CHAPTER 6

Bond Valuation and Interest

Rates
6 - 2
Lecture Agenda
Learning Objectives
Important Terms
Basic Structure of Bonds
Valuing Bonds
Bond Yields
Interest Rate Determinants
Other Types of Bonds/Debt Instruments
Summary and Conclusions
Concept Review Questions
Appendix Bond Duration
The Basic Structure of Bonds
Bond Valuation and Interest Rates
6 - 4
What is a Bond?
In its broadest sense, a bond is any debt instrument
that promises a fixed income stream to the holder
6 - 5
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 payment, which specifies the interest
payable over the life of the bond
Coupons are usually paid either annually or semi-annually
A fixed maturity date
6 - 6
Basic Structure of Bonds
Note:
The coupon rate, the maturity date, par value are all set
(fixed) at the time the bond was originally sold to the
market
6 - 7
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

(See the basic pattern of cash flows from a traditional bond on the next slide)
Basic Structure of Bonds
6 - 8
Cash Flow Pattern of a Bond
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
0 2
3
4 n 1
Coupon Coupon Coupon Coupon Coupon +
Face Value
Purchase
Price
Cash Inflows to
the Investor
Cash Outflows
to the Investor
Bond Features and Provisions
Bond Valuation and Interest Rates
6 - 10
More Bond Terminology
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 times
the face value.
If the coupon is paid twice a year, divide the annual
coupon by two
Example: A $1000 bond with an 8% coupon rate will
have an $80 coupon if paid annually or a $40 coupon if
paid semi-annually.

6 - 11
Security & Protective Provisions
Covenants
Positive covenants things the firm agrees to do
Supply periodic financial statements
Maintain certain ratios

Negative covenants things the firm agrees not to
do
Restrictions on the amount of debt the firm can take on
Prevents the firm from acquiring or disposing of assets
Bond Valuation
Annual Coupon Payments
Bond Valuation and Interest Rates
6 - 13
Bond Valuation
The value of a bond is a function of:
The bonds par (face) value
Term to maturity
Coupon rate
Investors required rate of return (discount rate is also
known as the bonds yield to maturity)
6 - 14
Bond Value
General Formula

) k (
F
k
) k (
I B
n
b b
n
b
+
+
(
(
(
(

=
1
1 1
1
1
[ 6-1]
Where:
I = interest (or coupon ) payments
k
b
= the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
6 - 15
Bond Valuation: Example
What is the market price of a ten year, $1,000 bond with a 5%
coupon, if the bonds yield-to-maturity is 6%?
( )
( )
( )
( )
10
10
1 1
1
1 1.06
1, 000
50
0.06
1.06
$926.40
n
b
n
b
b
k
F
B I
k
k

(
+
= + (
+
(

(

= + (
(

=
Calculator Approach:
1,000 FV
50 PMT
10 N
I/Y 6
CPT PV 926.40
Factors Affecting Bond Prices
Bond Valuation and Interest Rates
6 - 17
Coupon Rate Relationship to Yield-to-
Maturity
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 Then Bond Sells at a:
Coupon < YTM Market < Face Discount
Coupon = YTM Market = Face Par
Coupon > YTM Market > Face Premium
6 - 18
Factors Affecting Bond Prices
Inverse Relationship Between Yields and Prices
Yield to maturity (investors required return)
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
6 - 19
Price & Yield: 25 Year Bond, 10% Coupon
Price/Yield Relationship
0
50
100
150
200
250
300
350
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Percent YTM
P
r
i
c
e

p
e
r

$
1
0
0

o
f

F
a
c
e

V
a
l
u
e
As interest rates increase,
bond prices fall, but fall at a
decreasing rate
6 - 20
Bond Yields
The Yield to Maturity = Investors Required Rate of Return
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
Holds the bond to maturity
Is the bonds Internal Rate of Return (IRR)
6 - 21
Bond Yield to Maturity








The yield to maturity is that discount rate that causes the sum of
the present value of promised cash flows to equal the current
bond price.

YTM) (
F
YTM
YTM) (
I B
n
n
+
+
(
(
(
(

=
1
1 1
1
1
[ 6-2]
6 - 22
Solving for YTM
To solve for YTM, solve for YTM in the following formula:




There is a Problem:
You cant solve for YTM algebraically; therefore, must either
use a financial calculator, Excel, trial & error or approximation
formula.
( )
( )
1 1
1
n
n
YTM
F
B I
YTM
YTM

(
+
= +
(
+
(

6 - 23
Solving for YTM
Example: What is the YTM on a 10 year, 5% coupon bond
(annual pay coupons) that is selling for $980?
( )
( )
( )
( )
10
10
1 1
1
1 1
1, 000
980 50
1
5.26%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM

(
+
= + (
+
(

(
+
= + (
+
(

=
Financial Calculator
1,000 FV
980 +/- PV
50 PMT
10 N
I/Y 5.26%
YTM imp
If YTM = coupon rate, then par value = bond price
If YTM > coupon rate, then par value > bond price
Why? The discount provides yield above coupon rate
Price below par value, called a discount bond
If YTM < coupon rate, then par value < bond price
Why? Higher coupon rate causes value above par
Price above par value, called a premium bond

6 - 24
Using the Approximation Formula to
Solve for Yield to Maturity
Bond Valuation and Interest Rates
6 - 26
The Approximation Formula
This formula gives you a quick estimate of the yield
to maturity
It is an estimate because it is based on a linear
approximation (again you will remember the exponential
nature of compound interest)
Should you be concerned with the error inherent in
the approximated YTM?
NO
Remember a YTM is an ex ante calculation as a
forecast, it is based on assumptions which may or may
not hold in this case, therefore as a forecast or estimate,
the approximation approach should be fine.
6 - 27
The Approximation Formula
F = Face Value = Par Value = $1,000
B = Bond Price
I = the semi annual coupon interest
N = number of semi-annual periods left to maturity

1 YTM) annual - semi (1 YTM
YTM annual - semi 2 YTM
2
n
B - F
Maturity to Yield annual - Semi
2
+ =
=
+
+
=
B F
I
6 - 28
Example
Find the yield-to-maturity of a 5 year 6% coupon
bond that is currently priced at $850. (Always
assume the coupon interest is paid semi-annually.)
Therefore there is coupon interest of $30 paid semi-annually
There are 10 semi-annual periods left until maturity
6 - 29
Example with Solution
Find the yield-to-maturity of a 5 year 6% coupon bond that is
currently priced at $850. (Always assume the coupon interest is
paid semi-annually.)
% 97 . 9 1 ) 0486 . 1 ( 1 YTM) annual - semi (1 YTM
9.3% 0.09273 2 0.0486 YTM annual - semi 2 YTM
0486 . 0
925 $
30 $ 15 $
2
850 , 1 $
30 $
10
850 $ 000 , 1 $
2
n
B - F
Maturity to Yield annual - Semi
2 2
= = + =
= = = =
=
+
=
+

=
+
+
=
B F
I
The actual answer is 9.87%...so of course, the approximation
approach only gives us an approximate answerbut that is just
fine for tests and exams.
Short-Term Interest Rates
Bond Valuation and Interest Rates
6 - 31
Interest Rate Determinants
Interest is the price of money
Interest rates go:
Up when the demand for loanable funds rises
Down when the demand for loanable funds falls
Term Structure of Interest Rates
(Long-term Interest Rates)
Bond Valuation and Interest Rates

6 - 33
Term Structure of Interest Rates
Term structure is the relationship between time to maturity
and yields, all else equal
Yield curve graphical representation of the term structure
Normal upward-sloping; long-term yields are higher than short-
term yields
Inverted downward-sloping; long-term yields are lower than
short-term yields
When plotted on a graph, the line is called a Yield
Curve

6 - 34
Figure 7.6 Upward-Sloping Yield Curve
Figure 7.6 Downward-Sloping Yield
Curve
6 - 35
6 - 36
Theories of the Term Structure
Three theories are used to explain the shape of the
term structure
Liquidity preference theory
Investors must be paid a liquidity premium to hold less liquid,
long-term debt
Expectations theory
The long rate is the average of expected future short interest
rates
Market segmentation theory
Distinct markets exist for securities of different maturities