Lecture Note: Bond (Update: Jun-16-08)

Peerawich Thoviriyavej, Assumption University

1
1. Bond Valuation: the Present Value Approach

Bond is a debt instrument that entitles investor to two income sources. Correctly,
bond is a debt instrument that is longer than 20 years, however, for the sake of
simplicity and the purpose of this note, all maturity debt instrument will be called
bond. The first income source comes from coupon payments (c) or periodic coupon
payment. Each coupon payment (c) is calculated by multiplying the bonds periodic
coupon rateto the par valueof the bond. For example, a 20-year bond with a par
value of $1,000 and a coupon rate of 5% semi-annually will pay investor a coupon of
$25 or $1,000 x (5%/2) every six month for 20 years. If held to maturity, the investor
will receive a total of 40 coupon payments, once every six months.

The second income source is the par value (par) received at maturity that could result
in a capital gain or loss depending on the purchase price of that bond. Unlike typical
debt obligation where the borrower return the borrowed amount at maturity, the issuer
of bond always return par value of bond regardless of the purchase price. For
example, Joey needed $5,500 to start his dream business and asked to borrow from 10
friends equally, $550 each. Each friend would give him $550 and at maturity Joey
would give $550 back all his friends or the amount each friend gives him. However,
if Joey were to issue ten bonds with a par value of $500 to his friends but you all give
him $550 for each bond. At maturity, he would only be obligated to give you all $500
or the par value of the bond.

Students should keep in mind that the par value and the purchase price are two
distinctive terms but they may have the same number. The par value is considered a
book value whereas the purchase price is the market value. The selling price is also
the market value because essentially the selling price and the purchase price is the
identical. Consider these two examples; Bond A has a par value of 1,000 and selling
in the market for 1,100 whereas Bond B has a par value of 1,000 and selling for
1,000. Therefore, for Bond A the book value is 1,000 and the market value is 1,100,
however, Bond B the book value and the market value is the same at 1,000.

Applying the concept of time value of money and by identifying the two income
sources of a bond, the value of a bond can be determined simply by combining the
present value (PV) of 1) all expected periodic coupons and 2) the par value at
maturity. The value of a bond based on the PV concept is also the intrinsic value of
the bond, which is denoted by V
b
. If the market is perfect, the intrinsic value of the
bond will also be the market value or the selling price of that bond. Below is the
formula for calculating the intrinsic value of a bond.

Where c is the coupon payment, k is investors
require rate of return, par is the par value, and n is
the number of period (not year).


For example, a bond with 20 years to maturity paying a coupon of 10% compounded
annually, if our require rate of return is 14%, we could determine the value of this
bond as shown on the table in the right.

n
n
b
k
par
k
k
c V
) 1 (
) 1 ( 1
+
+
(

+
=
Lecture Note: Bond (Update: Jun-16-08)
Peerawich Thoviriyavej, Assumption University
2
First, we calculate the PV of all expected periodic coupon by using the ordinary
annuity formula
1
where one period coupon payment is c, period expected rate of
return of 14% as k, compounding period of 20 as n. This gives us the PV of all
expected periodic coupon of $662.31.

Then, we calculate the PV of the par value by using the PV formula where we
discount the par value using the same periodic require rate of return (14%) and
compounding period of 20. This gives us the PV of par value of $72.76.


The intrinsic value of this bond is simply the PV of the two sources of bond income or
$662.3131 + $72.7617 = $735.0748. Note that this bond value is not equal to the par
value. Clearly, bonds intrinsic value may not be the same as it par value. However,
there is one case when bonds intrinsic value will be equal to its par value. That is
when the coupon rate is equal to the bonds require rate of return.

1.1 Discount versus Premium
It is time to be acquainted with some bond terminologies. As you can see in our
calculation example that the bond presented has an intrinsic value less than the par
value of the bond. Assuming that this bond is selling in the market for exactly the
same price as we have calculated our bonds intrinsic value (V
b
) - $735.07, this bond
would be called a discount bond because the selling price is below its par value. On
the contrary, if the bond were sold at, for example, $1,023, we would call this bond a
premium bond because it is sold at a price below its par value. To determine the term
discount or premium, we simply compare the selling price (market value) against the
par value (book value) and pay no attention to the intrinsic value (V
b
). When the
market value and the book value is the same, we say the bond is sold at par.

1.2 Overpriced versus Underpriced Bond
As stated earlier, if the market is perfect, the intrinsic value of the bond will also be
the market value of that bond. Unfortunately, the market is not perfect, therefore, it is
possible the bonds market price and its intrinsic value is not the same. When the
market value is more than the intrinsic value, we say the bond is overpriced. Investors
tend to sell the bond thereby oversupplying the market with the bond causing the price
of such bond to decline until the market price fall to the same level as the intrinsic
value. The opposite is true when the market value is less than the intrinsic value.
Thus, we have the following relationships;
When MV > V
b
; overpriced
When MV < V
b
; underpriced


1
See detail formula in Formula Sheet
V
b
= pv of all coupons + pv of par value
20
20
) 14 . 1 (
1000
14 .
) 14 . 1 ( 1
100
+
+
(

+
=
b
V
76 . 72 31 . 662 + =
Lecture Note: Bond (Update: Jun-16-08)
Peerawich Thoviriyavej, Assumption University
3
Being able to identify mispriced bond could allow investors to make extra return from
selling and buying or buying and selling the bond. The strategy depends on the price
movement.

1.3 Capital Gain versus Capital Loss
Capital gain happens when the price you receive is higher than the price you paid.
When you sell a bond for a price that is higher than the price you paid for, the
differences is your capital gain. Capital loss occurs when the price you receive is
lower than the price you paid for.

Capital gain or loss also applies even if you hold the bond to maturity. This is because
if you bought a bond at a discount, when the bond matures, under normal
circumstances the issuer will return you the par value. The difference between
purchase price and the par value represents your capital gain or loss. If you purchased
a bond at a premium, you will have a capital loss at maturity. The fact that the gain or
loss is deferred into the future will affect how investors actual return expected from
investing in the bond which will be demonstrate in the Calculating Bonds Expected
Rate of Return section.

2. Relationship of Bond
Based on bond calculation formula, our next section begins looking at some
fundamental relationship exists in bond valuations.

2.1 Bond Price (V
b
) and Require Rate of Return (k)
To investigate this relationship, we calculate the same bond using different require
rate of return at 14%, 10%, and 8%. Results are shown below.

Table 1 Price Calculation of a 20-year Bond with 10% coupon rate at different require rate of
return
Annually
n = 20 i = 14%
100 662.31
1000 72.76
735.07
Discount Bond
require rate of return = 14%
Annually
n = 20 i = 10%
100 851.36
1000 148.64
1000.00
Par Bond
require rate of return = 10%
Annually
n = 20 i = 8%
100 981.81
1000 214.55
1196.36
Premium Bond
require rate of return = 8%


Our calculation shows that when interest rate continues to decline, bond price
continues to increase. Therefore, it is clear that the bond price and interest rate is
inversely related. They move in the opposite direction. When the require rate of return
Lecture Note: Bond (Update: Jun-16-08)
Peerawich Thoviriyavej, Assumption University
4
changes, the value of bond changes. This particular inverse relationship of bond value
and interest rate is also known as interest-rate risk.

Lecture Note: Bond (Update: Jun-16-08)
Peerawich Thoviriyavej, Assumption University
5
Bond Price and Maturity
0
200
400
600
800
1000
1200
1400
0 2 4 6 8 10 12 14 16 18 20
Year
Discount Bond
Par Bond
Premium Bond
WHEN

1) k = c%, V
b
= par

2) k > c%, V
b
< par (discount bond)

3) k < c%, V
b
> par (premium bond)

A careful review of this calculation reveals following noteworthy points.

1) When the interest rate (k) is equal
to coupon rate (c%), bond value is
the same as the par value
2) Assuming the bond is sold at V
b
,
when the interest rate is more than
the coupon rate, we have a
discount bond.
3) Assuming the bond is sold at V
b
,
when the interest rate is less than
the coupon rate, we have a
premium bond.

2.2 Bond price and Maturity
Now, we turn our focus on the relation of bond price and maturity. We will determine
the price movement as the bond ages. After calculated the price of bond through
maturity, the graph indicates bonds move closer to the par value as they approach
maturity and eventually reach the par value on maturity date.
At Year Discount Bond at Par Bond Premium Bond
Kb=14% Kb=10% Kb=8%
0 735.07 1000.00 1196.36
1 737.99 1000.00 1192.07
2 741.30 1000.00 1187.44
3 745.09 1000.00 1182.43
4 749.40 1000.00 1177.03
5 754.31 1000.00 1171.19
6 759.92 1000.00 1164.88
7 766.31 1000.00 1158.08
8 773.59 1000.00 1150.72
9 781.89 1000.00 1142.78
10 791.36 1000.00 1134.20
11 802.15 1000.00 1124.94
12 814.45 1000.00 1114.93
13 828.47 1000.00 1104.13
14 844.45 1000.00 1092.46
15 862.68 1000.00 1079.85
16 883.45 1000.00 1066.24
17 907.13 1000.00 1051.54
18 934.13 1000.00 1035.67
19 964.91 1000.00 1018.52
20 1000.00 1000.00 1000.00

Note that for our investigation of this relationship, we assume that no other factors
except for time to maturity factor that changes. It should be clear that the price of a
par bond remains constant through maturity because when k= c%, the bond value
equal the par value at all time. However, as maturity nears, a discount bond will
increase in value whereas a premium bond will decrease in value.

2.3 Sensitivity of Bond Price
Earlier, it had been identified that bond price is inversely related with interest rate
changes. That is when interest rate increases, bond price will decrease and vice versa.
Lecture Note: Bond (Update: Jun-16-08)
Peerawich Thoviriyavej, Assumption University
6
Figure 1
Various 10% Coupon-Bond at Different Interest
Rate
600
800
1000
1200
1400
1600
1800
2000
5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
5-Yr
10-Yr
20-Yr
30-Yr
40-Yr

To measure bond prices sensitivity to changes in interest rate, we select five 10%-
coupon bonds. Each bond has different maturity length, 5 years, 10 years, 20 years, 30
years, and 40 years. Prices at different levels of interest rate (k) are plotted on Figure
1. Clearly, all five bonds show different levels of sensitivity as evident by different
steepness in each line. Note that when interest rate is at 10%, which is equal to the
coupon rate in our example, every bond has a price equal to the par value.

The steeper the slope, the more sensitive the bond price becomes to a change in
interest rate. Based on our graph, the 40-year bond is the most sensitive whilst the 5-
year bond is the least sensitive to changes in interest rate. Thus, it is reasonable to
conclude that bonds with longer maturity will be more sensitive to changes in interest
rate than bonds with shorter maturity. Put differently, bond prices sensitivity
increases with maturity.

In bond theory, this sensitivity of changes in bond price to changes in interest rate
depends on more than length of maturity per se. It depends on length of maturity as
well as pattern of periodic coupon payment or cash being received. For example, a 5-
year bond is more sensitive than a 4-year bond, all other things being equal. However,
for the 5-year bond if investor is able to receive some coupons or cash payment
earlier, the early receipt of the cash payment could help reduce the sensitivity of the 5-
year bond to be less than that of the 4-year bond. Frederick Macaulay introduced the
concept of duration as a unit that would capture both the length of maturity as well as
the speed of the cash flow being received. Thus, if there are any coupons to be
received before the maturity date, the bonds duration will be less than the bonds
maturity year. At the same time, the duration of a bond that pays no coupon, a zero-
coupon bond, is exactly the same as the year to maturity. For example, the duration of
a 5-year zero-coupon bond is 5 or the same as the year to maturity. A 5-year bond that
pays coupons will have duration of less than 5.

Unfortunately, duration measurement is a linear function but the bond prices
sensitivity is a non-linear function as depicted in Figure 1. This put limitation on the
ability of duration to measure changes in bond price when face with large changes in
interest rate. A more accurate measurement is required. This more precise,
mathematically cumbersome measurement formula is known as bonds convexity. It
is a mathematical formula that is capable of tracing a convex line which is the pattern
Lecture Note: Bond (Update: Jun-16-08)
Peerawich Thoviriyavej, Assumption University
7
of the line illustrated in Figure 1. Given the limited scope of this course, we will not
attempt to discuss the concept of duration nor convexity beyond what have been
explained here.

2.4 Bond Price (V
b
) and Coupon Payment Frequency (n)
Now we will investigate the relationship between bond price (V
b
) and coupon
payment frequency (n) under the assumption that all bonds will be held to maturity.
Showing calculation of two income sources separately will help us visualize the effect
on each income element as well as the net effect on the bond price.

Table 2 Calculation Results When Number of Frequency (n) Increases
Annually Annually
n = 20 i = 14% n = 20 i = 8%
100 662.31 100 981.81
1000 72.76 1000 214.55
735.07 1196.36
Semi-annually Semi-annually
n = 40 i = 7% n = 40 i = 4.0%
50 666.59 50 989.64
1000 66.78 1000 208.29
733.37 1197.93
Quarterly Quarterly
n = 80 i = 3.50% n = 80 i = 2.0%
25 668.72 25 993.61
1000 63.79 1000 205.11
732.51 1198.72
Monthly Monthly
n = 240 i = 1.17% n = 240 i = 0.67%
8.33 670.14 8.33 996.29
1000 61.80 1000 202.97
731.94 1199.26
Premium Bond Discount Bond
require rate of return = 14% require rate of return = 8%


Investigating the relationship between bond price and coupon payment frequency,
holding other variables constant, we increase the number of coupon payment
frequency or compounding period (n) and recalculate the bond price. Calculation
results are presented in Table 2. For the discount bond, its price keeps declining as the
number of compounding period increases. The premium bond, on the contrary, its
price keeps rising as the number of compounding period increases.

Further analysis on the two components of bond income indicates the following:

After increase the compounding frequency (n);
1. the PV of periodic coupon payment keeps rising
2. the PV of the par value keeps shrinking

Supported by the concept of time value of money, the value of the first component
keeps increasing in both types of bond because the coupons can be reinvested more
frequently and thereby increasing their value. On the other hand, the value of the
second component keeps decreasing because the receipt of the par value will be
Lecture Note: Bond (Update: Jun-16-08)
Peerawich Thoviriyavej, Assumption University
8
further away making that it worth even less. Unless the two changes are offset, the
bond price will change. When the change from the present value of periodic coupon
payment exceeds the change from the present value of face value, the new bond price
will increase. The opposite is also true.

The above analysis yields the exact opposite relationship as in bond price and
maturity date where discount bonds increase in value but premium bonds decrease in
value as they approach maturity. Here, we are looking in the reverse direction - n
increases as to n decreases. Therefore, when number of coupon frequency increases, it
can be said that price of a discount bond will decrease where price of a premium bond
will increase.

Intuitively, this should be quite obvious. A discount bond will give investors capital
gain at maturity. By increasing frequency you are delaying receipts of that capital
gain making the price of your bond (V
b
) decline. A premium bond, on the contrary,
will give investors capital loss at maturity, thus, by increasing frequency you are
delaying payments of that capital loss making the bond even more attractive, hence, a
rise in the price of the bond.

Intentionally, a bond selling at par is not discussed here simply because the fact that a
bond which its coupon rate is equal to the rate return will always yield a price that is
exactly equal to the par value will always be true. To conclude, the relationship
between bond price and frequency is positively related for premium bond and
negatively related for a discount bond.

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