Key features of bonds

Bond valuation
Measuring yield
Assessing risk
7-1

What is a bond?
A long-term debt instrument in
which a borrower agrees to make
payments of principal and interest,
on specific dates, to the holders of
the bond.

7-2

Bond markets
Primarily traded in the over-thecounter (OTC) market.
Most bonds are owned by and traded
among large financial institutions.

7-3

Types
Treasury Bonds:
Bonds issued by the federal government,
sometimes referred to as government bonds.
Corporate Bonds:
Bonds issued by corporations.
Municipal Bonds:
Bonds issued by state and local governments.
Foreign Bonds:
Bonds issued by either foreign governments or
foreign corporations.

7-4

Key Features of a Bond

Par value face amount of the bond, which
is paid at maturity.
Coupon interest rate stated interest rate
(generally fixed) paid by the issuer.
Multiply by par to get payment of interest.
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).
7-5

Call Provision:

A provision in a bond contract that gives the

issuer the right to redeem the bonds under
specified terms prior to the normal maturity date.
The call provision generally states that the issuer
must pay the bondholders an amount greater
than the par value if they are called.
The additional sum, which is termed a call
premium, is often set equal to one years
interest.

7-6

Effects of a call provision

Allows issuer to refund the bond issue if
rates decline (helps the issuer, but hurts
the investor).
Call price is commonly the face value
plus one year of interest payments.
Most bonds have a deferred call(not
callable till after some time) and a
declining call premium(as the bond
reaches maturity the premium declines).

7-7

What is a sinking fund?

Provision to pay off a loan over its
life rather than all at maturity. Reduces
risk to investor, shortens average
maturity.
Sinking Fund Provision:

A provision in a bond contract that

requires the issuer to retire a portion of
the bond issue each year.
7-8

What is a sinking fund?

issuer can handle the sinking fund
in either of two ways:
1.The company can call in for
redemption (at par value) a certain
percentage of the bonds each year.
2.The company can buy the required
bonds on the open market.

7-9

How are sinking funds

executed?
Call x% of the issue at par, for sinking
fund purposes.
Likely to be used if interest rate is
below the coupon rate and the bond
sells at a premium.
Buy bonds in the open market.
Likely to be used if interest rate is
above the coupon rate and the bond
sells at a discount.
7-10

Other types (features) of

bonds
Convertible bond may be exchanged for
common stock of the firm, at the holders
option.
Warrant long-term option to buy a stated
number of shares of common stock at a
specified price.
Putable bond allows holder to sell the bond
back to the company prior to maturity.
Income bond pays interest only when
interest is earned by the firm.
Indexed bond interest rate paid is based
upon the rate of inflation.

7-11

Bond valuation
Value of the Bond = Present value

of interest payments + Present Value

of Principal.
Bond Value = PV of coupons + PV
of par

Bond Value = PV of annuity + PV

of lump sum
7-12

Bond valuation

7-13

Bond valuation

7-14

Bond valuation
Value of the Bond = Present value of

interest payments + Present Value of

Principal

PV of Annuity 1+- PV1of face

value
t

Bond Value INT

Where

bond

M
(1 r)

r
(1 r) N

N = time to maturity
r = the bonds market rate of interest.
INT = interest payment
M = the par, or maturity, value of the
7-15

Bond Valuation.
A bond that matures in eight years has

a par value of $1,000, an annual coupon

payment of $70, and a market interest
rate of 9 percent. What is its price?
($889.30)
A bond that matures in 12 years has a
par value of $1,000, an annual coupon of
10 percent, and a market interest rate of
8 percent. What is its price? ($1,150.72)
7-16

BOND YIELDS
Yield to Maturity (YTM)

The rate of return earned on a bond

if it is held to maturity.
Internal rate of return of the bond
that equates the present value of the cash
flow with the price of the bond.
Finding the YTM requires trial and error.

7-17

Bond Prices: Relationship Between

Coupon and Yield
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

7-18

BOND YIELDS
Wilson Wonders bonds have 12

years remaining to maturity. Interest

is paid annually, the bonds have a
$1,000 par value, and the coupon
interest rate is 10 % percent. The
bonds sell at a price of $850. What is
their yield to maturity?

7-19

BOND YIELDS
Solution:
GIVEN:
n= 12 years (to maturity)
Par Value= $1000
Coupon rate = 10% (paid

annually)
Bond Market Price = $850
YTM =?
7-20

BOND YIELDS
Solution:

1
1 - (1 r) t
Price INT
r

M

N
(1

r)

7-21

BOND YIELDS
Solution:
Step 2. Calculate % rate of return r.
Since Price < Par value,
therefore YTM > coupon rate.
So,
850< $1000 therefore YTM >
10%.
Now put values greater than 10% in
the main eq. and form a table.
7-22

BOND YIELDS
Solution:

7-23

Yield to Call (YTC)

. Yield to Call (YTC)

The rate of return earned on a bond

if it is called before its maturity date.
The

procedure for calculating will

remain the same as for YTM, except
that instead of Face value/maturity
value, call price will be used, and the
call period will be selected for time.
Using trial and error technique.
7-24

Yield to Call (YTC)

The Henderson Companys bonds

currently sell for $1,275. They pay a

$120 annual coupon and have a 20year maturity, but they can be called
in 5 years at $1,120. What is their
YTC?
7.31%;

7-25

Definitions
Annual coupon payment
Current yi
eld(CY)
Currentprice

Changein price
Capitalgainsyield(CGY)
Beginningprice
Expected
Expected

Expectedtotalreturn YTM
CY CGY

7-26

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.and YTM of 10.91%
Current yield

= $90 / $887
= 0.1015 = 10.15%

7-27

Calculating capital gains

yield
YTM = Current yield + Capital gains yield
CGY = YTM CY
= 10.91% - 10.15%
= 0.76%

7-28