Valuation of

Bonds
 What is a Bond?
• Bonds represent debt obligations – and therefore are a form of borrowing
• If a company issues a bond, the money they receive in return is a loan, and must be
repaid over time
• Bonds are often referred to as fixed-income securities because the lender can anticipate
the exact amount of cash they will have received if a bond is held until maturity. For
example, say you buy a corporate bond with a face value of $1,000, a coupon of 5% paid
annually, and a maturity of 10 years. This tells you that you will receive a total of $50
($1,000 x 0.05) of interest per year for the next 10 years
 Valuation of Bond
• An investor buys a bond for its future cash flows. To evaluate a bond, therefore, we have
to find the present value of the cash flows
• For a bond, we need to find the present value of all the interest payments and the
present value of the final payment, namely, the face amount of the bond.
 Important Concepts
• Face/Par Value: The first characteristic of a bond is its face, or par value. This
represents the amount of principal that a bondholder will receive at maturity, and is
also the value that that a bond is issued for at the time that a company or government
first sells them. The majority of corporate bonds today carry a face value of $1,000, but
may vary by issuer
• The Market Value: Although a bond may have a face value of $1000, it may not sell at
$1000 in the bond market. If the issuing company is not doing well financially, its bonds
may sell for less than $1000, perhaps at $950; the bond is selling at a discount. If the
market value of the bond is more than $1,000, and then it is selling at a premium . A
bond, which is priced at its face value, is selling at par.
• Coupon: A bond’s coupon rate is the amount of interest income it earns each year
based on its face value.
 Characteristics of Bond
• Let’s look at an example of Coupon vs Yield:
Suppose a bond has a $1,000 face value and issues semi-annual interest payments of
$20, totalling $40 a year. Its coupon rate is 4%. That coupon is fixed. No matter what
price the bond trades for, it will pay $40 a year in interest
A bond’s yield and its price are inversely related. At face value, a bond’s yield and coupon
rate are the same. But if the same bond sells at a premium price of $1,100, its yield is
3.63%, or $40 divided by $1,100
The current yield of a bond is calculated by dividing the annual coupon payment by
the current market value of the bond
• Maturity:
The maturity is the date at which the bond’s principal comes due and must be repaid to
lenders in full. Maturities for corporate bonds are typically in the range of one to five
years, with some bonds maturing in 10 or even 30 years
 Characteristics of Bond
• Issuer:
The type and quality of the bond issuer is also an important characteristic of a bond, as
the issuer's stability is your main assurance of getting paid back in full. For example, the
U.S. government is far more secure than any one corporation
• Bond Rating:
It is kind of a report card for a company's credit rating
Financially secure companies issue bonds that are safer investments, and have a high
rating, while risky companies have a low rating
 Characteristics of Bond
• Bond Rating:

The chart above illustrates the different bond rating scales from the major rating
agencies in the U.S.: Moody's, Standard and Poor's and Fitch Ratings
 Characteristics of Bond
• Current Yield vs Yield to Maturity:
Current Yield: The current yield of a bond is calculated by dividing the annual coupon
payment by the current market value of the bond. Because this formula is based on
the purchase price rather than the par value of a bond, it is a more accurate reflection
of the profitability of a bond relative to other bonds on the market.
Example:
If an investor buys a 6% coupon rate bond (with a par value of $1,000) for a discount of
$900, the investor earns annual interest income of ($1,000 X 6%), or $60. The current
yield is ($60) / ($900), or 6.67%
The $60 in annual interest is fixed, regardless of the price paid for the bond. If, on the
other hand, an investor purchases a bond at a premium of $1,100, the current yield is
($60) / ($1,100), or 5.45%.
The investor paid more for the premium bond that pays the same dollar amount of
interest, so the current yield is lower.
 Characteristics of Bond
• Current Yield vs Yield to Maturity:
Yield to Maturity: YTM is the total return anticipated on a bond if the bond is held until
the end of its lifetime. Yield to maturity is considered a long-term bond yield, but is
expressed as an annual rate.
When you hold a bond to maturity, you receive money in the form of interest
payments, plus there is a change in the value of the bond.
If you have bought the bond at a discount, it will rise in value reaching its face value at
maturity. On the other hand, the bond may drop in price if you have bought it at a
premium. In any case, it should be selling for its face value at maturity. The total price
change for the bond is (F − B) which may be positive or negative depending upon
whether F is more or less than B. On the average, the price change per year is (F − B)/n.
The average price of the bond for the holding period is (F + B)/2. We may calculate the
yield to maturity of a bond, approximately, by dividing the average annual return by the
average price. We write it as follows.
 Characteristics of Bond
• Current Yield vs Yield to Maturity (cont.):

Consider a bond with coupon rate 8% and 10 years to maturity. If the discount rate is
8%, then the bond is selling at par. Its value will remain $1000 with the passage of time
If the discount rate is 6%, the bondholders’ required rate of return is 6%. Since the bond
is providing 8% coupon, it is more than the required rate of return. This will make the
market value of the bond more than its face value and the bond will be selling at a
premium
If the discount rate is 10%, the bond will sell at a price less than $1000
 Valuation of Bond Example
A bond has a coupon of 6.5% and it pays interest semi-annually. With a face value of $1000, it will
mature after 2 years. If you require a return of 12% from this bond, how much should you pay for it?

DISCUSSED IN CLASS
 Valuation of Perpetual Bond
Consider a bond that is never going to mature, that is, it is a perpetual bond. An
investor will buy such a bond and earn interest on it. The bond will pay a steady income
forever. If he no longer needs an income, he can simply sell the bond to another
investor. The bond represents a perpetual income stream and we can evaluate it by
using

Another type of a bond is a zero-coupon bond. Such a bond does not pay any interest
but it does pay the principal at maturity. An investor who does not need a steady
income, but requires $1000 at a future time, may buy such a bond. The value of a zero-
coupon bond is
 Valuation of Bond Example
Suppose you have the option of keeping your money in a savings account that pays
interest at the rate of 6% per year, compounding it every year. You plan to keep this
money for the next 10 years and then withdraw it. You would like to have $1000 after
ten years. How much money should you deposit right now?

The answer is, the present value of $1000 discounted at the rate of 6% per year. That is,
1000/1.06^10 = $558.48.

Suppose a zero-coupon bond with face value $1000 is also available, which matures
after 10 years. If you can buy this bond for $558.48, it will serve your purpose perfectly.
It will also give you $1000 at maturity, after 10 years
 Characteristics of Bond
Duration: It is a measure of a bond’s sensitivity to interest rate changes. The higher the
bond's duration, the greater its sensitivity to the change (also know as volatility) and
vice versa.
Macaulay duration (named after Frederick Macaulay, an economist who developed the
concept in 1938) is the most common way to calculate duration:
 Characteristics of Bond
Duration (cont.): Looking at the formula, we can say that, Duration = Present value of a
bond's cash flows, weighted by length of time to receipt and divided by the bond's
current market value. For example, let's calculate the duration of a three-year, $1,000
Company XYZ bond with a semi-annual 10% coupon.
 Characteristics of Bond
Duration (cont.): Notice in the table on the previous slide that we first weighted the
cash flows by the periods in which the occurred and then calculated the present value
of each of these weighted cash flows (also, a measure of 5% is used instead of 10%
because payments are semi-annual).
To calculate the Macaulay duration, we then divide the sum of the present values of
these cash flows by the current bond price (which we are assuming is $1,000):
Company XYZ Macaulay duration = $5,329.48 / $1,000 = 5.33

Note that if the bond in the above example were trading at $900 today, then the
duration would be $5,329.48 / $900 = 5.92. If the bond were trading at $1,200 today,
then the duration would be $5,329.48 / $1,200 = 4.44.
 Characteristics of Bond
Duration (cont.): Bond prices are said to have an inverse relationship with interest
rates. Therefore, rising interest rates indicate bond prices are likely to fall, while
declining interest rates indicate bond prices are likely to rise.
As maturity increases, duration also increases and the bond’s price becomes more
sensitive to interest rate changes. Duration is expressed as a number of years.
As a general rule, for every 1% change in interest rates (increase or decrease), a bond’s
price will change approximately 1% in the opposite direction, for every year of duration.
If a bond has a duration of five years and interest rates increase 1%, the bond’s price
will drop by approximately 5% (1% X 5 years). Likewise, if interest rates fall by 1%, the
same bond’s price will increase by about 5% (1% X 5 years).