CHAPTER 7

Bonds and Their


Valuation
Key features of bonds
 Bond valuation
 Measuring yield
 Assessing risk

7-1
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.

7-2
Bond markets

 Primarily traded in the over-the-

counter (OTC) market.
 Most bonds are owned by and traded
among large financial institutions.
 Full information on bond trades in the
OTC market is not published, but a
representative group of bonds is listed
and traded on the bond division of the
NYSE.

7-3
 Key Features of a Bond
 Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
 Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply
by par 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
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.

7-5
What is a sinking fund?
 Provision to pay off a loan over its life rather
than all at maturity.
 Similar to amortization on a term loan.
 Reduces risk to investor, shortens average
maturity.
 But not good for investors if rates decline after
issuance.

7-6
How are sinking funds
executed?
 Call x% of the issue at par, for sinking fund purposes.
 Likely to be used if kd is below the coupon rate and the
bond sells at a premium.
 Buy bonds in the open market.
 Likely to be used if kd is above the coupon rate and the
bond sells at a discount.

7-7
 The value of financial assets

0 1 2 n
k ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value  1
 2
 ...  n
(1  k) (1  k) (1  k)

7-8
 Other types (features) of
bonds
 Convertible bond – may be exchanged for
common stock of the firm, at the holder’s
option.
 Warrant – long-term option to buy a stated
number of shares of common stock at a
specified price.
 Callable bond – allows holder to sell the bond
back to the company prior to maturity.
 Income bond – pays interest only when interest
is earned by the firm.
 Indexed bond – interest rate paid is based
upon the rate of inflation.
7-9
What is the opportunity cost of
debt capital?

 The discount rate (ki ) is the opportunity cost of capital, and is the
rate that could be earned on alternative investments of equal risk.

ki = k* + IP + MRP + DRP + LP

7-10
 What is the value of a 10-year, 10%
annual coupon bond, if kd = 10%?

0 1 2 n
k ...
VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB  1
 ...  10

(1.10) (1.10) (1.10)10
V  $90.91  ...  $38.55  $385.54
B
VB  $1,000

7-11
Using a financial
calculator to value a bond
 This bond has a $1,000 lump sum due at t = 10,
and annual $100 coupon payments beginning at
t = 1 and continuing through t = 10, the price of
the bond can be found by solving for the PV of
these cash flows.

INPUTS 10 10 100 1000

N I/YR PV PMT FV
OUTPUT -1000

7-12
An example:
Increasing inflation and kd
 Suppose inflation rises by 3%, causing kd =
13%. When kd rises above the coupon rate,
the bond’s value falls below par, and sells at
a discount.

INPUTS 10 13 100 1000

N I/YR PV PMT FV
OUTPUT -837.21

7-13
An example:
Decreasing inflation and kd
 Suppose inflation falls by 3%, causing kd =
7%. When kd falls below the coupon rate,
the bond’s value rises above par, and sells
at a premium.

INPUTS 10 7 100 1000

N I/YR PV PMT FV
OUTPUT -1210.71

7-14
 The price path of a bond

 What would happen to the value of this bond if

its required rate of return remained at 10%, or
VB
at 13%, or at 7% until maturity?

1,372 kd = 7%.
1,211
kd = 10%.
1,000
837
775 kd = 13%.
Years
to Maturity
30 25 20 15 10 5 0
7-15
Bond values over time

 At maturity, the value of any bond must

equal its par value.
 If kd remains constant:
 The value of a premium bond would decrease over time, until it
reached $1,000.
 The value of a discount bond would increase over time, until it reached
$1,000.
 A value of a par bond stays at $1,000.

7-16
What is the YTM on a 10-year, 9% annual
coupon, $1,000 par value bond, selling for
$887?

 Must find the kd that solves this model.

INT INT M
VB  1
 ...  N

(1  k d ) (1  k d ) (1  k d )N
90 90 1,000
$887  1
 ...  10

(1  k d ) (1  k d ) (1  k d )10

7-17
Using a financial calculator to
find YTM

 Solving for I/YR, the YTM of this bond is

10.91%. This bond sells at a discount,
because YTM > coupon rate.

INPUTS 10 - 887 90 1000

N I/YR PV PMT FV
OUTPUT 10.91

7-18
Find YTM, if the bond price was
$1,134.20.

 Solving for I/YR, the YTM of this bond is

7.08%. This bond sells at a premium,
because YTM < coupon rate.

INPUTS 10 -1134.2 90 1000

N I/YR PV PMT FV
OUTPUT 7.08

7-19
Definitions

Annual coupon payment

Current yield (CY) 
Current price

Change in price
Capital gains yield (CGY) 
Beginning price

 Expected   Expected 
Expected total return  YTM      
 CY   CGY 
7-20
An example:
Current and capital gains yield
 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.

Current yield = $90 / $887

= 0.1015 = 10.15%

7-21
Calculating capital gains yield

YTM = Current yield + Capital gains yield

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.

7-22
What is interest rate (or
price) risk?
 Interest rate risk is the concern that rising kd
will cause the value of a bond to fall.

% change 1 yr kd 10yr % change

+4.8% $1,048 5% $1,386 +38.6%
$1,000 10% $1,000
-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to interest

rate changes, and hence has more interest rate
risk.
7-23
What is reinvestment rate
risk?
 Reinvestment rate risk is the concern that
kd will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.

EXAMPLE: Suppose you just won

$500,000 playing the lottery. You
intend to invest the money and
live off the interest.

7-24
Reinvestment rate 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 $50,000 in income
and have $500,000 to reinvest. But, if 1-
year rates fall to 3%, your annual income
would fall to $15,000.
 If you choose the 10-year bond strategy:
 You can lock in a 10% interest rate, and
$50,000 annual income.

7-25
 Conclusions about interest rate and
reinvestment rate risk

Short-term AND/OR Long-term AND/OR

High coupon bonds Low coupon bonds
Interest
Low High
rate risk
Reinvestment
High Low
rate risk

 CONCLUSION: Nothing is riskless!

7-26
 Semiannual bonds

1. Multiply years by 2 : number of periods = 2n.

2. Divide nominal rate by 2 : periodic rate (I/YR) =
kd / 2.
3. Divide annual coupon by 2 : PMT = ann cpn / 2.

INPUTS 2n kd / 2 OK cpn / 2 OK
N I/YR PV PMT FV
OUTPUT

7-27
 What is the value of a 10-year, 10%
semiannual coupon bond, if kd = 13%?

1. Multiply years by 2 : N = 2 * 10 = 20.

2. Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.
3. Divide annual coupon by 2 : PMT = 100 / 2 = 50.

INPUTS 20 6.5 50 1000

N I/YR PV PMT FV
OUTPUT - 834.72

7-28
 Would you prefer to buy a 10-year, 10%
annual coupon bond or a 10-year, 10%
semiannual coupon bond, all else equal?
The semiannual bond’s effective rate is:
10.25% > 10% (the annual bond’s effective rate), so you would prefer the
semiannual bond.

m 2
 i Nom   0.10 
EFF%  1    1  1    1  10.25%
 m   2 

7-29
If the proper price for this semiannual bond is
$1,000, what would be the proper price for
the annual coupon bond?

 The semiannual coupon bond has an

effective rate of 10.25%, and the annual
coupon bond should earn the same EAR. At
these prices, the annual and semiannual
coupon bonds are in equilibrium, as they
earn the same effective return.

INPUTS 10 10.25 100 1000

N I/YR PV PMT FV
OUTPUT - 984.80
7-30
A 10-year, 10% semiannual coupon bond selling for
$1,135.90 can be called in 4 years for $1,050,
what is its yield to call (YTC)?

 The bond’s yield to maturity can be

determined to be 8%. 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.

INPUTS 8 - 1135.90 50 1050

N I/YR PV PMT FV
OUTPUT 3.568

7-31
Yield to call

 3.568% represents the periodic semiannual yield to call.

 YTCNOM = kNOM = 3.568% x 2 = 7.137% is the rate that a
broker would quote.
 The effective yield to call can be calculated
 YTCEFF = (1.03568)2 – 1 = 7.26%

7-32
If you bought these callable bonds, would
you be more likely to earn the YTM or YTC?

 The coupon rate = 10% compared to YTC =

7.137%. The firm could raise money by
selling new bonds which pay 7.137%.
 Could replace bonds paying $100 per year
with bonds paying only $71.37 per year.
 Investors should expect a call, and to
earn the YTC of 7.137%, rather than the
YTM of 8%.

7-33
When is a call more likely to
occur?
 In general, if a bond sells at a premium, then (1)
coupon > kd, so (2) a call is more likely.
 So, expect to earn:
 YTC on premium bonds.
 YTM on par & discount bonds.

7-34
Default risk

 If an issuer defaults, investors receive less than the promised

return. Therefore, the expected return on corporate and
municipal bonds is less than the promised return.
 Influenced by the issuer’s financial strength and the terms of the
bond contract.

7-35
Types of bonds

 Mortgage bonds
 Debentures
 Subordinated debentures
 Investment-grade bonds
 Junk bonds

7-36
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 D

 Bondratings are designed to reflect the

probability of a bond issue going into
default.

7-37
Factors affecting default risk
and bond ratings
 Financial performance
 Debt ratio
 TIE ratio
 Current ratio
 Bond contract provisions
 Secured vs. Unsecured debt
 Senior vs. subordinated debt
 Guarantee and sinking fund provisions
 Debt maturity

7-38
Other factors affecting
default risk
 Earnings stability
 Regulatory environment
 Potential antitrust or product liabilities
 Pension liabilities
 Potential labor problems
 Accounting policies

7-39
Bankruptcy

 Two main chapters of the Federal Bankruptcy Act:

 Chapter 11, Reorganization
 Chapter 7, Liquidation
 Typically, a company wants Chapter 11, while creditors may prefer
Chapter 7.

7-40
Chapter 11 Bankruptcy

 If company can’t meet its obligations …

 It files under Chapter 11 to stop creditors from
foreclosing, taking assets, and closing the business.
 Has 120 days to file a reorganization plan.
 Court appoints a “trustee” to supervise
reorganization.
 Management usually stays in control.
 Company must demonstrate in its
reorganization plan that it is “worth
more alive than dead”.
 If not, judge will order liquidation under Chapter 7.

7-41
Priority of claims in
liquidation
1. Secured creditors from sales of secured assets.
2. Trustee’s costs
3. Wages, subject to limits
4. Taxes
5. Unfunded pension liabilities
6. Unsecured creditors
7. Preferred stock
8. Common stock

7-42
Reorganization

 In a liquidation, unsecured creditors

generally get zero. This makes them more
willing to participate in reorganization even
though their claims are greatly scaled back.
 Various groups of creditors vote on the
reorganization plan. If both the majority of
the creditors and the judge approve,
company “emerges” from bankruptcy with
lower debts, reduced interest charges, and
a chance for success.

7-43