Valuing Bonds

Professor:
Burcu Esmer
Valuing Bonds

A bond is a debt instrument issued by governments or corporations to

raise money

The successful investor must be able to:

Understand bond structure
Calculate bond rates of return
Understand interest rate risk
Differentiate between real and nominal returns

2
Bond Basics
Bond: long-term debt security usually issued by a corporation or government
body
Notes
Notes are issued in two-, three-, five- and 10-year terms
Bonds
Bonds are long-term investments with terms of more than 10 years
Mortgage Bonds
These bonds are typically backed by real estate holdings and/or real
property such as equipment.
Collateral Trust Bonds
A bond that is secured by a financial asset - such as stock or other
bonds - that is deposited and held by a trustee for the holders of the bond.
Debentures
A type of debt instrument that is not secured by physical asset or
collateral. 3
Bond Basics (cont.)
Bond indenture: contract between issuer and investor that
specifies terms of agreement

face (par) value: principal to be repaid at end of loan

coupon rate: (CR) the amount of the coupon payment (C) as a %
of the face value of the bond
coupons: (coupon payment) periodic interest payments made
over the life of the bond
maturity date: when bonds face value is paid
frequency of payments: usually semiannually for U.S. corporate
bonds
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bond_certificate.jpg
 Straight Bonds
An annual bond pays the holder a coupon payment, C,
each year and returns the face or par value, FV, at
maturity. C=(Coupon rate)x(Face Value)
Coupon rate is a stated rate written
onto the bond. It does not change!

C C C C+FV

0 1 2 3 N
r

4
Decompose into a $C, N-period annuity + a lump sum of $FV received in N-
periods.
Pricing Bonds
value of any financial asset: depends on amount,
timing, and riskiness of cash flows
=> use Discounted Cash Flow (DCF) valuation:

Find PV of cash flows!

6
Bond Pricing: Example
What is the price of a 9% annual coupon bond with a par
value of $1,000 that matures in 3 years? Assume a
required rate of return of 4%.

7
 Bond Pricing
A bond is a package of two investments: an annuity and a final
repayment.
1
Bond price= x 1 +
(1+) (1+)

PVBond PVCoupons PVParValue

PVBond coupon ( Annuity Factor ) par value ( Discount Factor )
1 (1 r ) t
where Annuity Factor
r
1 8
and Discount Factor
(1 r )t
 Bond Pricing: Example
What is the value of a 3-year annuity that pays $90 each year and
an additional $1,000 at the date of the final repayment? Assume a
discount rate of 4%.

1 (1 .04) 3 1
PVBond $90 $1, 000
.04 (1 .04)3
$1,138.75

9
Semiannual Coupons
Most bonds in the U.S. pay interest twice a
year (1/2 of the annual coupon).
coupon rates and yield (YTM)s quoted on
annual basis
Adjustment needed:
divide coupon payment and yield (YTM) by 2
multiply n by 2.

10
Example
PK Inc. issues 10% bonds with 20 years to maturity. Similar
bonds have a YTM of 11%. What is the price of the PK Inc.
bond if coupons payments occur annually? What is the price
of the PK Inc. bond if coupons payments occur semi-annually

Annual coupon pmt: $100, N=20. FV=1000, YTM=11%

PV of annual coupon payments: 796.33
Annual pmt: . FV=1000, N=20, YTM=11%
PV of face value : 124.03
Total price= 796.33 + 124.03 =920.36

Semi-Annual coupon pmt: $50, N=40. FV=1000, YTM=5.5%

PV of semi-coupon payments: 802.31
PV of face value : 117.46
Total price= 919.77
11
Sample Treasury bond quotes
for May 14, 2010

Bid-ask spread

12
 Bond Yields

To calculate how much we earn on a bond investment,

we can calculate two types of 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 equals
the price
13
 Current Yield: Example
Suppose you spend $1,150 for a $1,000 face value
bond that pays a $60 annual coupon payment for 3
years.

What is the bonds current yield?

Your income as a proportion of the initial outlay. 14

How about capital gain return? What will happen to the price of the bond after 3
years?
 Yield to Maturity
Yield to Maturity:

coupon coupon (coupon par)

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

15
Yield to Maturity: Example
Suppose you spend $1,150 for a $1,000 face value bond
that pays a $60 annual coupon payment for 3 years.

What is the bonds yield to maturity?

$60 $60 ($60 $1,000)

$1,150
(1 r )1
(1 r ) 2
(1 r )3

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Pricing Bonds
To price a bond: discount the coupon payments and face value
at appropriate market rate

Yield to Maturity (YTM): the required market interest rate

that makes the discounted cash flows of the bond equal to the
bonds price

17
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.

18
Pricing Bonds
In general,
Bond Value= PV of coupons + PV of par
= PVA(r,n,pmt=coupon) + PV(r,n,FV=par)
r = YTM per coupon period for this type of bond
n = # of coupon periods until maturity

1
Bond price= x 1 +
(1+) (1+)

19
Treasury Yields
The interest rate on 10-year U.S. Treasury bonds

20
 Bond Prices & Interest Rates
As interest rates change, so do bond prices.

What is the present value of a 4% coupon bond with face value

$1,000 that matures in 3 years? Assume a discount rate of 5%.

What is the present value of this same bond at a discount rate of 2%?

21
Bond Pricing
Example
What is the price of a 5.0 % annual coupon bond,
with a $1,000 face value, which matures in 3
years? Assume a required return of 2.15%.

50 50 1,050
PV
(1.0215) (1.0215) (1.0215)3
1 2

PV $1,081.95
22
Bond Pricing
Example (continued)
What is the price of the bond if the required rate
of return is 5 %?

50 50 1,050
PV 1
2
3
(1.050) (1.050) (1.050)
PV $1,000

23
Bond Pricing
Example (continued)
What is the price of the bond if the required rate
of return is 8 %?

50 50 1,050
PV 1
2

(1.08) (1.08) (1.08)3
PV $922.69

24
Dynamic Behavior of Bond
Prices
Discount
A bond is selling at a discount if the price is less than the face
value.
Par
A bond is selling at par if the price is equal to the face value.
Premium
A bond is selling at a premium if the price is greater than the face
value.

25
Discounts and Premiums
If a coupon bond trades at a discount, an investor will earn a
return both from receiving the coupons and from receiving a
face value that exceeds the price paid for the bond.
If a bond trades at a discount, its yield to maturity will exceed its
coupon rate.
What is the relationship between current yield and the return on
bonds in this case?

If a coupon bond trades at a premium it will earn a return

from receiving the coupons but this return will be diminished
by receiving a face value less than the price paid for the bond.
Most coupon bonds have a coupon rate so 26
that the bonds will initially trade at, or very close to, par.
Discounts and Premiums
(cont'd)
Bond Prices Immediately After a Coupon Payment

27
Example

28
Example (cont'd)

29
Interest Rate Risk
Definition: changes in bond prices arising from fluctuating market interest
rates

1,200

1,100
Bond price ($)

1,000

900

800

700
0 2 4 6 8 10 12 14 16
Interest rate (%)

Note: The value of the 5% bond falls as interest rates rise 30

Fixed vs. variable components of a bond:

WARNING!!!
fixed: coupon, face value, maturity date
variable: time to maturity, YTM

31
 Interest rate sensitivity
Bond A: 8% Coupon, FV=$1,000, and matures in 5 years
Bond B: 8% Coupon, FV=$1,000, and matures in 10 years

Which bond is more sensitive to interest rates? Why?

32
 Interest Rate Risk
3,000

2,500

2,000
30 yr bond When the interest rate equals
$ Bond Price

the 5.0% coupon rate, both

1,500 bonds sell at face value

1,000
3 yr bond
500

33
-
0 2 4 6 8 10
YTM
 Interest rate sensitivity (Contd)
Bond A: 0% Coupon, FV=$1,000, and matures in 10 years
Bond B: 8% Coupon, FV=$1,000, and matures in 10 years

Which bond is more sensitive to interest rates? Why?

34
 Yield to Maturity - YTM
What rate of return would you earn if pay $935.82 for a $1000 face value
bond that pays an 8% coupon and that has 10 years to maturity?

P0=935.82 80 80 80 80+1,000

0 1 2 3 10
r=YTM=?

SOLVE: 935.82 = 80(PVIFAYTM=?,10) + 1000(PVIFYTM=?,10)

ITERATE (1st try 10%, then 9%!)

( or use your financial calculator

35
N=10, PMT=80, FV=1,000, PV=-935.82, I=?=YTM=9% )
What happens to the price of the bond if interest rates change causing
your required return to increase to 12%? To decrease to 4%?

P0= 80(PVIFA12%,10) + 1000(PVIF12%,10) =$773.99

Bond sells at a discount

P0= 80(PVIFA4%,10) + 1000(PVIF4%,10) =$1,324.44

Bond sells at a premium

If you buy this bond today and hold it to maturity your return will 36
be the yield to maturity!
 Bond Rate of Return
Rate of Return - Earnings per period per dollar invested.

total income
Rate of return =
investment

Coupon income + price change

Rate of return =
investment
37

Do not confuse the bonds rate of return over a particular investment period with
its YTM!
Rate of Return

38
 Rate of Return: Example

Suppose you purchase a 5% coupon bond, par value $1,000,

with 5 years until maturity, for $975.00 today. After one year
you sell the bond for $965.00.

What was the rate of return during the period?

39
What is the YTM when you bought the bond? Lower or higher than 4.10% ?
What happened to YTM after 1 year when you sold the bond?
 Interest Rate Risk
30-year maturity, 6% coupon PREMIUM bond with fixed 4% YTM and
30-year maturity, 2% coupon DISCOUNT bond with fixed 4% YTM
1,400
Price path for
1,300 Premium Bond

1,200

1,100
Bond Price

1,000

900
Maturity
800 Today

700 Price path for

40
Discount Bond
600
0 5 10 15 20 25 30
Time to Maturity
Time and Bond Prices
Holding all other things constant, the price of discount or
premium bond will move towards par value over time.
If a bonds yield to maturity has not changed, then the rate of
return of an investment in the bond equals its yield to
maturity even if you sell the bond early.

41
Example
One bond has a coupon rate of 8%, another a coupon rate of
12%. Both bonds have 10-year maturities and sell at a yield to
maturity of 10%. If their yields to maturity next year are still
10%, what is the rate of return on each bond? Does the higher
coupon bond give a higher rate of return?

42
Answer
Bond 1
1 1 $
1
,000
Year 0:
PV
$
80
10

10
$
877
.
11

0
.10
0
.
10
(
1.
10
)1
.
10

Year 1: 1 1 $
1
,000

PV
$
80 9

9
$884
.82

0.
100
.
10
(
1.
10
)1
.
10
$
80
($
884
.
82
$877
.
11
)
Rate of return =
0.
100
10
.
0%
$
877
.
11

Bond 2
Year 0: PV1 1$
1,
000
$

120
10
10

$
1
,
122
.89

0
.
100
.
10
(
1.
10
)1
.
10

1 1 $
1
,
000
Year 1:
PV
$

120 9

9
$1
,
115
.18

0.
100
.
10
(
1.
10
)1
.
10

Rate of return = $120 ($1115 .18 $1122 .89) 43

0.100 10.0%
$1122 .89
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.

44
The Yield Curve
Treasury strips are bonds that make a single payment. The yields on
Treasury strips in February 2008 show that investors received a
higher yield on longer term bonds.
Why do some people prefer short-term bonds then?

45
Nominal and Real Rates of
Interest
TIPS (treasury inflation protected securities)
The real cash flows are fixed but the nominal cash flows (interest
and principle) are increased as the CPI increases.

E.g. In 2008, 10- year TIPS offered a yield of 1.5% (Real interest
rate). The yield on nominal 10-year Treasury bonds was 3.8%.

46
 Example
The US treasury issues 3% coupon, 2-year TIPS. Assume 5%
inflation in the first year and further 4% in the second year.
Year 1 Year 2
Real Cash flows 30 1030

Year 1 Year 2
Nominal Cash flows 30*1.05=31.5 1030*1.05*1.04=1,124.76

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Real vs. Nominal Yields

Red line Real yield on long-term UK indexed bonds 48

Blue line Nominal yield on long-term UK bonds

Corporate Bonds and Default
Risk (a.k.a. Credit Risk)
Default premium
The difference between the promised yield on a
corporate bond and the yield on a U.S. Treasury
Bond with the same coupon and maturity.
Investment grade vs. Junk bonds
Investors pay less for bonds with credit risk than
they would for an otherwise identical default-free
bond.
The yield of bonds with credit risk will be higher
49
than that of otherwise identical default-free bonds.
 Bond Ratings
Standard
Moody' s & Poor's Safety

Aaa AAA The strongest rating; ability to repay interest and principal
is very strong.
Aa AA Very strong likelihood that interest and principal will be
repaid
Investment A A Strong ability to repay, but some vulnerability to changes in
grade circumstances
Baa BBB Adequate capacity to repay; more vulnerability to changes
in economic circumstances
Ba BB Considerable uncertainty about ability to repay.
B B Likelihood of interest and principal payments over
sustained periods is questionable.
Junk bonds
Caa CCC Bonds in the Caa/CCC and Ca/CC classes may already be
Ca CC in default or in danger of imminent default
C C C-rated bonds offer little prospect for interest or principal
50
on the debt ever to be repaid.
Corporate Yield Curves for
Various Ratings, February 2009

51
Source: Reuters
Yield Spreads and
the Financial Crisis

Source:
Bloomberg.com 52
Corporate Bonds
Zero coupons
no periodic interest payments
issued at a substantial discount from par
Floating rate bonds
Coupon rate change over time
E.g. Treasury rate plus 2%
Convertible bonds
Can be exchanged for a specified number of common stock
shares.

53
Zero-Coupon Bonds
Zero-Coupon Bond
Does not make coupon payments
Always sells at a discount (a price lower than face value), so they
are also called pure discount bonds
Treasury Bills are U.S. government zero-coupon bonds with a
maturity of up to one year.

54
Zero-Coupon Bonds (cont'd)
Suppose that a one-year, risk-free, zero-coupon bond with a
$100,000 face value has an initial price of $96,618.36. The
cash flows would be:

Although the bond pays no interest, your compensation is the

difference between the initial price and the face value.

55
Zero-Coupon Bonds (cont'd)
Yield to Maturity
The discount rate that sets the present value of the promised
bond payments equal to the current market price of the bond.
Price of a Zero-Coupon bond

FV
P
(1 YTM n )n

56
Zero-Coupon Bonds (cont'd)
Yield to Maturity
For the one-year zero coupon bond:

100,000
96,618.36
(1 YTM1 )

100,000
1 YTM1 1.035
96,618.36

Thus, the YTM is 3.5%.

57
Zero-Coupon Bonds (cont'd)
Yield to Maturity
Yield to Maturity of an n-Year Zero-Coupon Bond

1
FV n
YTM n 1
P

58