each

bond falls to 3%. Which bond would you most
like to own? The 3s, of course.
• Since they have the longer effective life, they
should benefit most from a fall in yields. Table
3.3 confirms that this is indeed the case:
• The 9s have the shorter average life and
therefore a shift in interest rates has a more
muted effect on the price.
 3-34

• A precise measure of the average life, one that

could be used to predict the exposure of each
bond’s price to fluctuations in interest rates.
• There is such a measure, and it is called duration
or Macaulay duration after its founder.
• Duration is the weighted average of the times to
each of the cash payments. The times are the
future years 1, 2, 3, etc., extending to the final
maturity date, which we call T. The weight for
each year is the present value of the cash flow
received at that time divided by the total present
value of the bond.
Duration and Volatility
3-35

1PV (C1 ) 2 PV (C2 ) 3 PV (C3 ) T PV (CT )

Duration     ... 
PV PV PV PV

duration
Modified duration volatility (%) 
1  yield
Table 3.4 Calculating the Duration of 9%
Seven-Year Bonds
3-36
Figure 3.3 The Term Structure of Interest Rates
3-37
excel
3-38
Law of One Price
3-39

• All interest-bearing instruments are priced to fit

the term structure
• This is accomplished by modifying the asset
price
• The modified price creates a new yield, which
fits the term structure
• The new yield is called the yield to maturity
(YTM)
Figure 3.4 Measuring the Term Structure
3-40

Spot rates on U.S. Treasury strips, December 2017

 3-41

• The relationship between short- and long-term

interest rates is called the term structure of
interest rates.
Explaining the Term Structure
3-42

Expectations Theory
o Term structure and capital budgeting
 CF should be discounted using term structure info
 When rate incorporates all forward rates, use spot
rate that equals project term
 Take advantage of arbitrage
Figure 3.5 Annual Rates of Inflation in the
United States from 1900–2017
3-43
Figure 3.6 Average Rates of Inflation in 20
Countries from 1900–2017
3-44
Real and Nominal Rates of Interest
3-45

• In the presence of inflation, an investor’s real

interest rate is always less than the nominal
interest rate
• Real rate of return:
Real and Nominal Rates of Interest Continued
3-46

Example
If you invest in a security that pays 10% interest annually
and inflation is 6%, what is your real interest rate?

Real interest rate = .03774 or 3.774%

Real and Nominal Rates of Interest Concluded
3-47

Treasury Inflation-Protected Securities (TIPS)

Example
If you invest in a 5% coupon, three-year TIPS and
inflation is 3% each year, what are your real annual cash
flows?

Year 1 2 3
Real cash flows $50 $50 $1,050
Figure 3.7 Inflation and Nominal Interest Rates
3-48
Figure 3.8 The Return on Treasury Bills and the
Rate of Inflation, 1953–2017, (a) UK
3-49
Figure 3.8 The Return on Treasury Bills and the
Rate of Inflation, 1953–2017, (b) U.S.
3-50
Figure 3.8 The Return on Treasury Bills and the
Rate of Inflation, 1953–2017, (c) Germany
3-51
The Risk of Default
3-52

• Default or Credit Risk—The risk that a bond

issuer may default on its bonds
• Default premium—The additional yield on a
bond that investors require for bearing credit
risk
• Investment-grade bonds—Bonds rated Baa or
above by Moody’s or BBB or above by
Standard & Poor’s
• Junk bonds—Bond with a rating below Baa or
BBB
Table 3.7 Prices and Yields of a Sample of
Corporate Bonds
3-53
Table 3.8 Key to Bond Ratings
3-54
Figure 3.9 Yield Spreads between Corporate and 10-
Year Treasury Bonds, January 1953–January 2018
3-55
Sovereign Bonds and Default Risk
3-56

• Sovereign Bonds and Default Risk

o Foreign currency debt
Default occurs when foreign government
borrows dollars
If crisis occurs, governments may run out of
taxing capacity and default
Affects bond prices, yield to maturity
Sovereign Bonds and Default Risk Continued
3-57

• Sovereign Bonds and Default Risk

o Own currency debt
Less risky than foreign currency debt
Governments can print money to repay bonds
Sovereign Bonds and Default Risk Concluded
3-58

• Sovereign Bonds and Default Risk

o Eurozone debt
Can’t print money to service domestic debts
Money supply controlled by European Central
Bank