Chapter 6

Bond Valuation

1
 Fixed Income (Debt) Securities

• A debt security is a claim on a specified periodic

stream of income.
• Bonds
– The borrower issues (i.e. sells) a bond to the lender for
some amount of cash.
– When the bond matures, the issuer pays the face value
(par value) to the bondholder.
– The issuer also makes pre-specified payments to the
bondholder on specified dates.
• These payments are called “coupon payments” and are equal to
the par value times the coupon rate

2
 Government and Corporate Bonds

• Municipal Bond
– A bond issued by a state or local government body
• Corporate Bond
– A long-term debt instrument indicating that a corporation
has borrowed a certain amount of money and promises to
repay it in the future under clearly defined terms
 Government and Corporate Bonds

• Par Value, Face Value, Principal

– The amount of money the borrower must repay at
maturity, and the value on which periodic interest
payments are based
• Coupon Rate
– The percentage of a bond’s par value that will be paid
annually, typically in two equal semiannual payments, as
interest
 Government and Corporate Bonds

• Legal Aspects of Corporate Bonds

– Bond Indenture
• A legal document that specifies both the rights of the
bondholders and the duties of the issuing corporation
– Standard Debt Provisions
• Provisions in a bond indenture specifying certain record-
keeping and general business practices that the bond issuer
must follow; normally, they do not place a burden on a
financially sound business
– Restrictive Covenants
• Provisions in a bond indenture that place operating and
financial constraints on the borrower
 Government and Corporate Bonds

• Legal Aspects of Corporate Bonds

– Subordination
• In a bond indenture, the stipulation that subsequent
creditors agree to wait until all claims of the senior debt
are satisfied
– Sinking-Fund Requirement
• A restrictive provision often included in a bond
indenture, providing for the systematic retirement of
bonds prior to their maturity
 Government and Corporate Bonds

• Legal Aspects of Corporate Bonds

– Collateral
• A specific asset against which bondholders have a claim
in the event that a borrower defaults on a bond
– Secured Bond
• A bond backed by some form of collateral
– Unsecured Bond
• A bond backed only by the borrower’s ability to repay
the debt
 Government and Corporate Bonds

• Legal Aspects of Corporate Bonds

– Trustee
• A paid individual, corporation, or commercial bank trust
department that acts as the third party to a bond
indenture and can take specified actions on behalf of
the bondholders if the terms of the indenture are
violated
 Government and Corporate Bonds
• Cost of Bonds to the Issuer
– Impact of Bond Maturity
• Usually, long-term debt pays higher interest rates than
short-term debt
– Impact of Offering Size
• Bond flotation and administration costs per dollar
borrowed are likely to decrease as offering size
increases
• However, the risk to the bondholders may increase,
because larger offerings result in greater risk of default,
all other factors held constant
– Impact of the Issuer’s Risk
• The greater the issuer’s default risk, the higher the
interest rate
 Government and Corporate Bonds

• Cost of Bonds to the Issuer

– Impact of the Risk-free Rate
• The risk-free rate in the capital market determines a
floor on the cost of a bond offering
• Generally, the rate on U.S. Treasury securities of equal
maturity is the lowest cost of borrowing money
– To that basic rate is added a risk premium that
reflects the factors mentioned prior (maturity,
offering size and issuer’s risk)
 Government and Corporate Bonds

• General Features of a Bond Issue

– Conversion Feature
• A feature of convertible bonds that allows bondholders to
change each bond into a stated number of shares of common
stock
– Call Feature
• A feature included in nearly all corporate bond issues that
gives the issuer the opportunity to repurchase bonds at a
stated call price prior to maturity
– Call Price
• The stated price at which a bond may be repurchased, by use
of a call feature, prior to maturity
 Government and Corporate Bonds

• General Features of a Bond Issue

– Call Premium
• The amount by which a bond’s call price exceeds its par
value
– Stock Purchase Warrants
• Instruments that give their holders the right to purchase
a certain number of shares of the issuer’s common stock
at a specified price over a certain period of time
 Government and Corporate Bonds

• Bond Yields
– Current Yield
• A measure of a bond’s cash return for the year
• Calculated by dividing the bond’s annual interest
payment by its current price
– Yield to Maturity (YTM)
– Yield to Call (YTC)
 Government and Corporate Bonds

• Bond Prices
– Though corporate bonds are held mostly by institutional
investors and are not as actively traded as stocks, it is still
important to understand market conventions for quoting
bond prices and yields.
– Basis points
• A way of quoting an interest rate such that 100 basis
points equals one percentage point
 Government and Corporate Bonds

• Bond Ratings
– Independent agencies such as Moody’s, Fitch, and Standard
& Poor’s assess the riskiness of publicly traded bond issues
– These agencies derive their ratings by using financial ratio
and cash flow analyses to assess the likely payment of bond
interest and principal
– Normally an inverse relationship exists between the quality
of a bond and the rate of return that it must provide
bondholders
 Credit Rating
• If a bond issuer is at risk for default, it will be
assigned a low credit rating.
• Models used to predict the default risk.
– Coverage ratios
– Leverage ratios
– Liquidity ratios
– Profitability ratios
– Cash flow to debt
 Table 6.2 Moody’s and Standard & Poor’s
Bond Ratings

Note: Some ratings may be modified to show relative standing within a major rating category; for example,
Moody’s uses numerical modifiers (1, 2, 3), whereas Standard & Poor’s uses plus (+) and minus (−) signs.
Sources: Based on Moody’s Investors Service, Inc., and based on Standard & Poor’s Corporation.
 Rates of Return on Bonds
• The Computations of Bond Return
– Holding period return
Pi, t +1 + Int i, t
HPR i, t =
Pi, t
where:
HPRi,t = the holding period return for bond i during period t
Pi,t+1 = the market price of bond i at the end of period t
Pi,t = the market price of bond i at the beginning of period t
Inti,t = the interest payments on bond i during period t

– The holding period yield (HPY) is

HPY = HPR - 1
 Valuation Fundamentals
• Basic Valuation Model
– The value of an asset is the present value of all the future
cash flows it is expected to provide.
CF1 CF2 CFn
V0 = + + + (6.4)
(1 + r ) (1 + r ) (1 + r )
1 2 n

• V0 = value of the asset at time zero

• CFt = cash flow expected in year t
• r = required return (discount rate)
• n = time period (investment’s life or investor’s holding
period)
 Bond Valuation
• Bond Fundamentals
– Bonds are long-term debt instruments used by business
and government to raise large sums of money, typically
from a diverse group of lenders
– Most corporate bonds
• pay interest semiannually (every six months) at a
stated coupon rate
• have an initial maturity of 10 to 30 years
• and have a par value, principal, or face value, of $1,000
that the borrower must repay at maturity
 Bond Valuation
• Bond Values for Annual Coupons
C C C C M
B0 = + ++ + +
(1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r )
1 2 3 n n

 n C   M 
B0 =   t 
+ n 
(6.5)
 t =1 (1 + r )   (1 + r ) 

• B0 = value (or price) of the bond at time zero

• C = annual coupon interest payment in dollars
• n = number of years to maturity
• M = par value in dollars
• r = annual required return on the bond
 Bond Valuation
• Bond Values for Annual Coupons
C  1  M
B0 =   1 − n 
+ (6.5a)
   (1 + r )  (1 + r )
n
r

• B0 = value (or price) of the bond at time zero

• C = annual coupon interest payment in dollars
• n = number of years to maturity
• M = par value in dollars
• r = annual required return on the bond
 Example
Tim Sanchez wishes to determine the current
value of the Mills Company bond. If the bond
pays interest annually and the required annual
return on the bond is 6% (equal to its coupon
rate), then we can calculate the bond’s value
using Equation 6.5a:
The timeline on the next slide depicts the
computations involved in finding the bond value.
Example
 Bond Valuation
• Bond Values for Semiannual Coupons
– As a practical matter, most bonds make
semiannual rather than annual interest payments
– Calculating the value for a bond paying
semiannual interest requires three changes to the
approach we’ve used so far:
1.Convert the annual coupon payment, C, to a semiannual
payment by dividing C by 2
2.Recognize that if the bond has n years to maturity it will
make 2n coupon payments (i.e., in n years there are 2n
semiannual periods)
3.Discount each payment by using the semiannual required
return calculated by dividing the annual required return, r,
by 2
 Bond Valuation
• Bond Values for Semiannual Coupons
C C C C
2 2 2 2 M
B0 = 1
+ 2
+ 3
+ + 2n
+ 2n
 r  r  r  r  r
1+  1+  1+   1+  1 + 
 2  2  2  2  2
 C   
 2n   
M
B0 =   2 t  +   (6.6)
 t =1  r     r  
2n

 1+     1 +  
  2    2  
• Bond Values for Semiannual Coupons
 
 
 C / 2  1  M
B0 =   1 − + (6.6a)
 r/2   r 
2n
  r 
2n

  1 +    1 + 
  2    2 

• B0 = value (or price) of the bond at time zero

• C = annual coupon interest payment in dollars
• n = number of years to maturity
• M = par value in dollars
• r = annual required return on the bond
 Example
Assuming that the Mills Company bond pays
interest semiannually and that the required
annual return, r, is 6%, Equation 6.6a indicates
that the bond’s value is
 Bond Pricing - Example
• 8% coupon rate, 30-year maturity, par value of $1000, semi-
annual coupons. Suppose that the interest rate is 8 %
annually:

• 8% coupon rate, 30-year maturity, par value of $1000, semi-

annual coupons. Suppose that the interest rate is 10 %
annually:

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 Bond Valuation
• Changes in Bond Prices
– When the required return rises, the bond price
falls, and when the required return falls, the bond
price rises
– Required Returns and Bond Prices
• Discount
– The amount by which a bond sells below its par value
» When the required return is greater than the
coupon rate, the bond’s value will be less than its
par value
• Premium
– The amount by which a bond sells above its par value
» When the required return falls below the coupon
rate, the bond’s value will be greater than par
 Determinants of Bond Prices
• Market interest rates
• Credit ratings
• Maturity
Bond Prices and Market Interest Rates
• Bonds are very sensitive to market interest rates.
• If you sell a bond in the secondary market before it matures, the
value of the bond will be affected by current market interest rates.
– When current interest rates are greater than a bond’s coupon
rate, the bond will sell at a discount (a price less than its face
value),
– When current interest rates are less than a bond’s coupon rate,
the bond will sell at a premium (a price more than its face
value).
What Determines Interest Rates
• Inverse relationship with bond prices
• Forecasting interest rates
• Fundamental determinants of interest rates
i = RFR + I + RP
where:
RFR = real risk-free rate of interest
I = expected rate of inflation
RP = risk premium
– Conceptually
i = f (Economic Forces + Issue Characteristics)
What Determines Interest Rates
• Effect of Economic Factors
– Real growth rate
– Tightness or ease of capital market
– Expected inflation
– Supply and demand of loanable funds
• Impact of Bond Characteristics
– Credit quality
– Term to maturity
– Indenture provisions
– Foreign bond risk including exchange rate risk
and country risk
 Bond Pricing
• Interest Rates and Bond Prices
– At a higher interest rate, the present value of the payments received
by the bondholders is lower.
– Bond price falls as the market interest rates rise.

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 Premium and Discount Bonds
• A premium bond is any bond that is currently trading at a
price above par.
• A discount bond is a bond trading at a price lower than par.
• Note: Bonds mature at a par value.

36
 Maturity and Prices

• Changing interest rates affect bonds with

varying maturities differently.
– When interest rates rise:
• The longer the bond’s maturity, the more discounted
bond’s price will be.
• Example:
– When interest rates fall:
• Bonds with longer maturities will have higher
premiums.
 Table 14.2 Bond Prices at
Different Interest Rates

Maturity and Bond Prices

Keeping all other factors the same, the longer the
maturity of a bond, the greater the sensitivity of prices
to the market interest rate.
 Bond Yields

• Yield to maturity: Average rate of return that will be

earned on a bond if it is bought now and held up to
maturity.
– Defined as: The interest rate that makes the present value
of the bond’s payments equal to its price.
– To calculate the yield-to-maturity, we need to solve the
bond pricing formula for r

 (1C
T

PB = t
+
ParValueT
+ r) (1+ r )
t T
t =1

39
 Bond Yields - Example
• Suppose an 8% coupon (semiannual payments),
$1000 par value, 30-year bond is selling at $1276.76.
What is its yield to maturity?

 (1C
T

PB = t
+
ParValueT
+ r) (1+ r )
t T
t =1

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 Yield to Maturity Example

10 yr Maturity
Coupon Rate = 7%
Price = $950

950 = 
20
35 1000
+
t =1 (1+ r ) (1+ r )
t T

r = 3.8635%