Bond Valuation

What is Bond?? (a long-term debt instrument)

A bond is a fixed income instrument that represents a loan made by an investor to a
borrower (typically corporate or governmental).

 A bond is referred to as a fixed income instrument since bonds traditionally

paid a fixed interest rate (coupon) to debtholders. Variable or floating
interest rates are also now quite common.

Features/Characteristics of Bonds

1. Face Value/Par value refers to the value stated on the face of the bond, which
shows the amount which the company or government body promises to pay at
the time of maturity.
It is also the reference amount the bond issuer uses when calculating interest
payments.
2. Coupon Rate is nothing but the fixed rate of interest payable to the bondholder.
It is the rate of interest the bond issuer will pay on the face value of the bond,
expressed as a percentage. For example, a 5% coupon rate means that
bondholders will receive 5% x $1000 face value = $50 every year.
3. Maturity Date is the date at which the bond gets matured, and the principal
amount is paid to the bondholder.

A bond indenture is a contract document between the issuing body and the
bondholder, that specifies the factors discussed above.

Who issues bond??

There are four primary categories of bonds sold in the markets.

 Government bonds such as those issued by the U.S. Treasury. Bonds issued
by the Treasury with a year or less to maturity are called “Bills”; bonds
issued with 1–10 years to maturity are called “notes”; and bonds issued with
more than 10 years to maturity are called “bonds”. The entire category of
bonds issued by a government treasury is often collectively referred to as
"treasuries." Government bonds issued by national governments may be
referred to as sovereign debt.
 Municipal bonds (Munis) are issued by states and municipalities. Some
municipal bonds offer tax-free coupon income for investors.
 Corporate bonds are issued by companies. Companies issue bonds rather
than seek bank loans for debt financing in many cases because bond markets
offer more favorable terms and lower interest rates.
 A foreign bond is a bond issued in a domestic market by a foreign entity in
the domestic market's currency as a means of raising capital.
 An international bond is a debt obligation that is issued in a country by a
non-domestic entity in its native currency.

What are International Bonds?

International bonds are bonds issued by a country or company that is not

domestic for the investor. The international bond market is quickly
expanding as companies continue to look for the cheapest way to borrow
money. By issuing debt on an international scale, a company can reach
more investors. It also potentially helps decrease regulatory constraints.

Three Categories of International Bonds

There are three general categories for international bonds: domestic, euro,
and foreign. The categories are based on the country (domicile) of the
issuer, the country of the investor, and the currencies used.
 Domestic bonds: Issued, underwritten and then traded with the currency
and regulations of the borrower’s country. For example, a British company
issues debt in the United Kingdom with the principal and interest
payments based or denominated in British pounds.
 Eurobonds: Underwritten by an international company using domestic
currency and then traded outside of the country’s domestic market. For
example, a British company issues debt in the United States with the
principal and interest payments denominated in pounds.
 Foreign bonds: Issued in a domestic country by a foreign company, using
the regulations and currency of the domestic country. For example, a
British company issues debt in the United States with the principal and
interest payments denominated in dollars.
Types of Bonds
 Fixed Rate Bond: Otherwise known as straight bonds, they carry a specified
coupon which remains constant throughout its life.
 Floating Rate Bond: Floating rate bonds are one, on which the interest rate is
not specified, and it fluctuates as per market conditions.
 A mortgage bond is a bond backed by real estate holdings or real property. In
the event of a default situation, mortgage bondholders could sell off the
underlying property backing a bond to compensate for the default.
 A debenture is a type of debt instrument that is not backed by any collateral and
usually has a term greater than 10 years. Debentures are backed only by the
creditworthiness and reputation of the issuer.
 Zero Coupon Bond: The bonds which do not carry periodic interest payment is
called zero coupon bond. The issuance of these bonds are made at a steep
discount over its face value and repaid at face value on maturity.
 Convertible Bond: Bonds that gives the holder the right to convert them into
equity at a fixed conversion price are called convertible bonds.
 Perpetual Bond (Consol): A perpetual bond is a bond that never matures. It has
an infinite life.
 Inflation bond: The bonds in which coupon is adjusted for inflation, so as to
ensure that the return is provided to the investor, which is free from the effect of
inflation.
 Callable bonds also have an embedded option but it is different than what is
found in a convertible bond. A callable bond is one that can be “called” back by
the company before it matures.
 A Puttable bond allows the bondholders to put or sell the bond back to the
company before it has matured.
 An income bond is a type of debt security in which only the face value of the
bond is promised to be paid to the investor, with any coupon payments paid only
if the issuing company has enough earnings to pay for the coupon payment.
 Junk bonds represent bonds issued by companies that are struggling financially
and have a high risk of defaulting or not paying their interest payments or
repaying the principal to investors. Junk bonds are also called high-yield bonds
since the higher yield is needed to help offset any risk of default.
Value of a Bond?

V = Coupon Payments + Maturity Value

V = Coupon Payments (PVIFAi,n) + Maturity Value (PVIFi,n)
V = CP (PVIFAi,n) + MV (PVIFi,n)

[ ]
1
1−
V =CP
(1+i)n
i
+ MV
[ 1
(1+i)
n
]
Example
Bond C has a $1,000 face value and provides an 8% annual coupon for 30
years. The appropriate discount rate is 10%. What is the value of the coupon
bond?
FV=1000
Coupon Rate = 8%
n = 30 years
i = 10%

Coupon Payment = Face value*Coupon rate = 1000*0.08 = $80

V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)

[ ]
1
1−
V =$ 80
(1+ 0.1)30
0.1
+ $ 1000
1
[
(1+0.1)
30
]
.
.
V = $80 (9.427) + $1,000 (.057)
V = $754.16 + $57.00
V = $811.16
Bond Price Relationships
Bonds have an inverse relationship to interest rates. When the cost of borrowing
money rises, bond prices usually fall, and vice-versa.
 Most bonds pay a fixed interest rate that becomes more attractive if interest
rates fall, driving up demand and the price of the bond.
 Conversely, if interest rates rise, investors will no longer prefer the lower
fixed interest rate paid by a bond, resulting in a decline in its price.

 The price investors are willing to pay for a bond can be significantly
affected by prevailing interest rates. If prevailing interest rates are higher
than when the existing bonds were issued, the prices on those existing
bonds will generally fall. That's because new bonds are likely to be issued
with higher coupon rates as interest rates increase, making the old or
outstanding bonds generally less attractive unless they can be purchased
at a lower price. So, higher interest rates mean lower prices for existing
bonds.
 If interest rates decline, however, bond prices of existing bonds usually
increase, which means an investor can sometimes sell a bond for more
than the purchase price, since other investors are willing to pay a
premium for a bond with a higher interest payment, also known as a
coupon.

1. When the market required rate of return is more than the stated coupon rate, the price of
the bond will be less than its face value. Such a bond is said to be selling at a discount
from face value. The amount by which the face value exceeds the current price is the
bond discount.

If a bond sells at a discount, then Po < Par and MR > Coupon rate.

2. When the market required rate of return is less than the stated coupon rate, the price of
the bond will be more than its face value. Such a bond is said to be selling at a premium
over face value. The amount by which the current price exceeds the face value is the
bond premium.
If a bond sells at a premium, then Po > Par and MR < Coupon rate.
 3. When the market required rate of return equals the stated coupon rate, the price of the
bond will equal its face value. Such a bond is said to be selling at par.

If a bond sells at par, then Po = Par and MR = Coupon rate.

Bond Yields
1. Yield to Maturity (YTM)

2. Yield to Call (YTC)

3. Current Yield (CY)

Yield to Maturity (YTM)

The market required rate of return on a bond (kd) is more commonly referred to as
the bond’s yield to maturity. Yield to maturity (YTM) is the expected rate of return
on a bond if bought at its current market price and held to maturity; it is also
known as the bond’s internal rate of return (IRR).
Mathematically, it is the discount rate that equates the present value of all expected
interest payments and the payment of principal (face value) at maturity with the
bond’s current market price.
i = YTM

[ ]
1
1−
PO =CP
(1+YTM )n
YTM
+ MV
[ 1
(1+YTM )
n
]
Example
Consider a $1,000-par-value bond with the following characteristics: a current
market price of $761, 12 years until maturity, and an 8 percent coupon rate (with
interest paid annually). Calculate YTM?
Data: Po = $761, FV = $1,000, n = 12 years, CR = 8%, YTM = ?
Hint: BP<FV (761<1000); MR>CR
At 10%
PO = CP (PVIFA10%,12) + MV (PVIF10%,12)

[ ]
1
1−
761=$ 80
(1+ 0.1)12
0.1
+ $ 1000
1
(1+0.1)[
12
]
[ ]
1
1−
PO =$ 80
3.138
0.1
+ $ 1000
1
3.138 [ ]
PO =$ 80
[ 1−0.3186
0.1 ]
+$ 1000 [ 0.3186 ]

PO =$ 80
[ 0.6814
0.1 ]
+$ 318.6

PO =$ 80 [ 6.814 ] + $ 318.6
PO =$ 545.12+ $ 318.6
PO =$ 863.72

At 15%
PO = CP (PVIFA15%,12) + MV (PVIF15%,12)

[ ]
1
1−
761=$ 80
(1+ 0.15)12
0.15
+ $ 1000
1
(1+0.15)
12
[ ]
..
..
PO =$ 80 [ 5.421 ] ++ $ 1000 [ 0.187 ]
PO =$ 433.68+ $ 187
PO =$ 620.68

Interpolation
 [[ ] ]
0.10 $ 863.72
a X YTM $ 761 b c
0.15 $ 620.68

X b
=
a c
X $ 103.12
=
0.05 $ 243.44
0.05× $ 103.12
X= =0.0212
$ 243.44
YTM =0.10+ X

YTM =0.10+ 0.0212 = 0.1212 = 12.12%

YTM =¿ 12.12%

Yield to Call (YTC)

If you purchased a bond that was callable and the company called it, you would not
have the option of holding the bond until it matured. Therefore, the yield to
maturity would not be earned.
For example, if Company’s 10% coupon bonds were callable and if interest rates
fell from 10% to 5%, then the company could call in the 10% bonds, replace them
with 5% bonds, and save $100 − $50 = $50 interest per bond per year. This would
be good for the company but not for the bondholders.
If current interest rates are well below an outstanding bond’s coupon rate, then a
callable bond is likely to be called, and investors will estimate its expected rate of
return as the yield to call (YTC) rather than as the yield to maturity.

PO = Coupon payment (PVIFAYTC, N) + Call Price (PVIFYTC, N)

[ ]
1
1−
PO =Coupon payment
(1+YTC ) N
YTC [
+ Call Price
1
(1+YTC )
N
]
“Call price” is the price the company must pay in order to call the bond (it is
often set equal to the par value plus 1 year’s interest)
Call Price = FV + Call Premium
N = Call year

Example
Consider a callable bond that has a face value of $1,000 and pays a semiannual
coupon of 10%. The bond is currently priced at $1,175 and has the option to be
called at $1,100 five years from now. Note that the remaining years until maturity
does not matter for this calculation.
Data: Po = $1,175, FV = $1,000, Call Price =$1,100, N = 5 years, CR = 10%,
YTC = ?

At 5%

[ ]
1
1−
PO =Coupon payment
(1+YTC ) N
YTC [
+ Call Price
1
(1+YTC )
N
]
[ ]
1
1−
1175=$ 100/2
(1+0.05/2)5∗2
0.05/2
+ $ 1100
1
(1+ 0.05/2)[
5∗2
]
[ ]
1
1−
PO =$ 50
1.280
0.025
+ $ 1100
1
1.280 [ ]
PO =$ 50
[ 1−0.7812
0.025 ]
+ $ 1100 [ 0.7812 ]

PO =$ 50
[ 0.218
0.025 ]
+ $ 859.32

PO =$ 50 [ 8.725 ] + $ 859.32
PO =$ 436.25+ $ 859.32
PO =$ 1295.57
At 10%

[ ]
1
1−
1175=$ 100/2
(1+0.1/2)5∗2
0.1/2
+ $ 1100
[ 1
(1+ 0.1/2)
5∗2
]
[ ]
1
1−
PO =$ 50
1.628
0.05
+ $ 1100
1
1.628 [ ]
PO =$ 80
[ 1−0.6142
0.05 ]
+ $ 1100 [ 0.6142 ]

PO =$ 80
[ 0.3857
0.05 ]
+ $ 675.62

PO =$ 80 [ 7.714 ] ++ $ 675.62
PO =$ 385.7 +$ 675.62
PO =$ 1061

Interpolation

[[ ] ]
0.05 $ 1295.57
a X YTC $ 1175 b c
0.10 $ 1061

X b
=
a c
X $ 120.57
=
0.05 $ 234.57
0.05× $ 120.57
X= =0.025
$ 234.57
YTC =0.05+ X
YTC =0.05+0.025 = 0.075 = 7.5%

YTC =¿ 7.5%

Current Yield (CY)

Unlike the yield to maturity, the current yield does not represent the rate of return
that investors should expect on the bond. The current yield provides information
regarding the amount of cash income that a bond will generate in a given year, but
it does not provide an accurate measure of the bond’s total expected return, the
yield to maturity.
Annual Interest /coupon
Current Yield= x 100
Current Bond Price

Example
If MicroDrive’s bonds with a 10% coupon were currently selling at $985, then the
bond’s current yield would be
Annual Coupon Payment =Face Value∗Coupon Rate
$ 100
CY = x 100=0.1015 x 100=10.15 %
$ 985