Chapter 6

Bonds and Bond

Valuation
 Learning Objectives
1. Understand basic bond terminology and apply the
time value of money equation in pricing bonds.
2. Understand the difference between annual and
semiannual bonds and note the key features of
zero-coupon bonds.
3. Explain the relationship between the coupon rate
and the yield to maturity.
4. Delineate bond ratings and why ratings affect
bond prices.
5. Appreciate bond history and understand the
rights and obligations of buyers and sellers of
bonds.
6. Price government bonds, notes, and bills.

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 6.1 Application of the Time Value
of Money Tool: Bond Pricing
• Bond: A financial contract that typically has a
stated maturity and periodic interest payments.
• Bonds - Long-term debt instruments
• Provide periodic interest income – annuity series
• Return of the principal amount at maturity –
future lump sum
• Prices can be calculated by using present value
techniques i.e. discounting of future cash flows.
• Combination of present value of an annuity and of
a lump sum

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 Loan = Debt Payment
Bonds = Debt ( borrower , lender )

Zero coupon Coupon bonds

Discount bond
gov
Issues
meni .

Borrowers Market
Corp1

Corpe
Q1 coupon bond AAA, FV=1000, CR=
Annual semi annual
8%, maturity 5 years ( Annual )
YTH =
5% < CR = 8% 37FV p = 855 8 .

YTM 12%
=
YTM 6 %
=

YTM = 12 % CR=8 % < FV &

So s (1
= ost) +

T I
1000
E

: Calculate Coupon
Step 1 1 0 05
08 1000 80
.

YTM 5 %
-

YTM 2 5 %
&
=
0 .

x = =
=

1128
.

123 = 8
! a
S
.

1 I I I

Sold at2 remuim

80 80
0808080
1000 YTM =
8% YTM =
4%
L
Senario 2 YTM5 %
9 =
3 (1-cin + mix

St
2
and
formulas
Annuity
L
Semi annual n =
5x 2 =
10

ii) + 12 % YTM 6%
=

Scenario 1 YTM
=
=

S
A
CA 80 40
FV Cs
- =

9 = (1 c)
,

-
+

T
(1-io) +is
-

YTM 2
5
=
=

(1 -
1000
852 79
(1)
=
.

S
=
855 . 80 Scenario 1 YTM 12 % Scenario 2
YTM- 5 % YTM 2 5%
=
.

1000
YTM-8 % YTM-CR 2 = FV -

(1 (i) / = 1131 .
2

sold at Par Scenario 3 YTM

A
= 8% YTM- Y %
S

2 =
1000
1
Scenario 3 YTM8 %
Q2. Ali has zero coupon bond, FV=5000, maturity = 20y
a) calculate the price today if YTM=10%
G 20
I 2
I
-
- . . . . . .

I
- -

I &

5000

5000 743 21
3 = - = .

N T
1 1)20
+0 -

b) recalculate the price if YTM=10% ( semi annual )

5000 710 22
& J
= .

,
1
0 +
20x2

C) recalculate if maturity= 18 years , YTM= 10%

5000
2 J - 899 . 22
Fas
Q1 coupon bond AAA, FV=1000, CR=
8%, maturity 5 years ( semi annyal )
YTH =
5% < CR = 8% 37FV
YTM = 12 %

-So (1st) +05)5 1

911 +
0

9 ci
- .

1128
-

= . 8

ii) + Sold at2 remuim

=

Senario 2 YTM5 %

(10)
=

Scenario 1 YM 12 %

YTM-8 % YTM-CR 2 = FV

sold at Par

Scenario 3 YTM8 %
 Table 6.1 Bond Information
August 1, 2008

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 6.1 (A) Key Components of a
Bond
Figure 6.1 Merrill Lynch • Par value : Typically $1000
corporate bond. • Coupon rate: Annual rate of
interest paid.
• Coupon: Regular interest
payment received by holder
per year.
• Maturity date: Expiration
date of bond when par value
is paid back.
• Yield to maturity: Expected
rate of return based on price
of bond

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 6.1 (A) Key Components of a
Bond

Example 1: Key components of a

corporate bond
Let’s say you see the following price quote
for a corporate bond:
Issue Price Coupon(%) Maturity YTM% Current Yld. Rating
Hertz Corp. 91.50 6.35 15-Jun-2010 15.438 6.94 B

Price = 91.5% of $1000$915; Annual coupon = 6.35% *1000  $63.50

Maturity date = June 15, 2010; If bought and held to maturityYield = 15.438%
Current Yield = $ Coupon/Price = $63.5/$915  6.94%

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 6.1 (B) Pricing a Bond in Steps

Since bonds involve a combination of an annuity

(coupons) and a lump sum (par value) its price is
best calculated by using the following steps:

Figure 6.2 How to price a bond.

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 6.1 (B) Pricing a Bond in Steps
(continued)

Example 2: Calculating the price of a corporate bond.

Calculate the price of an AA-rated, 20-year, 8% coupon
(paid annually) corporate bond (Par value = $1,000) which
is expected to earn a yield to maturity of 10%.

Year 0 1 2 3 18 19 20

$80 $80 $80 … $80 $80 $80

$1,000

Annual coupon = Coupon rate * Par value = .08 * $1,000 = $80 = PMT
YTM = r = 10%
Maturity = n = 20
Price of bond = Present Value of coupons + Present Value of par value

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 6.1 (B) Pricing a Bond in Steps
(continued)

Example 2: Calculating the price of a corporate bond

 1 
 1 
Present value of coupons = PMT   1 r 
n

 r 
 
 

 1 
 1 
= $80   1  0.10 
20

 0.10 
 
 
= $80 x 8.51359 = $681.09
1
Present Value of Par Value = FV 
1  r n
Present Value of Par Value = 1
$1,000 
1  0.10 20
Present Value of Par Value = $1,000 x 0.14864 = $148.64
Price of bond = $681.09 + $148.64
= $829.73

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 6.1 (B) Pricing a Bond in Steps
(continued)

Method 2. Using a financial calculator

Mode: P/Y=1; C/Y = 1

Input: N I/Y PV PMT FV

Key: 20 10 ? 80 1000
Output -829.73

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 6.2 Semiannual Bonds and
Zero-Coupon Bonds
• Most corporate and government bonds pay coupons on a
semiannual basis.
• Some companies issue zero-coupon bonds by selling them at
a deep discount.
• For computing price of these bonds, the values of the inputs
have to be adjusted according to the frequency of the coupons
(or absence thereof).
– For example, for semi-annual bonds, the annual coupon is
divided by 2, the number of years is multiplied by 2, and
the YTM is divided by 2.
– The price of the bond can then be calculated by using the
TVM equation, a financial calculator, or a spreadsheet.

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 6.2 Semiannual Bonds and Zero-
Coupon Bonds (continued)

Figure 6.4 Coca-Cola semiannual corporate bond.

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 6.2 Semiannual Bonds and Zero-
Coupon Bonds (continued)
Figure 6.5
Future cash
flow of the
Coca-Cola
bond.

Using TVM Equation

Using Financial Calculato

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 6.2 Semiannual Bonds and Zero-
Coupon Bonds (continued)

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 6.2 (A) Pricing Bonds after
Original Issue

The price of a bond is a function of the remaining

cash flows (i.e. coupons and par value) that would
be paid on it until expiration.

As of August, 2008 the 8.5%, 2022 Coca-Cola bond

has only 27 coupons left to be paid on it until it
matures on Feb. 1, 2022

Figure 6.6 Remaining cash flow of the

Coca-Cola bond.
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 6.2 (A) Pricing Bonds after
Original Issue (continued)
Example 3: Pricing a semi-annual coupon bond after
original issue:
Four years ago, the XYZ Corporation issued an 8% coupon
(paid semi-annually), 20-year, AA-rated bond at its par value
of $1000. Currently, the yield to maturity on these bonds is
10%. Calculate the price of the bond today.
Remaining number of semi-annual coupons
= (20-4)*2 = 32 coupons = n
Semi-annual coupon = (.08*1000)/2 = $40
Par value = $1000
Annual YTM = 10% YTM/25% = r

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 6.2 (A) Pricing Bonds after
Original Issue (continued)

Method 1: Using TVM equations

 1 
 1 n 
Bond Price = Par Value 
1
 Coupon   1 r  
1 r n  r 
 
 
 1 
 1 
Bond Price = $1,000 
1
 $40   1 0.05 
32

1 0.05 32  0.05 
 
 
Bond Price = $1000 x 0.209866 + $40 x 15.80268
Bond Price = $209.866 + $632.107
Bond Price = $841.97

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 6.2 (A) Pricing Bonds after
Original Issue (continued)

Method 2: Using a financial calculator

Mode: P/Y=2; C/Y = 2

Input: N I/Y PV PMT FV

Key: 32 10 ? 40 1000
Output -841.97

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 6.2 (B) Zero-Coupon Bonds

• Known as “pure” discount bonds and sold at

a discount from face value
• Do not pay any interest over the life of the
bond.
• At maturity, the investor receives the par
value, usually $1000.
• Price of a zero-coupon bond is calculated by
merely discounting its par value at the
prevailing discount rate or yield to maturity.

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 6.3 Yields and Coupon Rates

• A bond’s coupon rate differs from its yield to

maturity (YTM).
• Coupon rate -- set by the company at the
time of issue and is fixed (except for newer
innovations which have variable coupon
rates)
• YTM is dependent on market, economic, and
company-specific factors and is therefore
variable.

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 6.3 (A) The First Interest Rate:
Yield to Maturity

• Expected rate of return on a bond if held to

maturity.
• The price that willing buyers and sellers settle
at determines a bond’s YTM at any given point.
• Changes in economic conditions and risk factors
will cause bond prices and their corresponding
YTMs to change.
• YTM can be calculated by entering the coupon
amount (PMT), price (PV), remaining number of
coupons (n), and par value (FV) into the TVM
equation, financial calculator, or spreadsheet.

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 6.3 (B) The “Other” Interest
Rate: Coupon Rate

• The coupon rate on a bond is set by the

issuing company at the time of issue
• It represents the annual rate of interest that
the firm is committed to pay over the life of
the bond.
• If the rate is set at 7%, the firm is
committing to pay .07*$1000 = $70 per
year on each bond,
• It is paid either in a single check or two
checks of $35 paid six months apart.

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
• An issuing firm gets the bond rated by a rating
agency such as Standard & Poor’s or Moody’s.
• Then, based on the rating and planned maturity of
the bond, it sets the coupon rate to equal the
expected yield as indicated in the Yield Book
(available in the capital markets at that time) and
sells the bond at par value ($1000).
• Once issued, if investors expect a higher yield on
the bond, its price will go down and the bond will
sell below par or as a discount bond and vice-versa.
• Thus, a bond’s YTM can be equal to (par bond),
higher than (discount bond) or lower than
(premium bond) its coupon rate.

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
(continued)
Table 6.3 Premium Bonds, Discount Bonds, and
Par Value Bonds

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
(continued)
Figure 6.8 Bond prices and interest rates
move in opposite directions.

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
(continued)
Example 5: Computing YTM

Last year, The ABC Corporation had issued 8% coupon

(semi-annual), 20-year, AA-rated bonds (Par value =
$1000) to finance its business growth. If investors are
currently offering $1200 on each of these bonds, what is
their expected yield to maturity on the investment? If
you are willing to pay no more than $980 for this bond,
what is your expected YTM?

Remaining number of coupons = 19*2 = 38

Semi-annual coupon amount =( .08*$1000)/2 = $40

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
(continued)
Example 5 Answer
PV = $1200
Mode: P/Y=2; C/Y = 2
Input: N I/Y PV PMT FV
Key: 38 ? -120 40 1000
Output 6.19

Note: This is a premium bond, so it’s YTM

< Coupon rate of 8%

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 6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
(continued)
Example 5 Answer (continued)
PV = $980
Mode: P/Y=2; C/Y = 2
Input: N I/Y PV PMT FV
Key: 38 ? -980 40 1000
Output 8.21%

Note: This would be a discount bond,

so it’s YTM>Coupon rate of 8%

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 6.4 Bond Ratings

• Ratings are produced by Moody’s, Standard and Poor’s, and

Fitch

• Range from AAA (top-rated) to C (lowest-rated) or D

(default).

• Help investors gauge likelihood of default by issuer.

• Assist issuing companies establish a yield on newly-issued

bonds.

– Junk bonds: is the label given to bonds that are rated below BBB.
These bonds are considered to be speculative in nature and carry
higher yields than those rated BBB or above (investment grade).

– Fallen angels: is the label given to bonds that have had their ratings
lowered from investment to speculative grade.

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Table 6.4
Bond Ratings

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