Bond Valuation

BONDS
VALUATION
CHAPTER 7
Financial Market in the Financial System
Financial Market a market where those who
have excess funds and those who are in need of
funds will meet to transact the financial assets
that include both money and capital market
securities.
4 main parties: households, business firms,
foreigners and government.
2
SITI AISHAH BINTI KASSIM (FM2)
Characteristics of a Good Financial Market
Availability of information
Liquidity
Price continuity
Transaction cost
External efficiency or information
efficiency

3
Types of Securities Market
1. Money market
Short-term securities which have
maturity below than one-year.
2. Capital market
Long-term securities which have
maturity longer than one-year.
4
What is a Bond?
One of a debt financing
A long term debt (fixed income security) in which
the issuer (borrower) has agreed to pay fixed
income payments for a specified period and to
repay a fixed amount of principal at maturity to
the bondholder (lender).
Indenture the contract between the issuer and
the bondholder, which sets the obligations of the
issuer.

5
Key Features of a Bond
Par value face amount of the bond, which
is paid at maturity (assume $1,000).
Coupon interest rate a rate of interest payment for
every bond issued and usually be converted into Ringgit
amount by time the rate to the bond par value (CP = PV x
CR)
Maturity date years until the bond must be repaid.
Issue date when the bond was issued.
Yield to maturity rate of return earned on
a bond held until maturity (also called the promised
yield).
6
Bond Markets
Primarily traded in the over-the-counter (OTC)
market.
Most bonds are owned by and traded among large
financial institutions.
Full information on bond trades in the OTC market
is not published, but a representative group of
bonds is listed and traded on the bond division of
the NYSE.

7
Callable bonds
Allow the issuer to redeem the bond at any time
before the maturity date.
The bond will be call at premium price to
compensate for the holders.
Issuer will call the bond when market interest
rate decline reduce it interest expenses and
take the advantages of lower interest rate in the
market.
8
Sinking Fund
Provision in the indenture to pay off a loan over its
life rather than all at maturity. Failure to meet SF
requirement causes bond default, may force firm into
bankruptcy. Significant cash drain to firm.
Similar to amortization on a term loan. Reduces
amount needed to retire the remaining debt at
maturity.
Reduces risk to investor, shortens average maturity.
But not good for investors if rates decline after
issuance.

9
Types of Bonds
A. Unsecured Bonds:
Bonds that are not backed by an asset or collateral.
i. Debentures unsecured long-term bond
ii. Subordinated Debentures bonds that have a lower claim on
assets in the event of liquidation than do other senior debtholders.
iii. Income Bond issued by firms facing financial difficulties or
which are weak financially.
B. Secured Bonds:
Bonds that are backed by an asset or collateral.
i. Mortgage Bond secured by real estate or buildings, which are
of higher value than the value of the mortgage bond issued.
ii. Collateral Trust Bond secured by stock and/or bonds owned
by the issuer.
iii. Equipment Trust Certificates used to finance the purchase
of rolling stock such as trains, ships, boats and trucks.
10
Other Types of Bond Issues
Eurobonds issued by an international
borrower and sold to investors in countries with
currencies other than currency in which the bond
is denominated.
Junk Bonds also called high-yield securities
because of the higher risks of default faced by the
bondholders. Rated below BBB.
Zero (low) coupon bonds known as original
discount bond is sold at a large discount from
par.
11
Rating the Bond
To provide the potential investor an objective form of risk analysis
and evaluation on the quality of the bond and its issuer.
Rating Standard &
Poors
Moodys RAM
Highest AAA Aaa AAA
AA Aa AA
A A A
BBB Baa BBB
BB Ba BB
B B B
CCC Caa C
CC Ca
Lowest C C D
12
Definition of Value
Book Value the value of an asset shown on a firms
balance sheet which is determined by its historical cost
rather than its current worth.
Liquidation the amount that could be realized if an
asset is sold individually and not as part of a going
concern.
Market Value the observed value of an asset in the
marketplace where buyers and sellers negotiate an
acceptable price for the asset.
Intrinsic Value the value based upon the expected
cash flows from the investment, the riskiness of the asset,
and the investors required rate of return.
13
Principles of Bond Price Behavior
When the required rate of return (k) differ from
the bonds coupon rate, the market value of the
bond will differ from its par:
When required rate of return (k) = coupon interest rate,
bond will sell at par.
When required rate of return (k) > coupon interest rate,
bond will sell at a discount.
When required rate of return (k) < coupon interest rate,
bond will sell at premium.

14
The Value of Financial Assets
n
n
2
2
1
1
k) (1
CF
...
k) (1
CF
k) (1
CF
Value
+
+ +
+
+
+
=
0 1 2 n
k = ?%
CF
1
CF
n
CF
2
Value
...
15
What is the value of a 10-year, 10%
annual coupon bond, if k
d
= 10%?
(coupon=10%x$1000=$100/year)
$1,000 V
$385.54 $38.55 ... $90.91 V
(1.10)
$1,000
(1.10)
$100
...
(1.10)
$100
V
B
B
10 10 1
B
=
+ + + =
+ + + =
0 1 2 n
K
d
= 10%
$100

$100 + $1,000

$100

V
B
= ?
...
16
Mathematical Calculation
V
b
= CPN (PVIFA
r%,n
) + Par Value (PVIF
r%,N
)
= $100 (PVIFA
10%,10
) + $1000 (PVIF
10%,10
)
= $100(6.1446) + $1000(0.3855)
= $614.46 + $385.50
= $1,000

*(If coupon rate = interest/discount rate (k)
V
b
= Par Value/Maturity Value =$1000)
17
Using a financial calculator to
value a bond
This bond has a $1,000 lump sum due at t = 10,
and annual $100 coupon payments beginning
at t = 1 and continuing through t = 10, the price
of the bond can be found by solving for the PV
of these cash flows.
INPUTS
OUTPUT
N I/YR PMT PV FV
10 10 100 1000
-1000
18
An example:
Increasing inflation and k
d

Suppose inflation rises by 3%, causing k
d
=
13%. When k
d
rises above the coupon rate, the
bonds value falls below par, and sells at a
discount.
INPUTS
OUTPUT
N I/YR PMT PV FV
10 13 100 1000
-837.21
19
What is the V
b
if k
d
increases from
10% to 13%?
V
b
= $100 (PVIFA
13%,10
) + $1000(PVIF
13%,10
)
= $100 (5.4262) + 1000 (0.2946)
= $542.62 + $294.60
= $837.22 (bond sells at a discount)

20
An example:
Decreasing inflation and k
d

Suppose inflation falls by 3%, causing k
d
= 7%.
When k
d
falls below the coupon rate, the bonds
value rises above par, and sells at a premium.
INPUTS
OUTPUT
N I/YR PMT PV FV
10 7 100 1000
-1210.71
21
What is the V
b
if k
d
decreases
from 10% to 7%?
V
b
= $100 (PVIFA
7%,10
) + $1000(PVIF
7%,10
)
= $100 (7.0236) + $1000(0.5083)
= $702.36 + $508.30
= $1,210.66 (bond sells at a premium)
22
What is the YTM on a 10-year, 9%
annual coupon, $1,000 par value bond,
selling for $887?
Must find the k
d
that solves this model.
10
d
10
d
1
d
N
d
N
d
1
d
B
) k (1
1,000
) k (1
90
...
) k (1
90
$887
) k (1
M
) k (1
INT
...
) k (1
INT
V
+
+
+
+ +
+
=
+
+
+
+ +
+
=
23
Approximate YTM
AYTM (%) = I +(MV-V
b
)/N
(MV + V
b
)/2

ATYM =Approximate yield to maturity
I = $Interest or $coupon interest (x% of par
value of $1000. Example, if coupon/interest
is 9%, paid annually, I = 9% x 1000 = $90)
MV = Maturity/Par value = $1000
V
b
= Value/Price of bond

24
Find the YTM on a 10-year, 9% annual
coupon, $1,000 par value bond, selling for
$887
AYTM = I + (MV-Vb)/N
(MV +Vb)/2
= $90 + ($1000 - $887)/10
($1000 + $887)/2
= 11%
25
Interpolation (to get exact rate)
k
d
Present Value

10% $90(PVIFA
10%,10
) +$1000(PVIF
10%,10
) = $938.51
X% = $887.00
11% $90(PVIFA
11%,10
) + $1000(PVIF
11%,10
) = $883.13
1%

Proportion = $938.51 - $887.00 = 0.93%
$938.51 $883.13

Therefore X = 10% + 0.93% = 10.93%
26
Current Yield, Capital Gains Yield and
Expected Total Return
|
|
.
|
\
|
+
|
|
.
|
\
|
= =
=
=
CGY
Expected

CY
Expected
YTM return total Expected
price Beginning
price in Change
(CGY) yield gains Capital
price Current
payment coupon Annual
(CY) eld Current yi
27
An example:
Current and capital gains yield
Find the current yield and the capital gains yield
for a 10-year, 9% annual coupon bond that sells
for $887, and has a face value of $1,000.

Current yield = $90 / $887
= 0.1015 @ 10.15%
28
Calculating Capital Gains
Yield
YTM = Current yield + Capital gains yield

CGY = YTM CY
= 10.91% - 10.15%
= 0.76%

Could also find the expected price one year from
now and divide the change in price by the
beginning price, which gives the same answer.
29
What is interest rate (or
price) risk?
Interest rate risk is the concern that
rising kd will cause the value of a
bond to fall.
30
What is reinvestment rate
risk?
Reinvestment rate risk is the concern that k
d

will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.

EXAMPLE: Suppose you just won $500,000
playing the lottery. You intend to invest the
money and live off the interest.
31
Reinvestment rate risk example:
You may invest in either a 10-year bond or a
series of ten 1-year bonds. Both 10-year and 1-
year bonds currently yield 10%.

If you choose the 1-year bond strategy:
After Year 1, you receive $50,000 in income and have
$500,000 to reinvest. But, if 1-year rates fall to 3%, your
annual income would fall to $15,000.
If you choose the 10-year bond strategy:
You can lock in a 10% interest rate, and $50,000 annual
income.
32
Conclusions about interest rate
and reinvestment rate risk
CONCLUSION: Nothing is riskless!
Short-term
AND/OR High
coupon bonds
Long-term
AND/OR Low
coupon bonds
Interest
rate risk
Low High
Reinvestment
rate risk
High Low
33
Semiannual Bonds
1. Multiply years by 2 : number of periods = 2n.
2. Divide nominal rate by 2 : periodic rate (I/YR) = k
d
/ 2.
3. Divide annual coupon by 2 : PMT = ann cpn / 2.
INPUTS
OUTPUT
N I/YR PMT PV FV
2n k
d
/ 2 cpn / 2 OK OK
34
What is the value of a 10-year, 10%
semiannual coupon bond, if k
d
= 13%?
1. Multiply years by 2 : N = 2 * 10 = 20.
2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.
3. Divide annual coupon by 2 : PMT = 100 / 2 = 50.
INPUTS
OUTPUT
N I/YR PMT PV FV
20 6.5 50 1000
- 834.72
35
Semiannual Coupons/Interest
V
b
= I/2(PVIFA
r/2%,2N
) + MV(PVIF
r/2,2N
)

Example: What is the price of a bond with
coupon (interest) of 8.5% paid semi annually,
remaining maturity of 12 years, and required
rate of return is 10%?
I=8.5% x $1000=$85; semi-annually=$42.50
N= 12years x 2 = 24times; r = 10%/2 = 5%

Vb = $42.50(PVIFA
5%,24
) + $1000(PVIF
5%,24
)
= $896.51
36
Semiannual Bonds
V
b
= PV (Coupon Payments) + PV (Par Value)
V
b =
CPN PVIFA
r/2%, 2N
+ 1000PVIF
r/2%, 2N
2
V
b
= CPN (1 + r/2)
2N
1 + 1000
2 (r/2)(1 + r/2)
2N
(1 + r/2)
2N
37
Would you prefer to buy a 10-year, 10% annual
coupon bond or a 10-year, 10% semiannual
coupon bond, all else equal?
The semiannual bonds effective rate is:

10.25% > 10% (the annual bonds effective rate), so
you would prefer the semiannual bond.
10.25% 1
2
0.10
1 1
m
i
1 EFF%
2 m
Nom
=
|
.
|
\
|
+ =
|
.
|
\
|
+ =
38
If the proper price for this semiannual
bond is $1,000, what would be the proper
price for the annual coupon bond?
The semiannual coupon bond has an effective
rate of 10.25%, and the annual coupon bond
should earn the same EAR. At these prices, the
annual and semiannual coupon bonds are in
equilibrium, as they earn the same effective
return.
INPUTS
OUTPUT
N I/YR PMT PV FV
10 10.25 100 1000
- 984.80
39
Yield to Call
Price of Bond:
V
b
= I (PVIFA
r%,N
) + Call price(PVIF
r%,N
)

N= the number of years until the company can
call the bond.
r
d
= yield to call
40
A 10-year, 10% semiannual coupon bond selling
for $1,135.90 can be called in 4 years for $1,050,
what is its yield to call (YTC)?
The bonds yield to maturity can be determined to
be 8%. Solving for the YTC is identical to solving
for YTM, except the time to call is used for N and
the call premium is FV.
INPUTS
OUTPUT
N I/YR PMT PV FV
8
3.568
50 1050
- 1135.90
41
Yield to call
3.568% represents the periodic
semiannual yield to call.
YTC
NOM
= k
NOM
= 3.568% x 2 = 7.137% is
the rate that a broker would quote.
The effective yield to call can be calculated
YTC
EFF
= (1.03568)
2
1 = 7.26%
42
If you bought these callable bonds, would
you be more likely to earn the YTM or
YTC?
The coupon rate = 10% compared to YTC =
7.137%. The firm could raise money by selling
new bonds which pay 7.137%.
Could replace bonds paying $100 per year with
bonds paying only $71.37 per year.
Investors should expect a call, and to earn the
YTC of 7.137%, rather than the YTM of 8%.
43
When is a call more likely to
occur?
In general, if a bond sells at a premium, then (1)
coupon > k
d
, so (2) a call is more likely.
So, expect to earn:
YTC on premium bonds.
YTM on par & discount bonds.
44
THE END
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