Chapter 4

Valuing Bonds

Irwin/McGraw-Hill

Topics Covered


Bond Characteristics
reading the financial pages

Bond Prices and Yields

Bond prices and interest rates YTM vs. current yield Rate of Return Interest Rate Risk The Yield Curve Nominal and Real Rates of Interest Default Risk
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Definitions
Par or Face Value 

The amount of money that is paid to the bondholders at maturity. For most bonds this amount is $1,000. It also generally represents the amount of money borrowed by the bond issuer.

Coupon Rate 

The coupon rate, which is generally fixed, determines the periodic coupon or interest payments. It is expressed as a percentage of the bond's face value. It also represents the interest cost of the bond to the issuer.

Definitions
Coupon Payments 

The coupon payments represent the periodic interest payments from the bond issuer to the bondholder. The annual coupon payment is calculated by multiplying the coupon rate by the bond's face value. Since most bonds pay interest semiannually, generally one half of the annual coupon is paid to the bondholders every six months.

Maturity Date 

The maturity date represents the date on which the bond matures, i.e., the date on which the face value is repaid. The last coupon payment is also paid on the maturity date.

Definitions
Original Maturity 

The time from when the bond was issued until its maturity date.

Remaining Maturity 

The time currently remaining until the maturity date.

Call Date 

For bonds which are callable, i.e., bonds which can be redeemed by the issuer prior to maturity, the call date represents the earliest date at which the bond can be called.
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Definitions
Call Price 

The amount of money the issuer has to pay to call a callable bond (there is a premium for calling the bond early). When a bond first becomes callable, i.e., on the call date, the call price is often set to equal the face value plus one year's interest.

Required Return 

The rate of return that investors currently require on a bond.

Definitions
Yield to Maturity 

The rate of return that an investor would earn if he bought the bond at its current market price and held it until maturity. Alternatively, it represents the discount rate which equates the discounted value of a bond's future cash flows to its current market price.

Yield to Call 

The rate of return that an investor would earn if he bought a callable bond at its current market price and held it until the call date given that the bond was called on the call date.
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Bonds
Terminology  Bond - Security that obligates the issuer to make specified payments to the bondholder.  Coupon - The interest payments made to the bondholder.  Face Value (Par Value or Maturity Value) - Payment at the maturity of the bond.  Coupon Rate - Annual interest payment, as a percentage of face value.
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Bonds
WARNING
The coupon rate IS NOT the discount rate used in the Present Value calculations.

Bonds
WARNING
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.
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Bond Pricing
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.

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Bond Pricing
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  par ) cpn cpn PV !  .... 1 2 t (1  r ) (1  r ) (1  r )

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BOND PRICES AND INTEREST RATE



when the market interest rate exceeds the coupon rate, bonds sell for less than face value. When the market interest rate is below the coupon rate, bonds sell for more than face value.

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Bond Pricing
Example What is the price of a 6 % annual coupon bond, with a $1,000 face value, which matures in 3 years? Assume a required return of 5.6%.

Market rate

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Bond Pricing
Example What is the price of a 6 % annual coupon bond, with a $1,000 face value, which matures in 3 years? Assume a required return of 5.6%.

60 60 1,060 PV !   1 2 3 (1.056) (1.056) (1.056) PV ! $1,010.77

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Bond Pricing
Example (continued) What is the price of the bond if the required rate of return is 6 %?

60 60 1,060 PV !   1 2 3 (1.06) (1.06) (1.06) PV ! $1,000

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Bond Pricing
Example (continued) What is the price of the bond if the required rate of return is 15 %?

60 60 1,060 PV !   1 2 3 (1.15) (1.15) (1.15) PV ! $794.51

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Bond Pricing
Example (continued) What is the price of the bond if the required rate of return is 5.6% AND the coupons are paid semiannually?

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Bond Pricing
Example (continued) What is the price of the bond if the required rate of return is 5.6% AND the coupons are paid semiannually?

30 30 30 1,030 PV !   ...   1 2 5 (1.028) (1.028) (1.028) (1.028)6 PV ! $1,010.91

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Bond Pricing
Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments?

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Bond Pricing
Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments?

Time Periods Paying coupons twice a year, instead of once doubles the total number of cash flows to be discounted in the PV formula.
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Bond Pricing
Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments?

Time Periods Paying coupons twice a year, instead of once doubles the total number of cash flows to be discounted in the PV formula.

Discount Rate Since the time periods are now half years, the discount rate is also changed from the annual rate to the half year rate.
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Valuing a Discount Bond with Annual Coupons



Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1,000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond?

Using the formula:

  

B = PV of annuity + PV of lump sum B = 100[1 1/(1.11)5] / .11 + 1,000 / (1.11)5 B = 369.59 + 593.45 = 963.04

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Valuing a Premium Bond with Annual Coupons



Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond?
Using the formula:
  

B = PV of annuity + PV of lump sum B = 100[1 1/(1.08)20] / .08 + 1000 / (1.08)20 B = 981.81 + 214.55 = 1196.36

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Bond Yields


Current Yield - Annual coupon payments divided by bond price. Yield To Maturity - Interest rate for which the present value of the bonds payments equal the price. Yield to Call if the bond is callable and the market interest rate falls below the coupon rate it is likely to be called. In this case the earning would be YTC.
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How does adding a call provision affect a bond?



Issuer can refund if rates decline. That helps the issuer but hurts the investor. Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds. Most bonds have a deferred call and a declining call premium.

Bond Yields


Suppose you are offered a 14 year, 10 percent annual coupon, $1000 bond today for $1494.93. what interest rate would you earn on your investment if you bought this bond and held it till maturity. This rate is YTM.

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Current yield -activity



    

If the price of bond is $1136.16 and coupon rate is 10%. What interest amount earned annually? 10% of face value x 1000 = 100 What is current yield? Annual interest / current price 100 / 1136.16 = 0.088 -----------8.8%

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Bond Yields
Calculating Yield to Maturity (YTM=r) If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.

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Bond Yields
Calculating Yield to Maturity (YTM=r) If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.

(cpn  par ) cpn cpn PV !  .... 1 2 t (1  r ) (1  r ) (1  r )

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Bond Yields
Example What is the YTM of a 6 % annual coupon bond, with a $1,000 face value, which matures in 3 years? The market price of the bond is $1,010.77

60 60 1,060 PV !   1 2 3 (1  r ) (1  r ) (1  r ) PV ! $1,010.77
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Bond Yields
WARNING
Calculating YTM by hand can be very tedious. It is highly recommended that you learn to use the IRR or YTM or i functions on a financial calculator.

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No.1 Current market price of bond is Rs.1072.29 and coupon rate is 6.5 percent. Find yield to Maturity when maturity period is three years.

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YILED TO MATURITY (YTM) Current price Interest per year No. of year Maturity payment -1072.29 65 3 1000

YTM

PV -1072.29

NPER 3

PMT 65

FV 1000

RATE

?????

3.90%
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Check how it is possible by discounting all cash inflow

Cash inflow 65 65 65 1000

PVIF(3.9%) 0.9624639 0.9263368 0.8915657 0.8915657

PV 62.56015 60.21189 57.95177 891.5657 1072.29

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Q No.2: A 6 year bond pays interest of Rs.80 annually and sells for Rs.950. Give Yield to maturity-YTM

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Current price Interest No. of year maturity value

-950 80 6 1000

YTM

PV NPER -950 6

PMT 80

FV 1000

RATE

?????

9.119%
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Check this rate by discounting all cash inflow

cash inflow 80 80 80 80 80 1080

PVIF(.09119) 0.916 0.840 0.770 0.705 0.646 0.592

PV 73.314 67.188 61.573 56.427 51.712 639.766 949.9801703

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Q No.3

Five year maturity bond has par value Rs.1000. Its coupon Rate is 8% per year. Current market rate of return on same type of bond Is 9%. At what price bond should be sell in market?

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TO FIND CURRENT SELLING PRICE OF BOND. coupon rate current market rate is par value current market price maturity period ????? 5 years 80 9% 1000

PV ????

PMT 80

PER 5

FV 1000

PRICE = PV

($961.10)
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Discount all cash inflow by market rate, you get price cash inflow 80 80 80 80 1080 PVIG(9%) 0.91743119 0.84167999 0.77218348 0.70842521 0.64993139 PV 73.3945 67.3344 61.77468 56.67402 701.9259 961.1035 41

Bond Yields
Rate of Return - Earnings per period per dollar invested.

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Bond Yields
Rate of Return - Earnings per period per dollar invested.

total income Rate of return = investment Coupon income + price change Rate of return = investment
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Interest Rate Risk

1,080 1,060 1,040 1,020

Premium Bond

Bond Price

1,000 980 960 940 920 900 880 0 5 10 15 20 25 30

Discount Bond

Time to Maturity
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Interest Rate Risk

3,000 2,500

30 yr bond
2,000

$ Bond Price

1,500

1,000

3 yr bond

500

10

YTM

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Nominal and Real rates

16 14 12 10

Yield on UK nominal bonds

Percent

8 6 4 2 0 82 85 88 91 94

Yield on UK indexed bonds

Year
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Default Risk
   

Credit risk Default premium Investment grade Junk bonds

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Default Risk
Moody' s Standard & Poor's Safety

Aaa Aa A Baa Ba B Caa Ca C

AAA AA A BBB BB B CCC CC C

The strongest rating; ability to repay interest and principal is very strong. Very strong likelihood that interest and principal will be repaid Strong ability to repay, but some vulnerability to changes in circumstances Adequate capacity to repay; more vulnerability to changes in economic circumstances Considerable uncertainty about ability to repay. Likelihood of interest and principal payments over sustained periods is questionable. Bonds in the Caa/CCC and Ca/CC classes may already be in default or in danger of imminent default C-rated bonds offer little prospect for interest or principal on the debt ever to be repaid.
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Corporate Bonds
  

Zero coupons Floating rate bonds Convertible bonds

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The Yield Curve

Term Structure of Interest Rates - A listing of bond maturity dates and the interest rates that correspond with each date. Yield Curve - Graph of the term structure.

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Web Resources

www.finpipe.com www.investinginbonds.com www.bloomberg.com/markets/C13.html www.bondmarkets.com/publications/IGCORP/what.htm www.moodys.com www.standardandpoors.com/ratings

Click to access web sites Internet connection required

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