FIN 614

Basic Bond Valuation

Professor Robert B.H. Hauswald

Kogod School of Business, AU

Review Questions
Can you add rates of return (or interest rates)?

How do you work with interest rates?

What are reasonable measures for interest rates?
What is a Basis Point?
What is a Discount Factor?

What does a bank mean if it quotes you an interest rate of 8%?

Will you end up with $108 for a $100 investment in one year?

What is the Time Value of Money?

What is the Future Value?
What is the Present Value?
What is the Net Present Value?

Interest rate: 8% compounded daily.

Effective annual yield: 8.33%

Two important formulae: solving for x

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Bond Valuation

Robert B.H. Hauswald

x a = b x = b1 / a
ax = b x =

log b
log a
2

Cash Flow Valuation

The building blocks of valuation
interest and discount rates
future value and present value
financial decision making: NET Present Value

Valuation formulae: discrete and continuous

simple cash flows
mind the dates!
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Bond Valuation

Robert B.H. Hauswald

Valuation Fundamentals
Present Value of Future Cash Flows

Link Risk & Return

Expected
Return on Assets

Valuation
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Robert B.H. Hauswald

The Basic Valuation Insight

P0 =

CF 1
CF 2
CF n
+
+ . . .+
1
2
(1 + r )
(1 + r )
(1 + r ) n

P0 = Price of asset at time 0 (today)

CFt = cash flow expected at time t
r = discount rate (reflecting assets risk)
n = number of discounting periods (usually years)

This model can express the price of any asset at t mathematically.

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Robert B.H. Hauswald

Valuation of Bonds and Stock

First Principles:
Value of financial securities = PV of expected
future cash flows

To value bonds and stocks we need to:

Estimate future cash flows:
Size (how much) and
Timing (when)

Discount future cash flows at an appropriate rate:

The rate should be appropriate to the risk presented by
the security.
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Robert B.H. Hauswald

Fixed Income Instruments

Contractually fixed cash flows at certain (fixed)
future dates
conceptual: portfolio of cash flows
legal: backed by general credit of issuer recovery
right in case of missed payment or default
examples: CDs, loans, CP, bills, bonds

Valuation questions
the price is right?
what is return and borrowing cost?
how to compare returns across instruments?
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Bond Valuation

Robert B.H. Hauswald

The Most Famous Bond?

Bond finance raises the most money
fixed income instruments
types of bonds and loans

Valuation: the two twins

price and return: yield-to-maturity pricing

Learning objectives:
pricing simple bonds and introduction to risk
inherent in different bonds
FT and bond reporting
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Robert B.H. Hauswald

Bond Types
Bonds: standardized fixed income security
generally tradable, long term (10+ or 15+ years)
standardized: same conditions for all owners of security

Debenture: Unsecured Bond of 15 years or more

backed by general credit of the firm

Note: typically 3 - 10 years unsecured

Bill: less than 1 Year duration
does not pay coupon: interest at the end
types of bills: T-bills, commercial paper
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Robert B.H. Hauswald

Loan Types
Bank loan: terms are not standardized
negotiable, flexible: what does this mean for price?

Pure discount loans: corresponds to what FI security?

Borrower pays a single lump sum (principal and interest) at
maturity

Interest only: corporate, sovereign bonds

borrower pays interest only (coupon) each period and entire
principal at maturity.

Amortized loans: consumer (mortgage) loans

borrower repays part or all of principal over the life of the loan
1. fixed amount of principal repaid each period: uneven payments
2. fixed payments: uneven principal reduction.
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Bond Characteristics: Jargon

Coupon:
Principal:
Par (Face) Value:
Coupon Rate:
Maturity:
Price/Proceeds:
Current Yield:
Yield-to-Maturity:
All-in Cost:
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Bond Valuation

Interest Payment
Amount Borrowed
Amount Repaid at End of Loan
Coupon / Face Value
Years Until Repayment
Amount Raised
Coupon / Current Price

Lifetime return of the bond
Lifetime cost of the bond
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Bond Example
Consider a U.S. government bond listed as 6 3/8 of
December 2009.
The Par Value of the bond is $1,000.
Coupon payments are made semi-annually (June 30 and
December 31 for this particular bond).
Since the coupon rate is 6 3/8 the payment is $31.875.
On January 1, 2002 the size and timing of cash flows are:

$31.875

$31.875

$31.875

$1,031.875

6 / 30 / 09

12 / 31 / 09

L
1 / 1 / 02
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6 / 30 / 02

12 / 31 / 02
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Robert B.H. Hauswald

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Bond or Loan Structure

Covenants: legal provisions giving bondholders right to
specific actions such as forcing bankruptcy
Security: pledged assets committed to paying off debt,
Mortgage Bond
Seniority: order of payment in bankruptcy
1st Secured debt, Senior Debt, then Subordinated Debentures.

Call provision: enables corporation to repay and retire the

debt at will before maturity (on coupon dates only)
Sinking funds or serial maturities:
fund that firm contributes cash to for repayment.
investors know in advance when each bond series will be repaid

Investment Grade Bonds: Bonds rated Baa or higher by

Moody's or BBB or higher by Standard & Poors.
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Pure Discount Bonds

Information needed for valuing pure discount bonds:
Time to maturity (T) = Maturity date - todays date
Face value (F)
Discount rate (r): return on bond = yield to maturity

$0

$0

$0

$F

T 1

L
0

Present value of a pure discount bond at time 0:

PV =
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Bond Valuation

F
(1 + r )T

Robert B.H. Hauswald

14

Pure Discount Bonds: Example

Find the value of a 30-year zero-coupon bond
with a $1,000 par value and a YTM of 6%.
$0

$0

$0

$1,000
L

L
0

PV =
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30

29

F
$1,000
=
= $174.11
(1 + r )T (1.06) 30
Bond Valuation

Robert B.H. Hauswald

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Bond Pricing
Information needed to value level-coupon bonds:
Coupon payment dates and time to maturity (T)
Coupon payment (C) per period and Face value (F)
Discount rate: YTM = r

$C

$C

$C

$C + $ F

T 1

L
0

Value of a Level-coupon bond

= PV of coupon payment annuity + PV of face value

PV =
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C
1
F
1

+
r (1 + r )T (1 + r )T
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Robert B.H. Hauswald

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Bond Pricing Illustration

Find the present value (as of January 1, 2002), of a 6-3/8
coupon T-bond with semi-annual payments, and a maturity
date of December 2009 if the YTM is 5-percent.
On January 1, 2002 the size and timing of cash flows are:

$31.875

$31.875

$31.875

$1,031.875

6 / 30 / 09

12 / 31 / 09

L
1 / 1 / 02

PV =
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6 / 30 / 02

12 / 31 / 02

$1,000
$31.875
1
1
+
= $1,089.75

16
.05 2 (1.025) (1.025)16
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Robert B.H. Hauswald

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Bond Pricing Exercise

Suppose Harley Davidson Co. issued a global bond
20 years to maturity, notional face value $1,000
Annual coupon is $110. (11% Coupon Rate)
Similar bonds have a yield to maturity of 11%.

What is the bonds fair value?

Present value of face value = $1,000/(1.11)20 = $124.03
Present value of coupons = $110 x (1-1/(1.11) 20)/.11
= $110 x 7.9633 = $875.96
Adding the discounted face value and coupons (rounding error):

BOND VALUE = $124.03 + $875.96 = $1000

NB: if the YTM and coupon rate are the same, the bond must be
trading at PAR

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Bond Values and Yields

Yield to Maturity: YTM, the required market
discount rate that sets the discounted cash flows =
bonds current Market Price
calculated as the bonds internal rate of return (IRR) r

Bonds typical cash flows: coupons and face value

Example 1: Zero - Coupon Bond - Find the Value?
Single Payment 10 years from now, $1,000,
Yield to maturity on comparable bonds is 9%.

Example 2: Zero - Coupon Bond - Find the YTM

Single Payment 10 years from now, $1,000,
Current Bond price: $400

Given price, how to find the yield-to-maturity (bond

return)?
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Robert B.H. Hauswald

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Interest, Price, Return, Yield

Comparing funding costs or investment returns across
different maturities, market segments and instruments
unified measure required for lifetime borrowing cost: YIELD
example: 100, 100, 8% annual coupon, 15Y

Borrowing cost/return measured by bonds IRR

discount rate equating all cash flows to 0 including issue cost
implies: yield-to-maturity (return to investor), all-in cost
(borrowing cost to issuer taking into account all fees)

Yield-to-maturity: internal rate of return (discount rate)

equating all cash flows (proceeds debt service) to 0
formula:

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T
Ct
1,000
y : P0 t =1
+
=0
t
T
(
)
(
)
1
+
y
1
+
y

20
Bond Valuation Robert B.H. Hauswald

Finding the Yield to Maturity

It is usually a trial and error process to find the
YTM: solving a non-linear equation
A financial calculator or tables is the quickest and
easiest method
Even better: EXCEL
Facts of life about bond price and YTM:
bond sells at a premium: YTM below coupon rate
bond sells at a discount: YTM above coupon rate
bond prices and YTM are inversely related!
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Term Structure of Interest Rates

Relationship between yield and maturity is called the
Term Structure of Interest Rates
Graphical depiction is called a Yield Curve: Bloomberg
Usually, yields on long-term securities are higher than on
short-term securities: premium for uncertainty and inflation
Generally look at risk-free Treasury debt securities

Yield curves normally upwards-sloping

Long yields > short yields
Is often flat or inverted prior to recession

The Federal Reserve Board sets what interest rate?

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Discount Bonds/Premium Bonds

Discount bond: selling for less than par
YTM is greater than the coupon rate.

Premium bond: selling for more than par

YTM is less than the coupon rate
Examples: Discount/Premium bonds
Example 1: If the YTM on bonds similar to that of the Harley
Davidson Co. ($1,000 bond, $110 coupon, 20 years to
maturity) were 13% instead of 11% the bonds would trade at?
Example 2: If the YTM on bonds similar to that of the Harley
Davidson Co. ($1,000 bond, $110 coupon, 20 years to
maturity) were 9% instead of 11% the bonds would trade at?
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Robert B.H. Hauswald

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YTM and Bond Value

Bond Value

$1400

When the YTM < coupon, the bond

trades at a premium.

1300

1200

When the YTM = coupon, the

bond trades at par.

1100

1000

800
0

0.01

0.02

0.03

0.04

0.05

0.06
0.07
6 3/8

0.08

0.09

0.1

Discount Rate

When the YTM > coupon, the bond trades at a discount.

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Bond 1: Discount Bond

Present value of Principal = $1,000/(1.13)20 = $86.78
Annuity present value of coupons
= $110 x (1-1/(1.13) 20)/.13
= $110 x 7.0248 = $772.72
Price = $86.78 + $772.72 = $859.50
==> The difference between this price, $859.50, and the par price of
$1,000 is $140.50

This is equal to the present value of the difference between

YTM coupons and Harley Davidson's coupons:
$130 - $110 = $20 per year for 20 years at 13%
= $20 x PVIFA(13%,20)
= $20 x 7.0248 = $140.50
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Bond 2: Premium Bond

Present value of principal = $1,000/(1.09)20 = $178.43
Annuity present value of coupons:
= $110 x (1 -1/(1.09)20)/.09
= $110 x 9.1285 = $1,004.14

Adding the discounted face value and coupons together

= $178.43 + $1,004.14 = $1,182.57

The difference between this price, $1,182.57 and the par

price of $1,000, $182.57,
= present value of the difference between Harley
Davidson's coupons and coupon of bond at PAR:
= $110 - $90 = $20 per year for 20 years at 9%
= $20 x PVIFA(9%,20) = $20 x 9.1285 = $182.57.
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Robert B.H. Hauswald

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Bonds: Premiums & Discounts

What happens to bond values if required return is not equal to the coupon rate?

The bond's value will differ from its par value

R > Coupon Interest Rate

P0 < par value

DISCOUNT

R < Coupon Interest Rate

P0 > par value

PREMIUM

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Rules for Bond Pricing

1.
2.

Bond prices and market interest rates move in opposite

directions.
When coupon rate = YTM, price = par value.
When coupon rate > YTM, price > par value (premium bond)
When coupon rate < YTM, price < par value (discount bond)
A bond with longer maturity has higher relative (%) price
change than one with shorter maturity when interest rate
(YTM) changes. All other features are identical.
A lower coupon bond has a higher relative price change than
a higher coupon bond when YTM changes. All other features
are identical.

3.

4.

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Semi-Annual Coupons
Semi-annual coupons: Halve the p.a. coupon amount and
the quoted p.a. YTM, and double number of years
Example: A $1,000 bond with an 8% coupon rate maturing
in 10 years will have what price if the market quoted YTM
is 10%?
Present value of face value
= $1,000/(1.05)20 = $376.89
Annuity present value of coupons
= $40 x (1-l/(1.05)20)/.05
= $40 x 12.4622 = $498.49
Adding the discounted face value and coupons together:
= 376.89 + $498.49 = $875.38
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Bond Risks
A Quick Pass at Duration Analysis
Interest rate risk: changes in bond prices arising from
fluctuating interest rates (varying YTMs).
Ceteris paribus, the longer the time to maturity, the
greater the interest rate risk. Ceteris paribus, the lower
the coupon rate, the greater the interest rate risk.

Repayment Rate Risk: risk that debtor will repay

the amount owed before maturity
default risk: covenants and sinking funds.
rating agencies: downgrades and upgrades
fixed-income analysis: extracting default probabilities
and recovery rates from stock and bond prices
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Bond Value

Maturity and Bond Price

Sensitivity
Consider two otherwise identical bonds.
The long-maturity bond will have much more
volatility with respect to changes in the
discount rate

Par
Short Maturity Bond

C
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Bond Valuation

Discount Rate
Long Maturity
Bond

Robert B.H. Hauswald

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Bond Value

Coupon Rate and Bond Price

Sensitivity
Consider two otherwise identical bonds.
The low-coupon bond will have much more
volatility with respect to changes in the
discount rate

High Coupon Bond

Discount Rate
Low Coupon Bond
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Summary
Bond valuation: focus on the Cash Flows
Split valuation problem into 2 parts
the PV of the coupon payments
the PV of the final payment: redemption

Fair price of bonds = sum of these 2 amounts

While cash flows are fixed, market value is not
interest rate and yield volatility
how to simultaneously find yields and prices?
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Robert B.H. Hauswald

33