4 Bond Valuation - PPT PDF

Chapter 7
Chapter 7: Bond Valuation

 Introductions
 Bond Valuation
 Yield to Maturity
 Yield to Call
 Current Yield and Capital Gains Yield
 Implications: Price Risk, Reinvestment Risk, Default Risk
6-1
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
INTRODUCTIONS
6-2
What is a bond?
• A long-term debt instrument in which a borrower

agrees to make payments of principal and interest,
on specific dates, to the holders of the bond.
• Primarily traded in the over-the-counter (OTC)
market.
• Most bonds are owned by and traded among large
financial institutions.
7-3
Key Features of a Bond
• Par value: face amount of the bond, which

is paid at maturity (assume P1,000).
• Coupon interest rate: stated interest rate (generally
fixed) paid by the issuer. Multiply by par value to get
dollar payment of interest.
• Maturity date: years until the bond must be repaid.
• Issue date: when the bond was issued.
• Yield to maturity: rate of return earned on
a bond held until maturity (also called the “promised
yield”).
7-4
7-5
7-6
7-7
7-8
Pop Quiz
If a firm raises capital by selling new bonds, it could be called the “issuing
firm,” and the coupon rate is generally set equal to the required rate on
bonds of equal risk.
A. True
B. False
9
Effect of a Call Provision
• Allows issuer to refund the bond issue if rates

decline (helps the issuer, but hurts the investor).
• Borrowers are willing to pay more, and lenders
require more, for callable bonds.
• Most bonds have a deferred call and a declining call
premium.
7-10
Pop Quiz
A call provision gives bondholders the right to demand, or “call for,”
repayment of a bond. Typically, companies call bonds if interest rates
rise and do not call them if interest rates decline.
A. True
B. False
11
Pop Quiz
Sinking funds are provisions included in bond indentures that require
companies to retire bonds on a scheduled basis prior to their final
maturity.
A. True
B. False
12
Pop Quiz
The market value of any real or financial asset, including stocks, bonds,
or art work purchased in hope of selling it at a profit, may be estimated by
determining future cash flows and then discounting them back to the
present.
A. True
B. False
13
BOND VALUATION
6-14
The Value of Financial Assets
0 1 2 N
r% ...
Value CF1 CF2 CFN
CF1 CF2 CFN

Value   
1  r  1  r 
1 2
1  r N
7-15
What is the value of a $1,000 10-year, 10% annual
coupon bond, if rd = 10%?
0 1 2 N
10% ...
VB = ? 100 100 100 + 1,000
$100 $100 $1,000

VB     
1.101 1.1010 1.1010
VB  $90.91    $38.55  $385.54
VB  $1,000
7-16
What’s the value of its 10-year bonds outstanding with
the same risk but a 13% annual coupon rate?
• The annual coupon payment is P130. Since the risk

is the same it has the same yield to maturity as the
previous bond (10%). This bond sells at a premium
because the coupon rate > the yield to maturity.
= P1,184.34
7-17
What’s the value of its 10-year bonds outstanding with
the same risk but a 7% annual coupon rate?
• The annual coupon payment is P70. Since the risk is

the same it has the same yield to maturity as the
previous bonds (10%). This bond sells at a discount
because the coupon rate < the yield to maturity.
= P815.66
7-18
Changes in Bond Value over Time
• What would happen to the value of these three

bonds if the required rate of return remained at
10%?
VB
1,184
13% coupon rate
10% coupon rate

1,000
816 7% coupon rate

Years
to Maturity
10 5 0
7-19
Bond Values over Time
• At maturity, the value of any bond must equal its

par value.
• If rd remains constant:
– The value of a premium bond would decrease over
time, until it reached P1,000.
– The value of a discount bond would increase over
time, until it reached P1,000.
– The value of a par bond stays at P1,000.
7-20
Pop Quiz
Morin Company's bonds mature in 8 years, have a par value of P1,000,
and make an annual coupon interest payment of P65. The market
requires an interest rate of 8.2% on these bonds. What is the bond's
price?
a. P903.04
b. P925.62
c. P948.76
d. P972.48
e. P996.79
21
Pop Quiz
If the required rate of return (effective rate) is higher than the coupon rate
(nominal rate), then the longer the maturity date, the lower the price of the
bond.
A. True
B. False
22
Pop Quiz
The price sensitivity of a bond to a given change in interest rates is
generally greater the longer the bond's remaining maturity.
A. True
B. False
23
Pop Quiz
If the required rate of return on a bond (rd) is greater than its coupon
interest rate and will remain above that rate, then the market value of the
bond will always be below its par value until the bond matures, at which
time its market value will equal its par value. (Accrued interest between
interest payment dates should not be considered when answering this
question.)
A. True
B. False
24
Pop Quiz
The prices of high-coupon bonds tend to be less sensitive to a given
change in interest rates than low-coupon bonds, other things held
constant.
A. True
B. False
25
YIELD TO MATURITY
6-26
Yield to Maturity (YTM)
• The yield to maturity measures the compound annual

return to an investor and considers all bond cash flows.
It is essentially the bond’s IRR based on the current
price.
• Note that the yield to maturity will only be equal to the
IRR if the bond is selling for its face value (P1,000).
• And that rate will be the same as the bond’s coupon
rate.
• For premium bonds, the current yield > YTM.
• For discount bonds, the current yield < YTM.
6-27
Yield to Maturity (YTM) (cont.)
Example:
BCD's P1,000 par value bonds currently sell for P798.50.

The coupon rate is 10%, paid semiannually. If the bonds
have five years before maturity, what is the yield to maturity
or expected rate of return?
6-28
Yield to Maturity (YTM)
• Method I
– Must find the rd that solves this model.
INT INT M
VB     
1  rd 1 1  rd N 1  rd N
6-29
BCD's P1,000 par value bonds currently sell for P798.50. The coupon
rate is 10%, paid semiannually. If the bonds have five years before
maturity, what is the yield to maturity or expected rate of return?
P1,000(PVIF)
By trial and error try 8%.
P798.50 = P50 × 6.710 + P1,000 × .463
P798.50 = P798.50
Yield to maturity = (.08)(2) = .16
6-30
Example:
The market price of a 20-year, P1,000 bond that pays 9%

interest semiannually is P774.31. What is the bond’s yield to
maturity?
6-31
The market price of a 20-year, P1,000 bond that pays 9% interest

semiannually is P774.31. What is the bond’s yield to maturity?
By trial and error, select 6% semi-annually (12% annually).

P774.31 = (P45 × 15.046) + (P1,000 × 0.097)
P774.31 = P774.07
6-32
Pop Quiz
A P1,000 par value 10-year bond with a 10% coupon rate recently sold
for P900. The yield to maturity:
a. is 10%.
b. is greater than 10%.
c. is less than 10%.
d. cannot be determined.
33
Pop Quiz
What is the yield to maturity of a nine-year bond that pays a coupon rate
of 20% per year, has a P1,000 par value, and is currently priced at
P1,407? Round your answer to the nearest whole percent and assume
annual coupon payments.
a. 5%
b. 14%
c. 12%
d. 11%
34
Using YTM simple average
6-35
Using YTM weighted average
6-36
Pop Quiz
Adams Enterprises’ noncallable bonds currently sell for P1,120. They
have a 15-year maturity, an annual coupon of P85, and a par value of
P1,000. What is their yield to maturity?
a. 5.84%
b. 6.15%
c. 6.47%
d. 6.81%
e. 7.17%
37
YIELD TO CALL
6-38
Yield to Call
• Solving for the YTC is identical to solving for YTM, except

the time to call is used for N and the call premium is FV.
6-39
When is a call more likely to occur?
• In general, if a bond sells at a premium, then (1)

coupon > rd, so (2) a call is more likely.
• So, expect to earn:
– YTC on premium bonds.
– YTM on par and discount bonds.
7-40
Pop Quiz
Sadik Inc.'s bonds currently sell for P1,180 and have a par value of
P1,000. They pay a P105 annual coupon and have a 15-year maturity,
but they can be called in 5 years at P1,100. What is their yield to call
(YTC)?
a. 6.63%
b. 6.98%
c. 7.35%
d. 7.74%
e. 8.12%
41
Pop Quiz
If the coupon rate exceeds the YTM, then it is likely that the bonds will be
called and replaced with new, lower coupon bonds. In that case, the YTC
will be earned. Otherwise, one should expect to earn the YTM.
A. True
B. False
42
CURRENT YIELD AND
CAPITAL GAINS YIELD
6-43
Annual coupon payment
Current yield (CY) 
Current price
Change in price
Capital gains yield (CGY) 
Beginning price
Expected total return  YTM  Expected CY  Expected CGY
7-44
Pop Quiz
The current yield is a measure of the one-year return on a bond. The
current yield is calculated by taking a bond’s annual coupon payment and
dividing by its market price. Yield to maturity measures the return to
maturity on a bond.
A. True
B. False
45
An Example:
Current and Capital Gains Yields
• Find the current yield and the capital gains yield for
a 10-year, 9% annual coupon bond that sells for
$887, and has a face value of $1,000.
$90
Current yield 
$887
 0.1015  10.15%
7-46
Calculating Capital Gains Yield
YTM = Current yield + Capital gains yield and assuming

that YTM is 10.91%
CGY  YTM  CY
 10.91% 10.15%
 0.76%
Could also find the expected price one year from now
and divide the change in price by the beginning price,
which gives the same answer.
7-47
Pop Quiz
A 10-year corporate bond has an annual coupon of 9%. The bond is
currently selling at par (P1,000). Which of the following statements is
CORRECT?
a. The bond’s expected capital gains yield is zero.

b. The bond’s yield to maturity is above 9%.
c. The bond’s current yield is above 9%.
d. If the bond’s yield to maturity declines, the bond will sell at a discount.
e. The bond’s current yield is less than its expected capital gains yield.
48
Pop Quiz
A 15-year bond with a face value of P1,000 currently sells for P850.
Which of the following statements is CORRECT?
a. The bond’s coupon rate exceeds its current yield.

b. The bond’s current yield exceeds its yield to maturity.
c. The bond’s yield to maturity is greater than its coupon rate.
d. The bond’s current yield is equal to its coupon rate.
e. If the yield to maturity stays constant until the bond matures, the
bond’s price will remain at P850.
49
CY vs YTM vs CGY vs CR
7-50
Pop Quiz
Which of the following statements is CORRECT?
a. Assume that two bonds have equal maturities and are of equal risk,
but one bond sells at par while the other sells at a premium above
par. The premium bond must have a lower current yield and a higher
capital gains yield than the par bond.
b. A bond’s current yield must always be either equal to its yield to
maturity or between its yield to maturity and its coupon rate.
c. If a bond sells at par, then its current yield will be less than its yield to
maturity.
d. If a bond sells for less than par, then its yield to maturity is less than
its coupon rate.
e. A discount bond’s price declines each year until it matures, when its
value equals its par value.
51
RISKS: PRICE, REINVESTMENT &
DEFAULT
6-52
What is price risk? Does a 1-year or 10-year bond
have more price risk?
• Price risk is the concern that rising rd will cause the

value of a bond to fall.
rd 1-year Change 10-year Change
5% P1,048 P1,386
+ 4.8% +38.6%
10% 1,000 – 4.4%
1,000 –25.1%
15% 956 749
• The 10-year bond is more sensitive to interest

rate changes, and hence has more price risk.
7-53
Illustrating Price Risk
Value (P)
1,600
1,400 10-Year Bond
1,200 1-Year Bond
1,000
800
600
400
200
0 YTM(%)
0 5 10 15 20
7-54
Pop Quiz
A bond that had a 20-year original maturity with 1 year left to maturity has
more price risk than a 10-year original maturity bond with 1 year left to
maturity. (Assume that the bonds have equal default risk and equal
coupon rates, and they cannot be called.)
A. True
B. False
55
Pop Quiz
Because short-term interest rates are much more volatile than long-term
rates, you would, in the real world, generally be subject to much more
price risk if you purchased a 30-day bond than if you bought a 30-year
bond.
A. True
B. False
56
What is reinvestment risk?
• Reinvestment risk is the concern that rd will fall, and

future CFs will have to be reinvested at lower rates,
hence reducing income.
EXAMPLE: Suppose you just won P500,000 playing

the lottery. You intend to invest the money and live
off the interest.
7-57
Reinvestment Risk Example
• You may invest in either a 10-year bond or a series

of ten 1-year bonds. Both 10-year and 1-year
bonds currently yield 10%.
• If you choose the 1-year bond strategy:
– After Year 1, you receive P50,000 in income and have
P500,000 to reinvest. But, if 1-year rates fall to 3%,
your annual income would fall to P15,000.
• If you choose the 10-year bond strategy:
– You can lock in a 10% interest rate, and P50,000
annual income for 10 years, assuming the bond is not
callable.
7-58
Conclusions about Price Risk and Reinvestment Risk
Short-term Long -term

AND/OR AND/OR
High-coupon Low-coupon
Bonds Bonds
Price risk Low High
Reinvestment risk High Low
• CONCLUSION: Nothing is riskless.
7-59
Evaluating Default Risk:
Bond Ratings
Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC C
• Bond ratings are designed to reflect the probability

of a bond issue going into default.
7-60
Factors Affecting Default Risk and Bond Ratings
• Financial performance
– Debt ratio
– TIE ratio
– Current ratio
• Qualitative factors: Bond contract terms
– Secured vs. unsecured debt
– Senior vs. subordinated debt
– Guarantee and sinking fund provisions
– Debt maturity
7-61
Other Factors Affecting Default Risk
• Miscellaneous qualitative factors

– Earnings stability
– Regulatory environment
– Potential antitrust or product liabilities
– Pension liabilities
– Potential labor problems
7-62
Latest PH Credit Ratings
7-63
7-64
7-65
Pop Quiz
There is an inverse relationship between bonds' quality ratings and their
required rates of return. Thus, the required return is lowest for AAA-rated
bonds, and required returns increase as the ratings get lower.
A. True
B. False
66
Pop Quiz
Adams Enterprises’ noncallable bonds currently sell for P1,120. They
have a 15-year maturity, an annual coupon of P85, and a par value of
P1,000. What is their yield to maturity?
a. 5.84%
b. 6.15%
c. 6.47%
d. 6.81%
e. 7.17%
67
The Philippine Bond Market
• In 2018, the Philippine bond market continued

to be dominated by government securities.
• Although the size of the Philippine corporate
bond market grew over the past 3 years, it is
still relatively small compared to government
bonds.
• During the year, private issuances of local
currency bonds were mostly from the real
estate, financial corporations and holding firms.
7-68
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, orSource:
posted toBSP
a publicly
2018 accessible
Annual website,
Reportin whole or in part.
• BSP Circular No. 1010 dated 9 August 2018

– was issued to address the concern on
investor protection, price discovery and
transparency for the issuance of debt security
and to align with the Securities Regulations
Code.
– Streamlined requirements for the issuance of
bonds and commercial papers to
banks/quasi-banks (QBs) which demonstrate
the capacity to undertake their funding
strategy
7-69
posted toBSP
a publicly
2018 accessible
Annual website,
7-70
posted toBSP
a publicly
2018 accessible
Annual website,
The Philippine External Debt
7-71
7-72
posted toBSP
a publicly
2018 accessible
Annual website,
7-73
posted toBSP
a publicly
2018 accessible
Annual website,
7-74
posted toBSP
a publicly
2018 accessible
Annual website,
7-75
posted toBSP
a publicly
2018 accessible
Annual website,
7-76
posted toBSP
a publicly
2018 accessible
Annual website,
7-77
posted toBSP
a publicly
2018 accessible
Annual website,
Debt Payment Experience
• Respondents found it difficult to pay for their debts,

compared to those who said easy, due to the
following factors:
– not enough income/budget deficit/have no
capacity to pay;
– unstable job
– prioritized other household expenses
– high interest rate; and
– business is down.
7-78
End
7-79

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Chapter 7

Chapter 7: Bond Valuation

• A long-term debt instrument in which a borrower

• Par value: face amount of the bond, which

• Allows issuer to refund the bond issue if rates

CF1 CF2 CFN

$100 $100 $1,000

• The annual coupon payment is P130. Since the risk

• The annual coupon payment is P70. Since the risk is

• What would happen to the value of these three

10% coupon rate

816 7% coupon rate

• At maturity, the value of any bond must equal its

• The yield to maturity measures the compound annual

BCD's P1,000 par value bonds currently sell for P798.50.

The market price of a 20-year, P1,000 bond that pays 9%

The market price of a 20-year, P1,000 bond that pays 9% interest

By trial and error, select 6% semi-annually (12% annually).

• Solving for the YTC is identical to solving for YTM, except

• In general, if a bond sells at a premium, then (1)

YTM = Current yield + Capital gains yield and assuming

a. The bond’s expected capital gains yield is zero.

a. The bond’s coupon rate exceeds its current yield.

• Price risk is the concern that rising rd will cause the

• The 10-year bond is more sensitive to interest

• Reinvestment risk is the concern that rd will fall, and

EXAMPLE: Suppose you just won P500,000 playing

• You may invest in either a 10-year bond or a series

Short-term Long -term

• CONCLUSION: Nothing is riskless.

Investment Grade Junk Bonds

S&P AAA AA A BBB BB B CCC C

• Bond ratings are designed to reflect the probability

• Miscellaneous qualitative factors

• In 2018, the Philippine bond market continued

• BSP Circular No. 1010 dated 9 August 2018

• Respondents found it difficult to pay for their debts,

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