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CHAPTER 3

BONDS
VALUATION
Financial Market in the Financial System
2

 Financial Market – a market where those who


have excess funds and those who are in need of
funds will meet to transact the financial assets
that include both money and capital market
securities.
 4 main parties: households, business firms,
foreigners and government.

SITI AISHAH BINTI KASSIM (FM2)


Characteristics of a Good Financial Market
3

 Availability of information
 Liquidity
 Price continuity
 Transaction cost
 External efficiency or information
efficiency

SITI AISHAH BINTI KASSIM (FM2)


Types of Securities Market
4

1. Money market
Short-term securities which have
maturity below than one-year.
2. Capital market
Long-term securities which have
maturity longer than one-year.

SITI AISHAH BINTI KASSIM (FM2)


What is a Bond?
5

 One of a debt financing


 A long term debt (fixed income security) in which
the issuer (borrower) has agreed to pay fixed
income payments for a specified period and to
repay a fixed amount of principal at maturity to
the bondholder (lender).
 Indenture – the contract between the issuer and
the bondholder, which sets the obligations of the
issuer.

SITI AISHAH BINTI KASSIM (FM2)


Key Features of a Bond
6

 Par value – face amount of the bond, which


is paid at maturity (assume $1,000).
 Coupon interest rate – a rate of interest payment for
every bond issued and usually be converted into Ringgit
amount by time the rate to the bond par value (CP = PV x
CR)
 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”).

SITI AISHAH BINTI KASSIM (FM2)


Bond Markets
7

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


market.
 Most bonds are owned by and traded among large
financial institutions.
 Full information on bond trades in the OTC market
is not published, but a representative group of
bonds is listed and traded on the bond division of
the NYSE.

SITI AISHAH BINTI KASSIM (FM2)


Callable bonds
8

 Allow the issuer to redeem the bond at any time


before the maturity date.
 The bond will be call at premium price to
compensate for the holders.
 Issuer will call the bond when market interest
rate decline – reduce it interest expenses and
take the advantages of lower interest rate in the
market.

SITI AISHAH BINTI KASSIM (FM2)


Sinking Fund
9

 Provision in the indenture to pay off a loan over its


life rather than all at maturity. Failure to meet SF
requirement causes bond default, may force firm into
bankruptcy. Significant cash drain to firm.
 Similar to amortization on a term loan. Reduces
amount needed to retire the remaining debt at
maturity.
 Reduces risk to investor, shortens average maturity.
 But not good for investors if rates decline after
issuance.

SITI AISHAH BINTI KASSIM (FM2)


Types of Bonds
10
A. Unsecured Bonds:
Bonds that are not backed by an asset or collateral.
i. Debentures – unsecured long-term bond
ii. Subordinated Debentures – bonds that have a lower claim on
assets in the event of liquidation than do other senior debtholders.
iii. Income Bond – issued by firms facing financial difficulties or
which are weak financially.
B. Secured Bonds:
Bonds that are backed by an asset or collateral.
i. Mortgage Bond – secured by real estate or buildings, which are
of higher value than the value of the mortgage bond issued.
ii. Collateral Trust Bond – secured by stock and/or bonds owned
by the issuer.
iii. Equipment Trust Certificates – used to finance the purchase
of ‘rolling stock’ such as trains, ships, boats and trucks.
SITI AISHAH BINTI KASSIM (FM2)
Other Types of Bond Issues
11

 Eurobonds – issued by an international


borrower and sold to investors in countries with
currencies other than currency in which the bond
is denominated.
 Junk Bonds – also called ‘high-yield securities’
because of the higher risks of default faced by the
bondholders. Rated below BBB.
 Zero (low) coupon bonds – known as original
discount bond is sold at a large discount from
par.
SITI AISHAH BINTI KASSIM (FM2)
Rating the Bond
 To provide the potential investor an objective form of risk analysis
and evaluation on the quality of the bond and its issuer.

Rating Standard & Moody’s RAM


Poor’s
Highest AAA Aaa AAA
AA Aa AA
A A A
BBB Baa BBB
BB Ba BB
B B B
CCC Caa C
CC Ca
Lowest C C D

SITI AISHAH BINTI KASSIM (FM2)


12
Definition of Value
13

 Book Value – the value of an asset shown on a firm’s


balance sheet which is determined by its historical cost
rather than its current worth.
 Liquidation – the amount that could be realized if an
asset is sold individually and not as part of a going
concern.
 Market Value – the observed value of an asset in the
marketplace where buyers and sellers negotiate an
acceptable price for the asset.
 Intrinsic Value – the value based upon the expected
cash flows from the investment, the riskiness of the asset,
and the investor’s required rate of return.

SITI AISHAH BINTI KASSIM (FM2)


Principles of Bond Price Behavior
14

 When the required rate of return (k) differ from


the bond’s coupon rate, the market value of the
bond will differ from its par:
 When required rate of return (k) = coupon interest rate,
bond will sell at par.
 When required rate of return (k) > coupon interest rate,
bond will sell at a discount.
 When required rate of return (k) < coupon interest rate,
bond will sell at premium.

SITI AISHAH BINTI KASSIM (FM2)


The Value of Financial Assets
0 1 2 n
k = ?% ...
Value CF1 CF2 CFn

CF1 CF2 CFn


Value  1
 2
 ... 
(1  k) (1  k) (1  k)n

SITI AISHAH BINTI KASSIM (FM2) 15


What is the value of a 10-year, 10%
annual coupon bond, if kd = 10%?
(coupon=10%x$1000=$100/year)
0 1 2 n
Kd = 10% ...
VB = ? $100 $100 $100 + $1,000

$100 $100 $1,000


VB  1
 ...  10

(1.10) (1.10) (1.10)10
VB  $90.91  ...  $38.55  $385.54
VB  $1,000

SITI AISHAH BINTI KASSIM (FM2) 16


Mathematical Calculation
Vb = CPN (PVIFA r%,n) + Par Value (PVIF r%,N)
= $100 (PVIFA10%,10) + $1000 (PVIF10%,10)
= $100(6.1446) + $1000(0.3855)
= $614.46 + $385.50
= $1,000

*(If coupon rate = interest/discount rate (k)


Vb = Par Value/Maturity Value =$1000)

SITI AISHAH BINTI KASSIM (FM2) 17


Using a financial calculator to
value a bond
 This bond has a $1,000 lump sum due at t = 10,
and annual $100 coupon payments beginning
at t = 1 and continuing through t = 10, the price
of the bond can be found by solving for the PV
of these cash flows.

INPUTS 10 10 100 1000


N I/YR PV PMT FV
OUTPUT -1000

SITI AISHAH BINTI KASSIM (FM2) 18


An example:
Increasing inflation and kd
 Suppose inflation rises by 3%, causing kd =
13%. When kd rises above the coupon rate, the
bond’s value falls below par, and sells at a
discount.

INPUTS 10 13 100 1000


N I/YR PV PMT FV
OUTPUT -837.21

SITI AISHAH BINTI KASSIM (FM2) 19


What is the Vb if kd increases from
10% to 13%?

Vb = $100 (PVIFA13%,10) + $1000(PVIF13%,10)


= $100 (5.4262) + 1000 (0.2946)
= $542.62 + $294.60
= $837.22 (bond sells at a discount)

SITI AISHAH BINTI KASSIM (FM2) 20


An example:
Decreasing inflation and kd
 Suppose inflation falls by 3%, causing kd = 7%.
When kd falls below the coupon rate, the bond’s
value rises above par, and sells at a premium.

INPUTS 10 7 100 1000


N I/YR PV PMT FV
OUTPUT -1210.71

SITI AISHAH BINTI KASSIM (FM2) 21


What is the Vb if kd decreases
from 10% to 7%?

Vb = $100 (PVIFA7%,10) + $1000(PVIF7%,10)


= $100 (7.0236) + $1000(0.5083)
= $702.36 + $508.30
= $1,210.66 (bond sells at a premium)

SITI AISHAH BINTI KASSIM (FM2) 22


What is the YTM on a 10-year, 9%
annual coupon, $1,000 par value bond,
selling for $887?

 Must find the kd that solves this model.

INT INT M
VB  1
 ...  N
 N
(1  k d ) (1  k d ) (1  k d )
90 90 1,000
$887  1
 ...  10

(1  k d ) (1  k d ) (1  k d )10

SITI AISHAH BINTI KASSIM (FM2) 23


Approximate YTM
AYTM (%) = I +(MV-Vb)/N
(MV + Vb)/2

ATYM =Approximate yield to maturity


I = $Interest or $coupon interest (x% of par
value of $1000. Example, if coupon/interest
is 9%, paid annually, I = 9% x 1000 = $90)
MV = Maturity/Par value = $1000
Vb = Value/Price of bond

SITI AISHAH BINTI KASSIM (FM2) 24


Find the YTM on a 10-year, 9% annual
coupon, $1,000 par value bond, selling for
$887

AYTM = I + (MV-Vb)/N
(MV +Vb)/2
= $90 + ($1000 - $887)/10
($1000 + $887)/2
= 11%

SITI AISHAH BINTI KASSIM (FM2) 25


Interpolation (to get exact rate)
kd Present Value

10% $90(PVIFA10%,10) +$1000(PVIF10%,10) = $938.51


X% = $887.00
11% $90(PVIFA11%,10) + $1000(PVIF11%,10) = $883.13
1%

Proportion = $938.51 - $887.00 = 0.93%


$938.51 – $883.13

Therefore X = 10% + 0.93% = 10.93%

SITI AISHAH BINTI KASSIM (FM2) 26


Current Yield, Capital Gains Yield and
Expected Total Return
Annual coupon payment
Current yield (CY) 
Current price

Change in price
Capital gains yield (CGY) 
Beginning price

 Expected   Expected 
Expected total return  YTM      
 CY   CGY 
SITI AISHAH BINTI KASSIM (FM2) 27
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.

Current yield = $90 / $887


= 0.1015 @ 10.15%

SITI AISHAH BINTI KASSIM (FM2) 28


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.

SITI AISHAH BINTI KASSIM (FM2) 29


What is interest rate (or
price) risk?
Interest rate risk is the concern that
rising kd will cause the value of a
bond to fall.

SITI AISHAH BINTI KASSIM (FM2) 30


What is reinvestment rate
risk?
 Reinvestment rate risk is the concern that kd
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.

SITI AISHAH BINTI KASSIM (FM2) 31


Reinvestment rate 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.

SITI AISHAH BINTI KASSIM (FM2) 32


Conclusions about interest rate
and reinvestment rate risk
Short-term Long-term
AND/OR High AND/OR Low
coupon bonds coupon bonds
Interest
Low High
rate risk
Reinvestment
High Low
rate risk
 CONCLUSION: Nothing is riskless!

SITI AISHAH BINTI KASSIM (FM2) 33


Semiannual Bonds
1. Multiply years by 2 : number of periods = 2n.
2. Divide nominal rate by 2 : periodic rate (I/YR) = kd / 2.
3. Divide annual coupon by 2 : PMT = ann cpn / 2.

INPUTS 2n kd / 2 OK cpn / 2 OK
N I/YR PV PMT FV
OUTPUT

SITI AISHAH BINTI KASSIM (FM2) 34


What is the value of a 10-year, 10%
semiannual coupon bond, if kd = 13%?

1. Multiply years by 2 : N = 2 * 10 = 20.


2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.
3. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

INPUTS 20 6.5 50 1000


N I/YR PV PMT FV
OUTPUT - 834.72

SITI AISHAH BINTI KASSIM (FM2) 35


Semiannual Coupons/Interest
Vb = I/2(PVIFAr/2%,2N) + MV(PVIFr/2,2N)

Example: What is the price of a bond with


coupon (interest) of 8.5% paid semi annually,
remaining maturity of 12 years, and required
rate of return is 10%?
I=8.5% x $1000=$85; semi-annually=$42.50
N= 12years x 2 = 24times; r = 10%/2 = 5%

Vb = $42.50(PVIFA5%,24) + $1000(PVIF5%,24)
= $896.51
SITI AISHAH BINTI KASSIM (FM2) 36
Semiannual Bonds
Vb = PV (Coupon Payments) + PV (Par Value)
Vb = CPN PVIFA r/2%, 2N + 1000PVIF r/2%, 2N
2
Vb = CPN (1 + r/2)2N – 1 + 1000
2 (r/2)(1 + r/2)2N (1 + r/2)2N

SITI AISHAH BINTI KASSIM (FM2) 37


Would you prefer to buy a 10-year, 10% annual
coupon bond or a 10-year, 10% semiannual
coupon bond, all else equal?

The semiannual bond’s effective rate is:


m 2
 iNom   0.10 
EFF%  1    1  1    1  10.25%
 m   2 

10.25% > 10% (the annual bond’s effective rate), so


you would prefer the semiannual bond.

SITI AISHAH BINTI KASSIM (FM2) 38


If the proper price for this semiannual
bond is $1,000, what would be the proper
price for the annual coupon bond?
 The semiannual coupon bond has an effective
rate of 10.25%, and the annual coupon bond
should earn the same EAR. At these prices, the
annual and semiannual coupon bonds are in
equilibrium, as they earn the same effective
return.

INPUTS 10 10.25 100 1000


N I/YR PV PMT FV
OUTPUT - 984.80

SITI AISHAH BINTI KASSIM (FM2) 39


Yield to Call
Price of Bond:
Vb = I (PVIFAr%,N) + Call price(PVIFr%,N)

N= the number of years until the company can


call the bond.
rd= yield to call

SITI AISHAH BINTI KASSIM (FM2) 40


A 10-year, 10% semiannual coupon bond selling
for $1,135.90 can be called in 4 years for $1,050,
what is its yield to call (YTC)?

 The bond’s yield to maturity can be determined to


be 8%. Solving for the YTC is identical to solving
for YTM, except the time to call is used for N and
the call premium is FV.

8 - 1135.90 50 1050
INPUTS
N I/YR PV PMT FV
OUTPUT 3.568

SITI AISHAH BINTI KASSIM (FM2) 41


Yield to call
 3.568% represents the periodic
semiannual yield to call.
 YTCNOM = kNOM = 3.568% x 2 = 7.137% is
the rate that a broker would quote.
 The effective yield to call can be calculated
 YTCEFF = (1.03568)2 – 1 = 7.26%

SITI AISHAH BINTI KASSIM (FM2) 42


If you bought these callable bonds, would
you be more likely to earn the YTM or
YTC?

 The coupon rate = 10% compared to YTC =


7.137%. The firm could raise money by selling
new bonds which pay 7.137%.
 Could replace bonds paying $100 per year with
bonds paying only $71.37 per year.
 Investors should expect a call, and to earn the
YTC of 7.137%, rather than the YTM of 8%.

SITI AISHAH BINTI KASSIM (FM2) 43


When is a call more likely to
occur?
 In general, if a bond sells at a premium, then (1)
coupon > kd, so (2) a call is more likely.
 So, expect to earn:
 YTC on premium bonds.
 YTM on par & discount bonds.

SITI AISHAH BINTI KASSIM (FM2) 44


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