7

Valuing Bonds
Finance 3rd Edition

Cornett, Adair, and Nofsinger

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Bond Characteristics
Debt obligations
Repayment of principal
Interest payments

Known as fixed-income securities

7-2

Bond Characteristics
Indenture agreement contains bond terms
Maturity date
Par value
Time to maturity
Call feature
Coupon Rate

7-3

Bond Issuers
US Treasury

Corporations
Municipalities

7-4

Annual Bond Issuance

7-5

Other Bonds and Securities

Treasury Inflation-Protected Securities

(TIPS)
Indexed to inflation

U.S. government agency securities

Fannie Mae, Freddie Mac, student loans

Mortgage-backed securities

7-6

Reading Bond Quotes

Premium bond sells for higher price than

par
Discount bond sells for lower price than par
Coupon rate set at time of issue

7-7

Bond Valuation
Uses time value of money concepts

Price of bond
Present value of future cash flows discounted at

prevailing market interest rate

7-8

Bond Valuation
Zero coupon bond
No interest payments
Pays par value at maturity

7-9

Bond Valuation
Timeline for zero-coupon bond

7-10

Computing Price of Zero Coupon Bond

Assumptions
Compute the zeros price by finding present

value of $1,000 cash flow received in 20 years

40 semi-annual periods at 3% interest

Use present value equation

7-11

Present Value of Bond

Present value of interest payments +

Present value of par value

7-12

Bond Yields
Current Yield

Yield to Maturity
Yield to Call
Municipal Bond Equivalent Taxable Yield

7-13

Bond Yields
Yield to Maturity (YTM)
Discount rate that equates the present value of

future cash flows with current bond price

7-14

Bond Yields
Yield to Call
Price of callable bond = Present value of

interest payments to call data + Present value

of call price

7-15

Bond Yields
Municipal Bond Equivalent Taxable Yield
Compares tax-exempt municipal bonds to

taxable bonds

7-16

Credit Risk
Bond ratings

Credit risk and yield

7-17

Bond ratings
Credit quality risk is the chance the issuer will

not be able to repay on a timely basis

Credit rating agencies
Investment-grade bonds are AAA, AA, A or BBB rated

Junk bond (high-yield) are rated BB and below

7-18

Credit Risk and Yield

Yield is affected by credit risk
Lower quality bonds offer higher yields
Higher quality bonds offer lower yields

7-19

Yield to Maturity Long Term Bonds

7-20

Credit Risk and Yield

Investors only purchase higher risk when

higher returns possible

Junk bonds are high-yield bonds
Yield spread between high- and low-quality

bonds varies over time

7-21

Bond Markets
Decentralized, over-the-counter trading

Most trades occur between bond dealers

and large institutions

Bond prices have inverse relationship to

interest rates

7-22