Bond valuation

What is a bond?
What is a bond?
What is a bond?
What is a bond?
 What is a bond?

A bond is a long-term debt instrument issued by

a corporation or a government. It is a fixed-income
security.
 What is a bond?

A bond is a formal contract to repay borrowed

money with interest at fixed intervals.

A bond provides the borrower with external

funds to
finance long term investments (for
corporations)
finance current expenditures (for
municipal, state or national governments).
 Stocks and bonds: differences

Shares of stock Bond

Equity stake in the firm Creditor stake in the

firm
[i.e. owners] [.i.e. lenders]

Undefined term Defined term (maturity)

(outstanding indefinitely)
 Types of bonds

A non-zero coupon-paying bond is a coupon-

paying bond with a finite life.
A zero-coupon bond is a bond that pays no
interest but sells at a deep discount from face
value.
A perpetual bond is a bond that never
matures. It has an infinite life.
 Types of bonds

A fixed rate bond is a bond whose coupon

rate remains constant throughout the life of
the bond.
A floating rate bond is a bond with a
variable coupon that is linked to a reference
rate of interest, such as the LIBOR. [LIBOR +
20 b.p.]
An inflation-linked bond is a bond whose
coupon payments and principal are indexed to
inflation.
Gilts in the UK
 The maturity value

The maturity value [or face value (FV)] of a

bond is the stated value.
In the case of a U.S. bond, the FV is usually
$1,000.
 Coupon rate

The coupon rate [or coupon yield] of a bond

is the stated rate of interest.

Annual coupon payments (CP)

Coupon rate =
Face value (FV)

For example:
Annual coupon payments = $80
Face value = $1,000
Coupon rate = $80 ÷
$1,000
= 0.08 = 8%
 Sample problem #1

If the annual coupon payments are $70 and

the face value of a bond is $1,000, what is its
coupon rate?
Annual coupon payments (CP)
Coupon rate =
Face value (FV)

Annual coupon payments = $70

Face value = $1,000
Coupon rate = $70 ÷
$1,000
= 0.07 = 7%
 Sample problem #2

If the annual coupon payments are $100 and

the face value of a bond is $1,000, what is its
coupon rate?
Annual coupon payments (CP)
Coupon rate =
Face value (FV)

Annual coupon payments = $100

Face value = $1,000
Coupon rate = $100 ÷
$1,000
= 0.10 = 10%
 The discount rate

The discount rate [or capitalization rate] of a

bond is dependent on the risk of the bond.

The discount rate (k ) is composed of the

d
risk-free rate plus a premium for risk.
 Bond valuation

Bond value = PV of coupons + PV of MV

Bond value = PV annuity + PV of lump sum

Remember: as interest rates increase, the

PVs decrease.

So, as interest rates increase, bond prices

decrease.
 Bond valuation

Bond value = PV of coupons + PV of MV

Bond value = PV annuity + PV of lump sum

V = CP (PVIFA k d, n ) + FV
(PVIF k d, n )
 Bond valuation

A bond has a $1,000 face value and provides

an 8% annual coupon for 30 years. The
appropriate discount rate is 10%. What is the
value of the bond?

V = CP (PVIFA k d, n ) + FV
(PVIF k d, n )
 Bond valuation

A bond has a $1,000 face value and provides

an 8% annual coupon for 30 years. The
appropriate discount rate is 10%. What is the
value of the bond?
V = CP (PVIFA 10%, 30) + FV (PVIF
10%, 30)
= $80 (9.4269) + $1,000
(0.0573)
= $754.15 + 57.30
= $811.45
 Sample problem #1

A bond has a $1,000 face value and provides a

6% annual coupon for 20 years. The
appropriate discount rate is 6%. What is the
value of the bond?
V = CP (PVIFA 6%, 20) + FV (PVIF
6%, 20)
= $60 (11.4699) + $1,000
(0.3118)
= $688.19 + 311.80
= $999.99
 Sample problem #2

A bond has a $1,000 face value and provides a

6% annual coupon for 10 years. The
appropriate discount rate is 10%. What is the
value of the bond?
V = CP (PVIFA 10%, 10) + FV (PVIF
10%, 10)
= $60 (6.1446) + $1,000
(0.3855)
= $368.68 + 385.50
= $754.18
 Semi-annual compounding

Most bonds pay coupon payments twice a

year.
They pay ½ of the annual coupon payments.

Adjustments needed for semi-annual

compounding:
(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide CP by 2
 Semi-annual compounding

A non-zero coupon bond adjusted for semi-

annual compounding

V = CP/2 (PVIFA kd/2, n*2 ) + FV (PVIF

kd/2, n*2 )
 Sample problem #1

A bond has a $ 1,000 face value and provides

an 8% semi-annual coupon for 15 years. The
appropriate discount rate is 10% (annual
rate). What is the value of the coupon bond?

V = CP/2 (PVIFA 10%/2, 15*2 ) + FV (PVIF

10%/2, 15*2)

= $40 (15.3725) + $1,000

(0.2314)
= $614.90 + 231.40
= $846.30
 Sample problem #2

A bond has a $ 1,000 face value and provides

an 6% semi-annual coupon for 15 years. The
appropriate discount rate is 6% (annual rate).
What is the value of the coupon bond?

V = CP/2 (PVIFA 6%/2, 15*2 ) + FV (PVIF

6%/2, 15*2)

= $30 (19.6004) + $1,000

(0.4120)
= $588.01 + 412.00
= $1,000.01
 Zero-coupon bond valuation

A zero-coupon bond is a bond that pays no

interest but sells at a deep discount from its
face value.

V = FV (PVIF k d,

n)
 Zero-coupon bond example 1

A bond has a $1,000 face value and a 30-year

life. The appropriate discount rate is 10%.
What is the value of the zero-coupon bond?

V = FV (PVIF k d,

n)
 Zero-coupon bond example 1

A bond has a $1,000 face value and a 30-year

life. The appropriate discount rate is 10%.
What is the value of the zero-coupon bond?

V = FV (PVIF 10%, 30)

= $1,000 (0.0573)
= $57.30
 Zero-coupon bond example 2

A bond has a $1,000 face value and a 30-year

life. The appropriate discount rate is 6%.
What is the value of the zero-coupon bond?

V = FV (PVIF 6%, 30)

= $1,000 (0.1741)
= $174.10
 Zero-coupon bond example 3

A bond has a $1,000 face value and a 10-

year life. The appropriate discount rate is
6%. What is the value of the zero-coupon
bond?

V = FV (PVIF )
6%, 10

= $1,000 (0.5584)
= $558.40
 Perpetual bond valuation

A perpetual bond is a bond that never

matures. It has an infinite life.

V = CP / kd
 Perpetual bond example 1

A bond has a $1,000 face value and provides an

8% coupon. The appropriate discount rate is
10%. What is the value of the perpetual bond?

V = CP / kd
 Perpetual bond example 1

A bond has a $1,000 face value and provides an

8% coupon. The appropriate discount rate is
10%. What is the value of the perpetual bond?

CP = $1,000 * (8%) =
$80
kd = 10% = 0.10
V = CP / kd
= $80 / 0.10
= $800
 Perpetual bond example 2

A bond has a $1,000 face value and provides a

6% coupon. The appropriate discount rate is
20%. What is the value of the perpetual bond?

CP = $1,000 * (6%) =
$60
kd = 20% = 0.20
V = CP / kd
= $60 / 0.20
= $300
 Perpetual bond example 3

A bond has a $1,000 face value and provides a

5% coupon. The appropriate discount rate is
8%. What is the value of the perpetual bond?

CP = $1,000 * (5%) =
$50
kd = 8% = 0.08
V = CP / kd
= $50 / 0.08
= $625
 Yield to maturity (YTM)

The yield to maturity (YTM) of a bond is

the discount rate which returns the market
price of the bond.
 YTM is often used to price a bond.

 Bond prices are often quoted in terms of

YTM.
 YTM calculations

You want to determine the YTM for an issue

of outstanding bonds at your firm.
Your firm has an issue of 10% annual coupon
bonds with 15 years left to maturity.
The bonds have a current market value of
$1,250.

What is the YTM?

 YTM solution (9%)

$1,250 = $100 (PVIFA )

9%, 15
+
$1,000 (PVIF )
9%, 15

$1,250 = $100 (8.0607) +

$1,000 (.2745)
$1,250 = $806.07 +
$274.50
= $1,080.57

[Rate is too high]

 YTM solution (7%)

$1,250 = $100 (PVIFA )

7%, 15
+
$1,000 (PVIF )
7%, 15

$1,250 = $100 (9.1079) +

$1,000 (.3624)
$1,250 = $910.79 +
$362.40
= $1,273.19

[Rate is too low]

 YTM solution (interpolate)

.07 $1,273.19
$23.
.02 X YTM $1,250.00
$192.62
19
.09 $1,080.57

X = $23.19
.02 $192.62
 YTM solution (interpolate)

.07 $1,273.19
$23.19
.02 X YTM $1,250.00
$192.62
.09 $1,080.57

X = $23.19
.02 $192.62
 YTM solution (interpolate)

.07 $1,273.19
$23.19
.02 X YTM $1,250.00
$192.62
.09 $1,080.57

X= ($23.19)(0.02) X = .0024
$192.62

YTM = .07 + .0024 = .0724 or 7.24%

 YTM problem 1

You want to determine the YTM for an issue

of outstanding bonds at your firm.
Your firm has an issue of 8% annual coupon
bonds with 10 years left to maturity.
The bonds have a current market value of
$1,100.

What is the YTM?

 YTM problem 2

You want to determine the YTM for an issue

of outstanding bonds at your firm.
Your firm has an issue of 9% annual coupon
bonds with 12 years left to maturity.
The bonds have a current market value of
$1,310.

What is the YTM?

 Current vs. coupon yield

The current yield is the coupon payment (CP)

as a percentage of the current bond price (V).

Current yield = CP ÷ V

The coupon yield of a bond is the stated rate

of interest.

Annual coupon payments (CP)

Coupon yield =
Face value (FV)
 Premium vs. discount bond

A bond selling for more than its face value is

called a premium bond.
A bond selling for less than its face value is
called a discount bond.
 YTM, current, coupon yield

When a bond sells at a discount

YTM > current yield > coupon yield

When a bond sells at a premium

Coupon yield > current yield > YTM

When a bond sells at par

YTM = current yield = coupon yield
 The Bangladeshi bond market

Bangladesh’s bond market is TINY.

$18 billion bond market (as of 2021)

 Pakistan - $66 billion
 Indonesia - $233 billion
 Malaysia - $345 billion

Source:
https://www.tbsnews.net/thoughts/bond-mark
et-bangladesh-not-so-vibrant-promising-3179
65
 The Bangladeshi bond market

The bond market is dominated by short and

long term government securities.
The Bangladesh Bank sells 91-day, 182-day
and 364-day treasury bills and two, five, ten,
fifteen and twenty year treasury bonds.
The central bank holds auctions every week
and any investor can bid for bonds through
any primary dealer (currently 23 commercial
banks serve as primary dealers)
 The Bangladeshi bond market

An auction committee fixes the coupon rate

which is applicable throughout the
instrument’s life.
These government bonds pay interest or
coupon payments every six months.
Generally, these bonds are of 100,000 Taka
denomination or their multiples.
 The Bangladeshi bond market

There is a secondary bond market; however,

the trading activity is very limited.
Government paper has been traded since
2005.
Corporate bonds are far and few in between.
 The Bangladeshi bond market

The corporate bond market is highly under-

developed and has eight debentures and nine
bonds.

Notable corporate bonds include the Islamic

Bank Bangladesh Limited (IBBL) Mudaraba
Perpetual bond. (Perpetual bond)