BOND VALUATION

A long term contract under which a borrower promises to pay interest on specific dates and principal upon maturity.

TYPES OF BONDS


Treasury Bonds Issued by U.S. Government. No default risk but have interest rate risk. Corporate Bonds Issued by corporations and have default risk and interest rate risk. Municipal Bonds Issued by state and local governments and have default risk and interest rate risk. Foreign Bonds Issued by foreign governments and corporations and have default risk and interest rate risk.

BOND CHARACTERISTICS
 

 

Par Value Issue price or face value. Coupon Rate Rate of interest paid as a percentage of the par value. Maturity Date Date the principal is repaid. 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 - Bonds may be converted into common stock at a fixed price. Warrants Options issued with the bonds allowing holders to convert warrants to common stock at a fixed price. Income Bonds Only pays interest if the company makes a profit. Indexed bond Interest based on an inflation index.

COUPON PAYMENTS


Fixed Rate Interest rate stays the same through life of bond. Floating Rate Rate is fixed for a short time and then indexed to some other rate. Zero Coupon Bonds Issued at a deep discount and do not pay interest. Original Issue Discount Bond Any bond issued at less than par value.

BOND VALUATION
We will use what we have learned regarding risk and return and time value of money to value bonds.

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

BOND VALUATI0N
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? Par Value = 1,000 Interest Payment = Par Value x Coupon Rate

BOND VALUATI0N
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? Par Value = 1,000 Interest Payment = 1,000 x .10 = 100 n = 30 k = 10

BOND VALUATION
0 1 2 3 4 5 630 l-----l-----l-----l-----l-----l-----l.l -----l-----l-----l-----l-----l-----l.l 100 100 100 100 100 100.100 1,000

BOND VALUATI0N
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? The interest payment is an annuity and the maturity payment is a lump sum. We need to find the present value of both.

BOND VALUATI0N
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? n = 30, i = 10, Pmt = 100, FV = 1,000 Solve for PV

BOND VALUATI0N
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? n = 30, i = 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.

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

BOND VALUATION


 

Lets assume the bond in our example is issued. Five years go by. Interest rates go up so a bond of that risk would now demand a coupon rate of 14%, i.e., is our bond was issued today the coupon rate would have to be 14%, not 10%. What is the value of our bond?

BOND VALUATION
 

n = 30 5 = 25 i = 14, the required rate of return on the bond has gone from 10% to 14%, that is why bonds of the same risk as our bond are now being issued with 14% coupons Pmt = 100, our bond is still paying a 10% coupon FV = 1,000, the par value remains unchanged

BOND VALUATION
0 1 2 3 4 5 625 l-----l-----l-----l-----l-----l-----l.l -----l-----l-----l-----l-----l-----l.l 100 100 100 100 100 100.100 1,000

BOND VALUATION
n = 25, i = 14, Pmt = 100, FV = 1,000 What is the PV?

BOND VALUATION
n = 25, i = 14, Pmt = 100, FV = 1,000 $725.08 Whenever interest rates go up bond values fall. The reason is our bond now needs to yield 14%. The only way for a bond with a 10% coupon to yield 14% is for it to sell at a discount. This is why there is a maturity risk premium.

BOND VALUATION
Lets assume that rather than rising, interest rates fall. Now a bond with the same risk as our bond would be issued yielding 8%. What happens to the value of our bond?

BOND VALUATION
   

n = 3 5 = 25 i=8 Pmt = 100 FV = 1,000

BOND VALUATION
0 1 2 3 4 5 625 l-----l-----l-----l-----l-----l-----l.l -----l-----l-----l-----l-----l-----l.l 100 100 100 100 100 100.100 1,000

BOND VALUATION
    

n = 3 5 = 25 i=8 Pmt = 100 FV = 1,000 Solve for PV

BOND VALUATION
n = 25, i = 8, Pmt = 100, FV = 1,000 PV = $1,213.50 Whenever interest rates fall, bond prices go up. The reason is our bond with a 10% coupon now only needs to yield 8%. The only way a bond with a 10% coupon to yield 8% is for it sell at a premium.

BOND VALUATIN


The longer it is until a bond matures, the greater the impact of interest rate changes on its value. As a bond approaches maturity, its value will approach the par value.

BOND VALUATION


Lets use the bond in our example. Lets suppose 28 years have gone by. Lets assume the interest rate on bonds of the same risk is now 14%. What is the value of our bond?

BOND VALUATION
   

n = 30 28 = 2 i = 14 Pmt = 100 FV = 1,000

BOND VALUATION
0 1 2 l------l------l ------l------l 100 100 1,000

BOND VALUATION
    

n = 30 28 = 2 i = 14 Pmt = 100 FV = 1,000 Solve for PV

BOND VALUATION
n = 2, i = 14, Pmt = 100, FV = 1,000 PV = 934.13 When there was 25 years remaining to maturity the PV = 725.08 The difference in value is due to the fact that discounting has a greater impact the farther out payments are.

BOND VALUATION
Now lets look at the example where interest rates fell and assume there is two years left until maturity.

BOND VALUATION
   

n = 30 28 = 2 i=8 Pmt = 100 FV = 1,000

BOND VALUATION
0 1 2 l------l------l ------l------l 100 100 1,000

BOND VALUATION
    

n = 30 28 = 2 i=8 Pmt = 100 FV = 1,000 Solve for PV

BOND VALUATION
n = 2, i = 8, Pmt = 100, FV = 1,000 PV = 1,035.67 When there was 25 years left until maturity the PV = 1,213.50. This illustrates how a bonds value approaches par value as it nears maturity.

Bond Valuation


Bonds which sell for less than par value are known as discount bonds. Bonds which sell for more than par value are known as premium bonds. Bonds which are issued at a discount are known as original discount bonds.

BOND YIELDS


Bond yields may be calculated three different ways.

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? n = 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.

BOND VALUATION
0 1 2 3 4 5 630 l-----l-----l-----l-----l-----l-----l.l -----l-----l-----l-----l-----l-----l.l -1,000 100 100 100 100 100 100100 1,000

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? n = 30, Pmt = 100, FV = 1,000, PV = -1,000 Solve for i.

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? n = 30, Pmt = 100, FV = 1,000, PV = -1,000 i = 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? n = 25, Pmt = 100, FV = 1,000, PV = -1,225.08

BOND VALUATION
0 1 2 3 4 5 625 l-----l-----l-----l-----l-----l-----l.l -----l-----l-----l-----l-----l-----l.l -1,225.08 100 100 100 100 100 100100 1,000

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? n = 25, Pmt = 100, FV = 1,000, PV = -1,225.08 Solve for i.

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? n = 25, Pmt = 100, FV = 1,000, PV = -1,225.08 i = 7.91

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
n = 5 (years until bond can be called)

YIELD TO CALL
n = 5, Pmt = 100, FV = 1,000, PV = -1,225.08

BOND VALUATION
Callable 0 1 2 3 4 5 625 l-----l-----l-----l-----l-----l-----l.l -----l-----l-----l-----l-----l-----l.l -1,225.08 100 100 100 100 100 100100 1,000

YIELD TO CALL
n = 5, Pmt = 100, FV = 1,000, PV = -1,225.08 Solve for i.

YIELD TO CALL
n = 5, Pmt = 100, FV = 1,000, PV = -1,225.08 i = 4.83 The yield to call is less than the yield to maturity because we will receive fewer $100 payments.

CURRENT YIELD
The interest payment divided by the current price of the bond. In our example: Current Yield = 100/1,225.08 = 8.16%

SEMIANNUAL COUPONS
 

Most bonds have semiannual coupons. When valuing a bond with semiannual coupons divide the Pmt by 2; multiply n by 2. When finding the yield of a bond with semiannual coupons make the same adjustments and also multiply the answer by 2 to get the annual yield.

TYPES OF CORPORATE BONDS



 

Mortgage Bonds Bonds secured with real property. Debentures Unsecured bonds. Subordinate Debenture A debenture which has a claim subordinate to another debenture.

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. Junk bonds are bonds rated lower than BBB.