Bonds and Their Valuation: Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk

Chapter 7
Bonds and Their Valuation
Key Features of Bonds

Bond Valuation
Measuring Yield
Assessing Risk
7-1
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
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-the-counter (OTC)

market.
• Most bonds are owned by and traded among large
financial institutions.
• The Wall Street Journal reports key developments in
the Treasury, corporate, and municipal markets.
Online edition lists trading each day for the most
actively-traded investment-grade, high-yield, and
convertible bonds.
7-3
Key Features of a Bond
• Par value: face amount of the bond, which

is paid at maturity (assume $1,000).
• Coupon interest rate: stated interest rate (generally
fixed) paid by the issuer. Multiply by par value to
get dollar 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”).
7-4
Effect of a Call Provision
• Allows issuer to refund the bond issue if rates

decline (helps the issuer, but hurts the investor).
• Borrowers are willing to pay more, and lenders
require more, for callable bonds.
• Most bonds have a deferred call and a declining call
premium.
7-5
What is a sinking fund?
• Provision to pay off a loan over its life rather than

all at maturity.
• Similar to amortization on a term loan.
• Reduces risk to investor, shortens average maturity.
• But not good for investors if rates decline after
issuance.
7-6
How are sinking funds executed?
• Call x% of the issue at par, for sinking fund

purposes.
– Likely to be used if rd is below the coupon rate and
the bond sells at a premium.
• Buy bonds in the open market.
– Likely to be used if rd is above the coupon rate and
the bond sells at a discount.
7-7
Key Differences between
Debt and Equity Capital
Valuation Fundamentals
• Valuation is the process that links risk and return

to determine the worth of an asset.
• There are three key inputs to the valuation
process:
Cash flows (returns)
Timing
A measure of risk, which determines the required
return
© 2012
6-9
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in wholePearson
or in part.
Prentice
Basic Valuation Model
• The value of any asset is the present value of all future cash flows
it is expected to provide over the relevant time period.
• The value of any asset at time zero, V0, can be expressed as
where
v0 = Value of the asset at time zero

CFT = cash flow expected at the end of year t
r = appropriate required return (discount rate)
n = relevant time period
© 2012
6-10
or in part.
Prentice
The Value of Financial Assets
0 1 2 N
r% ...
Value CF1 CF2 CFN
CF1 CF2 CFN

Value   
1  r  1  r 
1 2
1  r N
7-11
Bond Valuation: Basic Bond Valuation
The basic model for the value, B0, of a bond is

given by the following equation:
Where
B0 = value of the bond at time zero
I= annual interest paid in dollars
n= number of years to maturity
M= par value in dollars
rd = required return on a bond
© 2012
6-12
or in part.
Prentice
Other Types (Features) of Bonds
• Convertible bond: may be exchanged for common

stock of the firm, at the holder’s 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.
7-13
What is the opportunity cost of debt capital?
• The discount rate (ri) is the opportunity cost of

capital, and is the rate that could be earned on
alternative investments of equal risk.
ri = r* + IP + MRP + DRP + LP
7-14
What is the value of a 10-year, 10% annual coupon
bond, if rd = 10%?
0 1 2 N
10% ...
VB = ? 100 100 100 + 1,000
$100 $100 $1,000

VB     
1.101 1.1010 1.1010
VB  $90.91    $38.55  $385.54
VB  $1,000
7-15
Changes in Bond Value over Time
• What would happen to the value of these three

bonds if the required rate of return remained at
10%?
VB
1,184
13% coupon rate
10% coupon rate

1,000
816 7% coupon rate

Years
to Maturity
10 5 0
7-16
Bond Values over Time
• At maturity, the value of any bond must equal its

par value.
• If rd remains constant:
– The value of a premium bond would decrease over
time, until it reached $1,000.
– The value of a discount bond would increase over
time, until it reached $1,000.
– The value of a par bond stays at $1,000.
7-17
Definitions
Annual coupon payment

Current yield (CY) 
Current price
Change in price
Capital gains yield (CGY) 
Beginning price
Expected total return  YTM  Expected CY  Expected CGY
7-18
An Example:
Current and Capital Gains Yields
• 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.
$90
Current yield 
$887
 0.1015  10.15%
7-19
Calculating Capital Gains Yield
YTM = Current yield + Capital gains yield
CGY  YTM  CY
 10.91%  10.15%
 0.76%
Could also find the expected price one year from now
and divide the change in price by the beginning price,
which gives the same answer.
7-20
What is price risk? Does a 1-year or 10-year bond
have more price risk?
• Price risk is the concern that rising rd will cause the

value of a bond to fall.
rd 1-year Change 10-year Change
5% $1,048 $1,386
+ 4.8% +38.6%
10% 1,000 – 4.4%
1,000 –25.1%
15% 956 749
• The 10-year bond is more sensitive to interest

rate changes, and hence has more price risk.
7-21
Illustrating Price Risk
Value ($)
1,600
1,400 10-Year Bond
1,200 1-Year Bond
1,000
800
600
400
200
0 YTM(%)
0 5 10 15 20
7-22
What is reinvestment risk?
• Reinvestment risk is the concern that rd will fall, and

future CFs will have to be reinvested at lower rates,
hence reducing income.
EXAMPLE: Suppose you just won $500,000 playing

the lottery. You intend to invest the money and live
off the interest.
7-23
Reinvestment Risk Example
• You may invest in either a 10-year bond or a series

of ten 1-year bonds. Both 10-year and 1-year
bonds currently yield 10%.
• If you choose the 1-year bond strategy:
– After Year 1, you receive $50,000 in income and have
$500,000 to reinvest. But, if 1-year rates fall to 3%,
your annual income would fall to $15,000.
• If you choose the 10-year bond strategy:
– You can lock in a 10% interest rate, and $50,000
annual income for 10 years, assuming the bond is not
callable.
7-24
Conclusions about Price Risk and Reinvestment Risk
Short-term Long -term

AND/OR AND/OR
High-coupon Low-coupon
Bonds Bonds
Price risk Low High
Reinvestment risk High Low
• CONCLUSION: Nothing is riskless!
7-25
Semiannual Bonds
1. Multiply years by 2: Number of periods = 2N

2. Divide nominal rate by 2: Periodic rate (I/YR) = rd/2
3. Divide annual coupon by 2: PMT = Annual coupon/2
7-26
Yield to Maturity (YTM)
• The yield to maturity (YTM) is the rate of

return that investors earn if they buy a bond at a
specific price and hold it until maturity.
(Assumes that the issuer makes all scheduled
interest and principal payments as promised.)
• The yield to maturity on a bond with a current
price equal to its par value will always equal the
coupon interest rate.
• When the bond value differs from par, the yield
to maturity will differ from the coupon interest
rate.
© 2012
6-27
or in part.
Prentice
Yield to Maturity (YTM): Semiannual
Interest and Bond Values
• The procedure used to value bonds paying interest semiannually
is similar to that shown in Chapter 5 for compounding interest
more frequently than annually, except that here we need to find
present value instead of future value. It involves
Converting annual interest, I, to semiannual interest by dividing I by 2.
Converting the number of years to maturity, n, to the number of 6-month
periods to maturity by multiplying n by 2.
Converting the required stated (rather than effective) annual return for
similar-risk bonds that also pay semiannual interest from an annual rate,
rd, to a semiannual rate by dividing rd by 2.
© 2012
6-28
or in part.
Prentice
Yield to Maturity (YTM): Semiannual
Interest and Bond Values (cont.)
• Assuming that the Mills Company 20 years’

bond pays interest semiannually and that the
required stated annual return, rd is 12% for
similar risk bonds that also pay semiannual
interest, substituting these values into the
previous equation yields
Default Risk
• If an issuer defaults, investors receive less than the

promised return. Therefore, the expected return on
corporate and municipal bonds is less than the
promised return.
• Influenced by the issuer’s financial strength and the
terms of the bond contract.
7-30
Types of Bonds
• Mortgage bonds
• Debentures
• Subordinated debentures
• Investment-grade bonds
• Junk bonds
7-31
Evaluating Default Risk:
Bond Ratings
Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC C
• Bond ratings are designed to reflect the probability

of a bond issue going into default.
7-32
Factors Affecting Default Risk and Bond Ratings
• Financial performance
– Debt ratio
– TIE ratio
– Current ratio
• Qualitative factors: Bond contract terms
– Secured vs. unsecured debt
– Senior vs. subordinated debt
– Guarantee and sinking fund provisions
– Debt maturity
7-33
Other Factors Affecting Default Risk
• Miscellaneous qualitative factors

– Earnings stability
– Regulatory environment
– Potential antitrust or product liabilities
– Pension liabilities
– Potential labor problems
7-34
Bankruptcy
• Two main chapters of the Federal Bankruptcy Act:

– Chapter 11, Reorganization
– Chapter 7, Liquidation
• For large organizations, reorganization occurs more
frequently than liquidation, particularly in those
instances where the business is worth more “alive
than dead.”
7-35
Priority of Claims in Liquidation
1. Secured creditors from sales of secured assets

2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock
7-36

Bonds and Their Valuation: Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk

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Chapter 7

Bonds and Their Valuation

Key Features of Bonds

• A long-term debt instrument in which a borrower

• Primarily traded in the over-the-counter (OTC)

• Par value: face amount of the bond, which

• Allows issuer to refund the bond issue if rates

• Provision to pay off a loan over its life rather than

• Call x% of the issue at par, for sinking fund

• Valuation is the process that links risk and return

v0 = Value of the asset at time zero

CF1 CF2 CFN

The basic model for the value, B0, of a bond is

• Convertible bond: may be exchanged for common

• The discount rate (ri) is the opportunity cost of

$100 $100 $1,000

• What would happen to the value of these three

10% coupon rate

816 7% coupon rate

• At maturity, the value of any bond must equal its

Annual coupon payment

YTM = Current yield + Capital gains yield

• Price risk is the concern that rising rd will cause the

• The 10-year bond is more sensitive to interest

• Reinvestment risk is the concern that rd will fall, and

EXAMPLE: Suppose you just won $500,000 playing

• You may invest in either a 10-year bond or a series

Short-term Long -term

• CONCLUSION: Nothing is riskless!

1. Multiply years by 2: Number of periods = 2N

• The yield to maturity (YTM) is the rate of

• Assuming that the Mills Company 20 years’

• If an issuer defaults, investors receive less than the

Investment Grade Junk Bonds

• Bond ratings are designed to reflect the probability

• Miscellaneous qualitative factors

• Two main chapters of the Federal Bankruptcy Act:

1. Secured creditors from sales of secured assets

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