Valuation and

Characteristics of Bonds

Principles Used

Principle 1: The Risk-Return Trade-off

We Wont Take on Additional Risk Unless
We Expect to Be Compensated with
Additional Return.
Principle 2: The Time Value of Money A
Dollar Received Today is Worth More
Than a Dollar Received in the Future
Principle 3: Cash-Not Profits-Is King.

BOND VALUATION

Type of debt or long-term

promissory note, issued by a
borrower, promising to its holder a
predetermined and fixed amount
of interest on specific dates and
principal upon maturity.

BOND CHARACTERISTICS

Par Value
Coupon Rate
Maturity Date
Call Provision

Convertible Bonds
Income Bonds.
Indexed bond

BOND CHARACTERISTICS

Par Value:

Face value of the bond, returned to the

bondholder at maturity

Maturity Date:

The length of time until the bond issuer

returns the par value to the bondholder
and terminates or redeems the bond.

BOND CHARACTERISTICS

Coupon Rate:

Rate of interest paid as a percentage

of the par value.
Fixed Rate Vs Floating Rate
Zero Coupon Bonds Issued at a deep
discount and do not pay interest.

Interest Payment:
= Coupon rate X Par Value

BOND CHARACTERISTICS

Call Provision The borrower may

redeem the bond early. Usually includes
a call premium.
Sinking Fund Provision Requires
borrower to regularly retire a portion of
the bond by either calling it or buying it
on the open market.

BOND CHARACTERISTICS

Convertible Bonds:

Income Bonds:

Bonds may be converted into

common stock at a fixed price.
Only pays interest if the company
makes a profit.

Indexed bond:

Interest based on an inflation index.

TYPES OF BONDS

US Government Bonds
Municipal Bonds
Corporate Bonds
EuroBonds
Junk Bonds

U.S. Government Bonds

Treasury Bills

No coupons (zero coupon security)

Face value paid at maturity
Maturities up to one year

Treasury Notes

Coupons paid semiannually

Face value paid at maturity
Maturities from 2-10 years

U.S. Government Bonds

Treasury Bonds

Coupons paid semiannually

Face value paid at maturity
Maturities over 10 years
The 30-year bond is called the long
bond.

Treasury Strips

Zero-coupon bond
Created by stripping the coupons and
principal from Treasury bonds and notes.

CORPORATE BONDS

Mortgage Bonds Bonds secured

with real property.
Debentures Unsecured bonds.

Eurobonds

Securities (bonds) issued in a country

different from the one in whose currency
the bond is denominated
Example:

a U.S. dollar-denominated bond issued by a

non-U.S. entity outside the U.S.
A eurodollar bond thatisdenominated in U.S.
dollars and issued in Japan by an Australian
company would be an example of a
eurobond. The Australian company in this
example could issue the eurodollar bond in
any country other than the U.S.

Junk Bonds (High-Yield Bonds)

Junk Bond is a bond that is rated below

investment grade at the time of purchase.
High risk debt with ratings of BB or below
by Moodys and Standard & Poors
High yield typically pay 3%-5% more
than AAA grade long-term bonds
These bonds have a higher risk of default
or other adverse credit events, but
typically pay higher yields than better
quality bonds in order to make them
attractive to investors.

BOND RATINGS

Bonds are rated as to their riskiness

by several firms. (Moodys Investment
Service and Standard & Poors)

Bonds with the highest rating are rated

AAA.
As bonds become riskier their ratings
drop. Riskiness is the chance of default.
Investment grade bonds must be rated at
least BBB.

Bond Ratings
Moodys

S&P

Quality of Issue

Aaa

AAA

Highest quality. Very small risk of default.

Aa

AA

Baa

BBB

Ba

BB

Caa

CCC

Ca

CC

High specullative quality. May be in default.

Lowest rated. Poor prospects of repayment.

In default.

High quality. Small risk of default.

High-Medium quality. Strong attributes, but potentially
vulnerable.
Medium quality. Currently adequate, but potentially
unreliable.
Some speculative element. Long-run prospects
questionable.
Able to pay currently, but at risk of default in the
future.
Poor quality. Clear danger of default .

Bond Valuation

The value of a bond is a

combination of:

The amount and timing of the cash

flows to be received by investors
maturity
The investors required rate of return

BOND VALUATION
VB = Present Value of the Interest
Payments plus the Present Value of
the Maturity Value (Par Value).

BOND VALUATION
BOND
VALUE

Interest
Paymen
t ($)

Interest Rate

Par
Value

Numb
er of
Period
s

BOND VALUATI0N

A company issues a 3 year bond with a par

value of $1,000 and a coupon rate of 10%.
The required rate of return on the bond is
also 10%. What is the value of the bond?
Par Value = 1,000
Interest Rate (r) = 10%
Interest Payment = 10% x 1,000 = $100
No. of periods = 3 years

BOND VALUATION
Present Value of the Interest Payments

Interest
Paymen
t $100

10% ~ .10

Bond Valuation
Present Value of the Interest Payments

0 r=10%

$100
$91
$83
$75
$249

$100

$100

100

100

(1 + .
10)1

100

(1 + .
10)2

(1 + .
10)3

Bond Valuation
Present Value of the Maturity Value

$1,000

3 yrs
10% ~ .10

Bond Valuation
Present Value of the Maturity Value

0 r=10%

3
$1,000
$1,000
(1 + .
10)3

$751

Bond Valuation

Present Value of the Interest Payments plus the Present Value of the Maturit

$100
$91
$83

$100

$100

$1,000

100

100

$1,000

(1 + .
10)1

100

(1 + .
10)2

(1 + .
10)3

(1 + .
10)3

$75
$249
$751
$1,000 = Vb

When the coupon rate and i are equal the value of

the bond will always be the par value.

Review Questions

TAKE TEN
MINUTES

In your groups calculate the value of

the bonds.
A company issues a 3 year bond
with a par value of $1,000 and a
coupon rate of 10%. The required
rate of return on the bond is also
5%. What is the value of the bond?
A company issues a 3 year bond
with a par value of $1,000 and a
coupon rate of 5%. The required
rate of return on the bond is also
10%. What is the value of the bond?

BOND VALUATI0N

A company issues a 3 year bond with a par

value of $1,000 and a coupon rate of 10%.
The required rate of return on the bond is
also 5%. What is the value of the bond?
Par Value = 1,000
Interest Rate (r) = 5%
Interest Payment = 10% x 1,000 = $100
No. of periods = 3 years

Bond Valuation

Present Value of the Interest Payments plus the Present Value of the Maturit

$100
$95
$91

$100

$100

$1,000

100

100

$1,000

(1 + .
05)1

100

(1 + .
05)2

(1 + .
05)3

(1 + .
05)3

$86
$272
$864
$1,136 = Vb

Whenever interest rates fall, bond prices go up. Sell

at a premium.

BOND VALUATI0N

A company issues a 3 year bond with a

par value of $1,000 and a coupon rate of
5%. The required rate of return on the
bond is also 10%. What is the value of
the bond?
Par Value = 1,000
Interest Rate (r) = 10%
Interest Payment = 5% x 1,000 = $50
No. of periods = 3 years

Bond Valuation

Present Value of the Interest Payments plus the Present Value of the Maturit

$45
$41

$50

$50

$50

$1,000

50

50

$1,000

(1 + .
10)1

50

(1 + .
10)2

(1 + .
10)3

(1 + .
10)3

$38
$124
$751
$876 = Vb

Whenever interest rates go up bond values fall.

Sells at a discount.

BOND VALUATION
Interest rates change over time, so a
bonds value will fluctuate over
time.

BOND VALUATI0N (EXCEL)

A company issues a 30 year bond with a par value
of $1,000 and a coupon rate of 10%. The
required rate of return on the bond is also 10%.
What is the value of the bond?
Using PV formula
nper = 30, rate = .10, Pmt = 100, FV = 1,000
PV = 1,000
When the coupon rate and i are equal the value of
the bond will always be the par value.

SEMI-ANNUAL COUPONS

Most bonds have semiannual

coupons.
When valuing a bond with
semiannual coupons divide the
Pmt by 2; multiply n by 2.

BOND VALUATI0N

A company issues a 3 year bond with a par

value of $1,000 and a coupon rate of 10%.
The required rate of return on the bond is
also 10%. What is the value of the bond, if
interest payments are paid semi-annually?
Par Value = 1,000
Interest Rate (r) = 10% per yr / 2 = 5%
Interest Payment = (10%/2) x 1,000 = 50
No. of periods = 3 X 2 = 6

BOND VALUATION

nper = 6
rate = .05
Pmt = 50
FV = 1,000
PV = ???

BOND VALUATION

nper = 6
rate = .05
Pmt = 50
FV = 1,000
PV = 1,000

Calculate the value of a bond with the following

features, assuming that interest is paid semiannually and that the face value of the bond is
$1,000:
Proble
m

Coupo
n rate

Yield to
maturity

Years to
maturity

8%

10%

4%

6%

1.5

6%

4%

6.25%

6%

4%

8%

2.5

Bond
value

BOND YIELDS
Yield to maturity the yield you will
receive if you hold the bond until it
matures.

YIELD TO MATURITY
Lets use the same example: we issue a
bond with a 10% coupon. The price is
$1,000 (the par value). What is the yield
to maturity?
nper = 30, Pmt = 100, FV = 1,000, PV =
-1,000
The FV and Pmt are amounts we will
receive; the PV is an amount we pay so
it is a minus.

YIELD TO MATURITY
Lets use the same example: we issue a bond
with a 10% coupon. The price is $1,000 (the
par value). What is the yield to maturity?
nper = 30, Pmt = 100, FV = 1,000, PV = -1,000
rate = 10%
The same as the Coupon rate; if FV and PV
are equal the interest rate will equal the
coupon rate.

YIELD TO MATURITY
Now lets assume that 5 years go by
and we pay $1,225.08 for our
bond. What is the yield to
maturity?
nper = 25, Pmt = 100, FV = 1,000,
PV = -1,225.08

YIELD TO MATURITY
Now lets assume that 5 years go by
and we pay $1,225.08 for our bond.
What is the yield to maturity?
nper = 25, Pmt = 100, FV = 1,000,
PV = -1,225.08
rate = 7.91

Review Questions
In your groups calculate the YTM

The $1,000 face value EFG bond has a

coupon of 10% (paid semi-annually),
matures in 4 years, and has current
price of $1,140. What is the EFG bond's
yield to maturity?

The NOP bond has an 8% coupon rate

(semi-annual interest), a maturity
value of $1,000, matures in 5 years,
and a current price of $1,200. What is
the NOP's yield-to-maturity?

YIELD TO CALL

Companys can call bonds early.

Companys will generally call
bonds when interest rates have
fallen and new bonds can be
issued with a lower coupon rate.

YIELD TO CALL

Lets assume the bond in our

example is callable 10 years after
issue.
Again, five years have gone by, so
the bond can be called in five years.
All other information remains the
same.

YIELD TO CALL
nper = 5 (years until bond can be
called)
Pmt = 100
FV = 1,000
PV = -1,225.08
Rate = ????

YIELD TO CALL
nper = 5 (years until bond can be
called)
Pmt = 100
FV = 1,000
PV = -1,225.08
Rate = 4.83

The yield to call is less than the yield to

maturity because we will receive fewer
$100 payments.

CURRENT YIELD
The ratio of the interest payment to
the bonds current market price.

The interest payment divided by the

current price of the bond.

In our example:
Current Yield = 100/1,225.08 =
8.16%

Review Questions
In your groups calculate the following:

The $1,000 face value ABC bond has a coupon

rate of 6%, with interest paid semi-annually,
and matures in 5 years. If the bond is priced to
yield 8%, what is the bond's value today?

The KLM bond has a 8% coupon rate,with

interest paid semi-annually, a maturity value of
$1,000, and matures in 5 years. If the bond is
priced to yield 6%, what is the bond's current
price?

The HIJ bond has a current price of $800, a

maturity value of $1,000, and matures in 5
years. If interest is paid semi-annually and the
bond is priced to yield 8%, what is the bond's
annual coupon rate?