Investment -Chapters 11- Bond Valuation

Chapter 11
Bond Valuation
Bonds
“A bond is a debt investment in which an investor

loans money to an entity which borrows the funds
for a definite period of time at a variable or fixed
interest rate”.
Why invest in Bonds?
❑ They can provide current income for conservative
investors.
❑ At times, they can provide capital gains for more

aggressive investors.
❑ Some bonds can provide tax-free income, e.g.,

municipal bonds.
❑ They can be used for capital preservation and long-

term capital accumulation.
Categories of bonds
1. Corporate bonds are issued by companies. They are high
risk than government bonds.
2. Government bonds are issued by a government to

support spending and obligations.
3. Municipal bonds are issued by states and municipalities.

They can offer tax-free coupon income for residents of
those municipalities.
4. U.S. Treasury bonds (more than1-10years to

maturity),where as bills ( less than 1year maturity) are
collectively referred to as simply “Treasuries”.
Bond Terminology
Face value: The price of a bond when first issued.
Coupon rate: The periodic interest payments promised to

bondholders are a fixed percentage of bonds face value or
simply the interest rate.
Maturity: The time until the principal is scheduled to be

repaid.
Call provisions: Some bonds contain a provision which

enables the issuer to buy the bond back from the bondholder
at a pre-specified price.
Bond Terminology
Put provision: Some bonds contain a provision due to which

the buyer can sell the bond at a pre-specified price before its
maturity date.
Convertible Bonds enable investor to exchange the bonds for

a specified number of shares of the issuing company
Bond Price Behavior
❑ Price of a bond is a function of its coupon rate, its maturity,
and market movements in interest rates.
❑ Longer maturities move more with changes in interest rates.

Bond Price and Interest Rate
❑ The behavior of interest rate is the single most important
force in the bond market.
❑ Interest rate and bond price move in apposite directions.
❑ When interest rise, bond prices fall.
❑ When interest rates drop, bond prices move up.
❑ Bond markets are bullish when interest rates are falling

or low.
❑ Bond markets are bearish when interest rates are rising
or high
Bonds and Risk
❑ Interest Rate Risk is the chance that changes in the
market interest rates will affect the bond’s value.
❑Purchasing Power Risk is the chance that bond yields will

lag behind inflations rates.
❑Business/Financial Risk is the chance that the issuer of

the bond will default on interest and/or principal
payments.
❑Liquidity Risk is the risk that a bond will be difficult to

sell at a reasonable price.
❑Call Risk is the risk that a bond will be ”called” before its
scheduled maturity date.
The bond indenture
❑To issue a bond, a third-party trustee, which is usually a
bank or a trust company, is assigned by the issuer to serve
the needs of the bondholders, including bringing suit in
the event of a default.
❑The bond indenture is a legal contract between the issuer

and the trustee that specifies the scope and the
responsibilities of the borrower, the trustee, and the
lender.
The bond indenture
❑The bond indenture lists down the restrictive provisions
which are designed to protect bondholders and describes
the repayment provisions.
❑The indenture specifies the coupon rate, the par value, the
date of maturity, the procedures to modify the indenture
after issuance, the purpose of the bond issue, call
provision, etc.
Bond Price
The price of any financial instrument is equal to the present
value of the expected cash flow
The bond price is the present value of all future cash flows
expected from the bond, which includes periodic coupon
payments and the face (or par) value at maturity. The bond
price represents the amount an investor would be willing to
pay today to receive those future cash flows, given the
required rate of return (or discount rate).
Coupon Rate
❑ It is the nominal rate of interest that is fixed and is printed
on the bond certificate.
❑ It is calculated on the face value of the bond
❑ It is the rate at which interest is paid by the company to

the bondholder
Example: A bond has a face value of $1000 with an interest

rate of 12% p.a.
It means that $120 will be paid by the company on an

annual basis to the bond holder till maturity
Current Yield
❑ The current market price of the bond in the secondary
market may differ from its face value (i.e. it may be
currently selling at a discount or at a premium).
❑ Current yield relates the annual interest receivable on a

bond to its current market price
Current yield =
(Annual interest / Current market price)*100%
It thus measures the annual return accruing to a bondholder

who purchases the bond from the secondary market and sells
it before maturity presumably at a price at which he bought
the bond
Current Yield
Example: A bond has a face value of $1000 and a coupon

rate of 12%. It is currently selling for $800.
The current yield = (120/800) * 100 = 15%
➢ Current yield > coupon rate : when bond is selling at a

discount
➢ Current yield < coupon rate : when bond is selling at a

premium
Bond Price
The price of a bond can be calculated using the following formula:
Where:
• Coupon Payment is the periodic interest payment received (calculated as

Face Value × Coupon Rate)
• Face Value is the bond’s value at maturity (typically $1,000 for most bonds).
• r is the discount rate or required rate of return (per period).
• n is the total number of periods until the bond matures.

Example (1)
What is the price of the following bond?
• Face value: $1,000
• Maturity: 10 years
• Coupon rate: 8%
• Required rate of return: 9%
Example (2)
What is the price of the following bond?
• Par value: $1,000
• Coupon rate: 10%
• Required rate of return: 12%
Example (3)
What is the value of the following semi-annual bond?
• Interest rate: 9%
Example (4)
• Maturity value: $1,000
• Maturity: 9.5 years
• Coupon rate: 7%
• Discount rate: 7%
Example (5)
• Coupon rate: 9%
Example (6)
What is the price of the following quarterly bond?
• Coupon rate: 10%

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Chapter 11

“A bond is a debt investment in which an investor

❑ At times, they can provide capital gains for more

❑ Some bonds can provide tax-free income, e.g.,

❑ They can be used for capital preservation and long-

2. Government bonds are issued by a government to

3. Municipal bonds are issued by states and municipalities.

4. U.S. Treasury bonds (more than1-10years to

Coupon rate: The periodic interest payments promised to

Maturity: The time until the principal is scheduled to be

Call provisions: Some bonds contain a provision which

Put provision: Some bonds contain a provision due to which

Convertible Bonds enable investor to exchange the bonds for

❑ Longer maturities move more with changes in interest rates.

❑ Interest rate and bond price move in apposite directions.

❑ When interest rise, bond prices fall.

❑ When interest rates drop, bond prices move up.

❑ Bond markets are bullish when interest rates are falling

❑Purchasing Power Risk is the chance that bond yields will

❑Business/Financial Risk is the chance that the issuer of

❑Liquidity Risk is the risk that a bond will be difficult to

❑The bond indenture is a legal contract between the issuer

❑ It is calculated on the face value of the bond

❑ It is the rate at which interest is paid by the company to

Example: A bond has a face value of $1000 with an interest

It means that $120 will be paid by the company on an

❑ Current yield relates the annual interest receivable on a

It thus measures the annual return accruing to a bondholder

Example: A bond has a face value of $1000 and a coupon

The current yield = (120/800) * 100 = 15%

➢ Current yield > coupon rate : when bond is selling at a

➢ Current yield < coupon rate : when bond is selling at a

• Coupon Payment is the periodic interest payment received (calculated as

• r is the discount rate or required rate of return (per period).

• n is the total number of periods until the bond matures.

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