Bond Valuation and Interest Rates

The Basic Structure of Bonds

What is a bond? a bond is any debt instrument that promises a fixed income stream to the holder Fixed income securities are often classified according to maturity, as follows:
Less than one year Bills or Paper 1 year < Maturity < 7 years Notes < 7 years Bonds

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The Basic Structure of Bonds

A typical bond has the following characteristics:
A fixed face or par value, paid to the holder of the bond, at maturity A fixed coupon, which specifies the interest payable over the life of the bond
Coupons are usually paid either annually or semi-annually

A fixed maturity date

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The Basic Structure of Bonds

Bond indenture - the contract between the issuer of the bond and the investors who hold it The market price of a bond is equal to the present value of the payments promised by the bond

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The Basic Structure of Bonds

Cash Flow Pattern for a Traditional Coupon-Paying Bond
FIGURE 6-1

I F

I = interest payments, and F = principal repayment

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Cash Flow Pattern of a Bond

0 1 2 Coupon

3
Coupon

4 Coupon

n Coupon + Face Value

Purchase Coupon Price

Cash Outflows to the Investor

Cash Inflows to the Investor

The Purchase Price or Market Price of a bond is simply the present value of the cash inflows, discounted at the bonds yield-to-maturity
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The Basic Structure of Bonds

Term-to-maturity the time remaining to the bonds maturity date Coupon rate the annual percentage interest paid on the bonds face value; to calculate the dollar value of the annual coupon, multiply the coupon rate by the face value
If the coupon is paid twice a year, divide the annual coupon by two Example: A $1,000 bond with an 8% coupon rate will have an $80 coupon if paid annually or a $40 coupon if paid semi-annually
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Bond Valuation
The value of a bond is a function of:
Par value Term to maturity Coupon rate Investors required rate of return (discount rate is also known as the bonds yield to maturity)

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Bond Valuation: Example

What is the market price of 15-years, $1,000 bond with a 10% coupon, if the bonds yield-to-maturity is 10%?

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Bond Value
General Formula

[ 6-1]

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Bond Value
General Formula

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Bond Value
General Formula

VB= 100* 7.6061 + 1000* 0.2394 = 760.61+ 239.4= 784.55 $

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Bond Value
General Formula

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Bond Value
General Formula
1- INT= 1000 *8%= 80$ N= 19 years M= 1000 Kd= 6% 19 19 VB= 80/(1+6%) + 1000 /(1+6%) VB= 80 * 11.1581+ 100 * 0.3305= 1223.148$

2- INT= 1000 *8%= 80$ N= 19 years M= 1000 19 Kd= 10% 19 VB= 80/(1+10%) + 1000 /(1+10%) VB= 80 * 8.3649+ 100 * 0.1635= 832.692$

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Factors Affecting Bond Prices

Bond Price-Yield Curve
When interest rates increase, bond prices fall
FIGURE 6-2

Price ($)

Market Yield (%)

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Factors Affecting Bond Prices

Bond Price-Yield Curve

CHAPTER 6 Bond Valuation and Interest Rates

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Factors Affecting Bond Prices

Bond Price-Yield Curve

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Factors Affecting Bond Prices

The relationship between the coupon rate and the bonds yield-to-maturity (YTM) determines if the bond will sell at a premium, at a discount, or at par

If Coupon < YTM

Then Market < Face

Bond Sells at a: Discount

Coupon = YTM Coupon > YTM

Market = Face Market > Face

Par Premium

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Bond Valuation: Semi-Annual Coupons

So far, we have assumed that all bonds have annual pay coupons. While this is true for many bonds, it is not true for other bond issues, which have coupons that are paid semi-annually To adjust for semi-annual coupons, we must make three changes:
Size of the coupon payment (divide by 2) Number of periods (multiply by 2) Yield-to-maturity (divide by 2)

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For example, suppose you want to value a 5-years, $10,000 Government of Canada bond with a 4% coupon, paid twice a year, given a YTM of 6%.
INT /2=( 10000 *4%)/2= 400/2= 200$ N * 2=5 * 2=10 M= 10000 Kd /2= 6% /2= 3%
10 10

VB= 200/(1+3%) + 10000 /(1+3%) VB= 200 * 8.5302+ 10000 * 0.7441 = 9147.04$
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Factors Affecting Bond Prices

There are three factors that affect the price volatility of a bond
Yield to maturity Time to maturity Size of coupon

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Bond Yields
Yield-to-maturity (YTM) the discount rate used to evaluate bonds
The yield earned by a bond investor who:
Purchases the bond at the current market price Held the bond to maturity Reinvested all of the coupons at the YTM

Is the bonds Internal Rate of Return (IRR)

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Factors Affecting Bond Prices

Yield to maturity
Bond prices go down when the YTM goes up Bond prices go up when the YTM goes down

Look at the graph on the next slide. It shows how the price of a 25 year, 10% coupon bond changes as the bonds YTM varies from 1% to 30% Note that the graph is not linear instead it is said to be convex to the origin

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Factors Affecting Bond Prices

Price and Yield: 25 Year Bond, 10% Coupon

Price/Yield Relationship
350 300 250 200 150 100 50 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 Percent YTM

Price per $100 of Face Value

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Factors Affecting Bond Prices

Time to maturity
Long bonds have greater price volatility than short bonds
The longer the bond, the longer the period for which the cash flows are fixed

Size of coupon
Low coupon bonds have greater price volatility than high coupon bonds
High coupons act like a stabilizing device, since a greater proportion of the bonds total cash flows occur closer to today & are therefore less affected by a change in YTM
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Interest Rate Risk & Duration

The sensitivity of bond prices to changes in interest rates is a measure of the bonds interest rate risk A bonds interest rate risk is affected by:
Yield to maturity Term to maturity Size of coupon

These three factors are all captured in one number called duration

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Duration
Duration is a measure of interest rate risk The higher the duration, the more sensitive the bond is to changes in interest rates A bonds duration will be higher if its:
YTM is lower Term to maturity is longer Coupon is lower

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Bond Value
General Formula

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Bond Value
General Formula

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