Valuing Bonds

What is a bond? Example

Par value/Face value $1,000

Coupon Rate 5%
Issued Today
Matures 30 years from today

Scheduled
Payments: $50/year interest for 30 years
$1,000 par at end of year 30

2
 Bond Pricing: Present Value
• The value (price) of a bond is the present
value of the future cash flows promised,
discounted at the market rate of interest

Bond Price = Present Value of payments

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 PV of bond cash flows

C1 C2 CN + F N
PB = 1
+ 2
+ ... N
(1 + i) (1 + i) (1 + i)
Where PB = price of bond or present value of promised payments;
Ct = coupon payment in period t, where t = 1, 2, 3,…, N;
FN = par value (principal amount) due at maturity;
i = market interest rate (discount rate or market yield); and
N = number of periods to maturity.
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 YTM
• Yield to maturity is the rate implied by
the current bond price

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 Bond Yields:
Yield to Maturity
• If Bond Price =par,
Yield to maturity = the coupon rate

• If Bond Price >par,

Yield to maturity < the coupon rate
 premium.

• If Bond Price < par,

Yield to maturity > the coupon rate
 discount.
•
Bond Price   Yield to maturity

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 Valuing a Discount Bond with Annual
Coupons
• Consider a bond with a coupon rate of 10%
and coupons paid annually. The par value is
$1,000 and the bond has 5 years to maturity.
The yield to maturity is 11%. What is the
value of the bond?

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Valuing a Premium Bond with Annual
Coupons
• Suppose you are looking at a bond that has a 10%
annual coupon and a face value of $1,000. There
are 20 years to maturity and the yield to maturity is
8%. What is the price of this bond?

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 Computing yield to maturity
Investor buys 5% percent coupon
(semiannual payments) bond for $951.90;
bond matures in 3 years. Solve the bond
pricing equation for the interest rate (i) such
that price paid for the bond equals PV of
remaining payments due under the bond.

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 Bond Prices:
Consols

Yearly Coupon Payment

PConsol 
i

The interest rate rises and the price of the consol move
in opposite directions.

You are considering purchasing a consol that promises

annual payments of $4.If the current interest rate is 5
percent, what is the price of the consol?

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 Bond Pricing:
Important Property
The price of a bond (PCB) and the interest rate (i)
are inversely related:

i  PCB 
Assuming that the current interest rate is 3 percent,
compute the value of a 5-year, 5 percent coupon
bond with a face value of $1000.

What happens when the interest rate goes to 4

percent?

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 YTM with Annual Coupons

• Consider a bond with a 10% annual coupon

rate, 15 years to maturity, and a par value
of $1,000. The current price is $928.09.
 Will the yield be more or less than 10%?

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 Bond Yields:
Current Yield

Yearly Coupon Payment

Current Yield 
Price Paid

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 Bond Yields:
Current Yield
Example:
1yr, 5% coupon bond selling for $99
(Assume a Par value of $100)

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Current Yield =  0.0505 , or 5.05%
99

Note:
Yield to maturity:6.06%

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Bond Yields:
Comparisons

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 Bond Yields:
Holding Period Returns

The holding period return is the return to

holding a bond and selling it before maturity.

Holding period return can differ from

the yield to maturity.

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 Bond Yields:
Holding Period Returns
Examples:
– 10 year bond
– 6% coupon rate
– Purchase at face value, $100
– Hold for one year and then sell it

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 Bond Yields:
Holding Period Returns
What if the interest rate falls to 5%
1yr Holding Period Return =

$6 $107.11  $100 $13.11

   0.1311
$100 $100 $100
1-yr Holding Period Return = 13.11%

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 Bond Yields:
Holding Period Returns

What if the interest rate rises to 7%

1yr Holding Period Return =
$6 $93.48  $100  $0.52
   0.0052
$100 $100 $100
1-yr Holding Period Return = 0.52%

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 Bond Yields:
Holding Period Returns

Holding Period Return

Yearly Coupon Payment Change in Price of the Bond

 
Price Paid Price of the Bond

= Current Yield + Capital Gain (as a %)

6-20
 Bond yields: risks rewarded
Yield rewards investor for at least 3 risks:

• Credit or default risk: chance that issuer may be

unable or unwilling to pay as agreed.

• Reinvestment risk: potential effect of variability

of market interest rates on return at which
payments can be reinvested when received.

• Price risk: Inverse relationship between bond

prices and interest rates.

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Bond Ratings
Bond Ratings (cont’d)