Bonds and bond valuation

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Bonds and bond valuation
Objectives:
 Bond valuation
 Returns from investing in a bond
 Why bond prices change
 Maturity Risk Premium
 Liquidity Premium
 Zero-coupon bonds
 Bond Markets and Types
 Credit Ratings
 Covenants

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Bond Valuation
 Par Value = Some amount of funds paid at the maturity of
a bond.
 In this class, assume that the par value is $1000, unless
otherwise stated. Also known as face value or the
principal.

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Bond Valuation: Terminology
 Coupon (C) is the interest in ($) paid.
 Coupons may be paid semi-annually, quarterly or
monthly.
 Note: Assume annual coupons, if coupon frequency is not
provided.
 If the coupon per year is $90, the semi-annual coupon is
$45.00.
 The coupon rate = Coupon/Par Value = 90/1000 = 0.09.
 Current yield = Coupon/Price

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Terminology
 Maturity is the life of a bond, N.
 Yield = Yield-to-maturity of a bond.

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Bills, Notes and Bonds
 Bills: debt securities ≤ 1 year to maturity.
 E.g. Treasury bills
https://www.treasurydirect.gov/marketable-securities/treasury-bills/

 Notes: debt securities with more than 1 year to 10

years to maturity.
 Corporate Debt Securities (>1year, ≤ 10 years)
 E.g. Treasury Notes
https://www.treasurydirect.gov/marketable-securities/treasury-notes/

 Bonds: more than 10 years to maturity.

 Corporate Debt Securities (>10 years)
 E.g. Treasury
https://www.treasurydirect.gov/marketable-securities/treasury-bonds/

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Review Time Value of Money: Present Value of
annuity of $ 1 (end-of-period)
 Present Value of annuity of four payments of $ 1

(present value annuity factor) =

1 1 1 1
+ + +
1 + 𝒓𝒓 (1 + 𝒓𝒓) 𝟐𝟐 1 + 𝒓𝒓 𝟑𝟑 1 + 𝒓𝒓 𝟒𝟒

1
1 −
(1 + 𝒓𝒓)𝒏𝒏
= 1
𝒓𝒓
 If discount rate is 10%, present value
1
1 −
(1 + 0.1)𝟒𝟒
= 1
0.1
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Future value of an annuity of $1.00 (end-of-period)
Future value of an annuity of $1.00 (future value annuity
factor)
(1 + 𝒓𝒓)𝑁𝑁 − 1
=
𝒓𝒓

 Future value of an annuity of $1.00 for four payments

and 10% as the investment rate

(1 + 0.1) 4 − 1
= = 4.641
0.1
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Abbreviations
 PVAF = present value annuity factor
 PVF = present value factor
 FVAF = future value annuity factor

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Bond Valuation of fixed-coupon bearing
bond
 The value of a bond (or the Price) is the present value of
its expected future cash flows discounted at the
appropriate discount rate (also known as required rate of
return).
 The appropriate discount rate is the yield-to-maturity
(yield) in the case of a bond.
 For a bond that pays coupon annually,
Price (P) = C X PVAFYield, N + 1000 X PVFYield,N

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Yield to Maturity
 Yield to Maturity is not the return one gets from
investment in a bond.
 Reinvestment rate is the rate at which the intermediate
cash flows are invested.
 For the case of a bond the intermediate cash flows are
the coupon payments.

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Bond prices on coupon payment dates
 When bond sells at par on coupon payment dates,
coupon rate = yield to maturity
 When bond sells below par or at a discount on coupon
payment dates, coupon rate < yield to maturity.
 When bond sells above par or at a premium on coupon
payment dates, coupon rate > yield to maturity.

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Bond prices on coupon payment dates:
yield to maturity is greater than coupon
rate
 You bought an annual-coupon 10-year bond
today. The yield-to-maturity was 9%. The coupon
rate is 8%, and the par value is $1000.
 Price today = 80 PVAF (9%, 10) + 1000 PVF
(9%, 10)
= 935.82
1
1−
(1+0.𝟎𝟎𝟎𝟎)𝟏𝟏𝟏𝟏 𝟏𝟏𝟏𝟏𝟏𝟏𝟏𝟏
 Price = 80 + 𝟏𝟏𝟏𝟏 = 935.82
0.09 1+𝟎𝟎.𝟎𝟎𝟎𝟎

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If yield to maturity = coupon rate
 You bought an annual-coupon 10-year bond
today. The yield-to-maturity was 8%. The coupon
rate is 8%, and the par value is $1000.

 Price today = 80 PVAF (8%, 10) + 1000 PVF

(8%, 10)
= 1,000

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If yield to maturity < coupon rate
 You bought an annual-coupon 10-year bond
today. The yield-to-maturity was 6%. The coupon
rate is 8%, and the par value is $1000.
 Price today = 80 PVAF (6%, 10) + 1000 PVF
(6%, 10)
= 1147.20

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Bond prices on other dates
 On dates other than coupon payment dates, what is the price of
the bond?

 Not in the syllabus.

 Not in the exam.

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Example on Bond Valuation
 You just bought a 10-year annual-coupon corporate bond
today at the yield to maturity of 6%. Par value is $1000.
The coupon rate is 5%.
 You plan to hold the bond for six years. You expect to be
able to reinvest the coupon payments at the rate of 6%
annually for the next six years.
 At the end of six years, the inflation rate is expected to get
worse, and the yield to maturity is expected to be 12%.
 What is the expected annualized return on your
investment over the six-year period?

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Example on Bond Valuation
 Price today = 50 PVAF (6%, 10) + 1000 PVF (6%, 10) =
$926.399
 FV coupon reinvestment = 50FVAF (6%, 6) = $348.766
 Price when sold = 50 PVAF (12%, 4) + 1000 PVF (12%,
4) = $787.386
 Ending value = $1136.152
 Initial price = $926.399
 Geometric rate = 3.46%

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Geometric Rate of Return

 The geometric rate of return

= (1136.152/ 926.399)1/6 - 1
= 3.46%.

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Why bond prices change
 Required rate of return = real rate + inflation premium +
Default risk premium + maturity (liquidity) premium
For U.S government bonds (assumed default free):
 Required return increases if investors believe inflation
premium will get worse in the future.
 Real rate may change too but changes are generally
small.

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Why bond prices change
 For corporate bonds:
 Bond prices will fall if creditworthiness of firm declines,
i.e. default risk goes up.
 Bond prices will fall if inflation rates will unexpectedly go
up in the future.
 For government bonds but not from USA:
 Bond prices will fall if credit risk of the nation increases, i.e.
default risk goes up.

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E.g. Credit risk premium
 A 8% coupon-rate corporate debt security has 1-year to
maturity. The risk-free Treasury bill return is 5%. The
credit risk premium is 1.5%. What is the price of the debt
security today? Par = $1,000.
 Price = 1,080/(1.065) = $1,014.08

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Bond prices and interest rates
 Provide economic explanations as to why fixed-coupon
bond prices fall when market interest rates (yield-to-
maturity) rise.
 Fixed-coupon bonds have fixed income or coupons. When
market interest rates rise, the bond having fixed coupon
has become more unattractive in price so bond prices fall.
 Provide economic explanations as to why fixed-coupon
bond prices increase when market interest rates (yield-to-
maturity) fall.
 When market interest rates fall, the bond having fixed
coupon has become more attractive in price so bond prices
rise.

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Semi-annual coupon payments on coupon-
payment dates
 Price (P) = C/2 X PVAFsemiannual yield, #periods + 1000 X PVF
semiannual yield, #periods

 semiannual yield = semiannual yield to maturity

 #periods = number of 6-month periods

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E.g. 10-year 4.5% coupon maturity May 15
2034, coupons paid semiannuallly
 Maturity = 10 years.
 #periods = 20 semiannual periods
 Par = $100 (note that par value is $100 in this case).
 Semiannual Coupon = 2.25
 Semiannual yield = 2.306%
 Note that nominal annual yield = 4.612% i.e., 2*(2.306%).
 Note that nominal yield is not the effective yield.
 Price (P) = 2.25 X PVAF0.02306, 20 + 100 X PVF 0.02306, 20
 Price = $99.11079

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Semi-annual coupon payments
 When bond sells at par on coupon payment dates,
semiannual coupon rate = semiannual yield to maturity
 When bond sells below par or at a discount on coupon
payment dates, semiannual coupon rate < semiannual
yield to maturity.
 When bond sells above par or at a premium on coupon
payment dates, semiannual coupon rate > semiannual
yield to maturity

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To show bond prices are more variable for
longer-term bonds
1- Year 10-year

100 100
P0 = = $90.909 P0 = = $38.554
(1 + 0.10) 1
(1 + 0.10) 10

1Year 10-year

100 100
P0 = = $90.0909 P0 = = $35.2184
(1 + 0.11) 1
(1 + 0.11) 10

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Maturity risk premium
 Because bond prices are more variable for longer-term
bonds, there is higher maturity risk premium for holding
bonds of longer maturities.
 Interest rate or required rate = real rate + inflation
premium + maturity risk premium (for US Treasuries)
 Interest rate or required rate = real rate + inflation
premium + maturity risk premium + credit risk premium
(for corporate bonds)

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Maturity risk premium
 We saw that bonds with longer years to maturity
experience higher price volatility with same yield change.
 Hence higher risk premium required to compensate
investors for holding bonds with longer years to maturity.

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Liquidity premium
 Higher risk premium required to compensate investors for
holding securities that have lower liquidity.
 Liquidity of an asset refers to its trading volume and
frequency of trading.
 Assets with higher trading volume and higher frequency
of trading considered as having higher liquidity.
 Longer-maturity debt securities considered having less
liquidity.

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Required Rate with liquidity premium
 Required rate = real rate + inflation premium + maturity
risk premium + liquidity premium + credit risk premium
(for corporate bonds)
 Required rate = real rate + inflation premium + maturity
risk premium + liquidity premium (for US Treasuries, if we
assume US Treasuries do not have default risk).

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Zero-Coupon Debt Securities
 Zero-coupon bonds are fixed-income securities that don't
make interest payments each year like regular bonds.
 The bond is sold at a deep discount to its face value, a
known cash flow, and at maturity the bondholder collects
the face value.
 These bonds can be issued by the government or a
corporation.
 There is no reinvestment risk which is the uncertainty
about the future returns that intermediate cash flows, i.e.
coupons, will yield when they are reinvested.

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Zero-Coupon Debt Securities
 The coupon and principal components trade separately.
 These coupon and principal components are attractive in
the sense that the yields of these securities can be locked
in.

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Zero-coupon debt from coupon-bearing
debt securities
 The underlying note:
 C = $100, Par = $1000
 Annual-coupon

Par
C C
C C C

t=0 1 2 3 4 5

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Coupon Components and Principal
Components
 Draw these components:
C C

t=0 1 t=0 4

C C

t=0 2 t=0 5

C
Par

t=0 3
t=0 5

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Liquidity of Zeros
 Zeros are not as liquid (or as heavily traded) as Treasury
coupon-bearing bonds.
 US Treasuries coupon-bearing bonds are very liquid.

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Future required interest rates are not the same
 Suppose the required rates of return of Power Tools debt securities
are 5%, 6% and 6.8% respectively in years 1, 2 and 3 respectively.
 The required rates = real rate + inflation premium + credit risk
premium + maturity risk premium + liquidity premium.
 Coupon = $50, par value = $1000, N = 3 years.
 What is the price of this debt security?
50 50 50
 Price = + + +
1+0.05 1+0.05 (1+0.06) 1+0.05 1.06 (1.068)

1000
=
1+0.05 1.06 (1.068)

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Historical inflation rates USA
 http://inflationdata.com/inflation/Inflation_Rate/Histori
calInflation.aspx

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Bonds: Part II

 Bond Markets and Types

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The Bond Indenture
 Contract between the company and the bondholders
and includes
 The basic terms of the bonds
 The total amount of bonds issued
 A description of property used as security, if applicable
 Sinking fund provisions
 Call provisions
 Details of protective covenants

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Bearer vs registered
 Bearer-form: Anyone just holding the bond certificates
are entitled to obtaining interest and principal.
 Registered form: Holder has rights only if he or she
appears on a security register maintained by the issuer
or an intermediary.

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Debentures
 Debentures in USA refer to unsecured debt.
 Debentures in UK refer to secured debt.

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Credit Ratings

 Credit Ratings

Character: Any known history of not paying? Is borrower’s

personal character in doubt?
Capacity: Does borrower have capacity to pay?
Collateral: If borrower cannot pay, is there an asset
(collateral) the lender can get hold of?
Covenants: The do’s and don’ts of what a borrower can
and cannot do.

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Credit Rating Firms
 Standard and Poor’s
 Moody’s
 Fitch
 Long-term ratings are opinions of the relative credit risk of
financial obligations (debt securities included) with an
original maturity of one year or more (ref: Moody’s
https://ratings.moodys.io/ratings).

 Short-term credit ratings are opinions of the ability of

issuers to honor short-term financial obligations (debt
securities included) with original maturity no more than
365 days (ref: S&P).
 For this course, no need to memorize the exact figures for
maturity. Short-term: < 1 year; Long-term: > 1 year
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(approx.)
Credit Ratings

https://finance.yahoo.com/news/corporate-credit-ratings-mean-investors-182355194.html
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Bond Ratings – Investment Quality
 High Grade
 Moody’s Aaa and S&P AAA – capacity to pay is extremely
strong
 Moody’s Aa and S&P AA – capacity to pay is very strong
 Medium Grade
 Moody’s A and S&P A – capacity to pay is strong, but more
susceptible to changes in circumstances
 Moody’s Baa and S&P BBB – capacity to pay is adequate,
adverse conditions will have more impact on the firm’s
ability to pay

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Bond Ratings - Speculative
 Low Grade
 Moody’s Ba, B, Caa and Ca
 S&P BB, B, CCC, CC
 Considered speculative with respect to capacity to pay.
 Very Low Grade
 Moody’s C and S&P C – poor respects of ever attaining
investment grade standing.
 Moody’s D and S&P D – in default with principal and
interest in arrears
 Note that there is no need to memorize the exact
details of each rating scale. However, do note the
relative positioning of the scale. E.g. AAA is
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considered of higher credit quality than BBB.
Sovereign Debt
Debt issued by governments.

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Covenants
 Covenants: What the borrower must and cannot do.
 What the borrower must do: Positive covenants.
 Must pay interest and principal payments on time.
 Must maintain machines in good order if used as collateral
(or pledged)
 Must furnish audited financial statements on time.

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Negative covenants
 What the borrower cannot do: Negative covenants
 Cannot sell assets without permission of existing
bondholders.
 Cannot issue new bonds without permission of existing
bondholders.
 Cannot issue new bonds that rank senior to existing bonds.
 Must not pay too much dividends; a formula must be
followed about how much dividends to pay.

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Not in the exam:
 https://thehill.com/opinion/finance/575722-the-us-has-never-defaulted-on-its-
debt-except-the-four-times-it-did/

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