FINA2010 Financial Management

Lecture 6: Bond Valuation

Instructor: Prof. Jangwoo Lee

CUHK Business School

1
 Overview
Week Lecture No. Topic Reading / Notes
8Jan – 11Jan Lecture 1 Introduction Chapter 1
15Jan – 18Jan Lecture 2 Financial Statement Analysis Chapters 2, 3
22Jan – 25Jan Lecture 3 Time Value of Money Chapter 5, 6
Chapter 9 /Assignment 1
29Jan – 1Feb Lecture 4 Capital Budgeting I
Due (Thursday)
5Feb – 8Feb Lecture 5 Capital Budgeting II Chapter 9
22Feb Midterm Exam
26Feb – 29Feb Lecture 6 Bond Valuation Chapter 7
11Mar – 14Mar Lecture 7 Stock Valuation Chapter 8
18Mar – 21Mar Lecture 8 Return and Risk I Chapter 12,13
25Mar – 28Mar Lecture 9 Return and Risk II Chapter 12,13
Chapter 13 / Assignment
8Apr – 11Apr Lecture 10 Mispricing and EMH
2 Due(Thursday)
15Apr – 18Apr Lecture 11 Review Class by the TAs + Final Exam (18Apr)

2
 Valuation Principle
• In finance, valuation involves computing
benefits/costs (the PV of future cash flows)
associated with a proposed asset or project.
𝑇
𝐶𝐹𝑡
𝑉𝑎𝑙𝑢𝑒 = ෍ ( 𝑡
)
1+𝑟
𝑡=1
𝑃𝑉 𝑜𝑓 𝐶𝐹𝑡
• We will now apply these principles to price
bonds.

3
 Outline
• Bond terminologies

• Determinants of bond yields

– Fisher effect

• Bond Valuation

4
 What is a Bond?
• A bond is a fixed-income security sold to raise
money from the public.

• Tom receives $100 1 year today

Tom Investors
(entrepreneur) (Jerry, Spike, etc)

• Tom gives a $110 bond due 1 year from today

5
 What is a Bond?
• Governments, municipalities and companies
can issue bonds.

• One who buys a corporate bond is a creditor

of the company, NOT an owner (unlike
stockholders who are owners).

6
 Bond Markets
• Most bonds are owned by and traded among
large financial institutions.

• Primarily traded in the over-the-counter (OTC)

market, with dealers connected electronically.

• Some bonds are ‘listed’ and traded on public

market exchanges.
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 Bond Market Information
• Extremely large number of bond issues, but
generally low daily volume in single issues.
• Makes getting up-to-date prices difficult,
particularly on small companies or municipal issues
• Treasury securities are the exception.
• Bond quotes are available online
– http://asianbondsonline.adb.org
– http://www.fundsupermart.com
– http://finra-markets.morningstar.com/BondCenter/

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Actual Bond…

9
 Some Basic Terminology
• Coupon: the stated interest payment made on a bond.
• Face value: the amount of a bond that is repaid at the end
of the term. Also called par value (usually 1,000 or 100).
• Coupon rate: the stated annual coupon interest rate of the
bond, equal to the annual coupon divided by the face
value of a bond.
• Maturity: the specified date on which the principal
amount of a bond is paid. Also refer to the lifetime itself.
– Unlike stocks, bonds have finite lifetimes.
• Yield to maturity (YTM): the rate required in the market
on a bond. Also called the bond’s yield.

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 More Bond Terminology
• Basis points: a unit of measure, used to
express yields or interest rates. Most often
used to express differences between yields.
The basis point unit is one-hundredth of one
percentage point (1 bps = 0.01% = 0.0001).
– E.g., if a bond begins with a yield of 5.5% and the
yield increases over time to 5.62%, the increase is
12 basis points (0.12%).

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 An Extreme Example: Zero-Coupon Bond

• A zero-coupon bond is a special bond that

pays no periodic interest until the maturity
date, when you receive the face value of the
bond.

• Also called zeroes, deep discount bonds, or

original issue discount bonds (OIDs).

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 Zero Coupon Bonds
• A zero-coupon bond with 1-year maturity and $1000 face value?

0 1 2 3 4 5 Year

Coupon =$0
Face Value =$1000

• A zero-coupon bond with 5-year maturity and $100 face value?

0 1 2 3 4 5 Year

$0 $0 $0 $0 $0
$100

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 Bond Terminologies in Timeline
• Let’s consider a bond with a 5-year maturity.
0 1 2 3 4 5 Year

Coupon Coupon Coupon Coupon Coupon

Face Value

• Coupon rate: Coupon / (Bond Face Value)

𝐶𝐹𝑡
• The market price of the bond = σ1≤𝑡≤5 ( )
1+𝑦𝑖𝑒𝑙𝑑 𝑡
• Bond value = PV of coupons + PV of face value
• As interest rates (yield) increase, present values
decrease.
• So, as interest rates increase, bond prices decrease and
vice versa. 14
Putting the Main Bond Characteristics Together

• If you buy a bond, the issuer (i.e., the borrower)

promises to pay you back:
– The “par value” (assume $1,000) on a particular day
(the “maturity date”), and
– Periodic “coupons” at a predetermined rate of interest
based on the stated “coupon rate” and the number of
coupon payments per year.
• As a creditor/lender, your cash flows to be
received will be the par value and the periodic
coupon payments.

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 Outline
• Bond terminologies

• Determinants of bond yields

– Fisher effect

• Bond Valuation

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U.S. Nominal Interest Rates: 1800 – 2013

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 Inflation and Interest Rates
• Real rate of interest: rate reflecting the real
increase in change in purchasing power of $
invested.
• Nominal rate of interest: quoted rate of
interest, reflects actual money increase versus
money invested.
• The ex ante nominal rate of interest includes
our real rate of return plus an adjustment for
expected inflation.

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 The Fisher Effect
• The Fisher Effect defines the relationship between real
rates, nominal rates, and inflation
1 + 𝑅 = (1 + 𝑟) × (1 + ℎ)
– where R is nominal rate
– r is real rate
– h is expected inflation rate
• Approximation: 𝑅 ≈ 𝑟 + ℎ
• Financial rates, such as interest rates, discount rates, and
rates of return, are almost always quoted in nominal
terms.
• Principle on PV calculations: either discount nominal cash
flows at a nominal rate or discount real cash flows at a
real rate.
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 Example: The Fisher Effect
• If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
• 𝑅 = 1 + 𝑟 × 1 + ℎ − 1 = 1 + 0.1 ×
1 + 0.08 − 1 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because the real return and expected inflation
are relatively high, there is significant
difference between the actual Fisher Effect
and the approximation.
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 Quick Review MCQ
• The outstanding bonds of Winter Time Products
provide a real rate of return of 3.03 percent. The
current rate of inflation is 4.68 percent. What is
the actual nominal rate of return on these
bonds?
• A. 7.58 percent
• B. 7.33 percent
• C. 7.71 percent
• D. 7.76 percent
• E. 7.85 percent

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Other Factors Affecting Bond Yields
• Treasury notes and bonds are default-free,
taxable, and highly liquid. When we look at bonds
issued by corporations or municipalities, we
should also consider:
• Default risk premium: the compensation for
possibility of default.
• Taxability premium: the compensation for
unfavorable tax status.
• Liquidity premium: the compensation for lack of
liquidity.
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 Bond Ratings
Moody S&P Safety
Aaa AAA Extremely strong capacity to pay interest and principal
Grade Bonds
Investment

Aa AA Very strong capacity to pay interest and repay principal

A A Strong capacity to pay interest and repay principal
Baa BBB Adequate capacity to pay interest and repay principal
Ba; B BB; B Predominantly speculative w.r.t. capacity to pay interest
Speculative/Junk

Caa CCC and repay principal. Although such debt is likely to have
some quality and protective characteristics, these are
Bonds

Ca CC outweighed by large uncertainties or major risk

exposures to adverse conditions. Issues rated C by
C C
Moody’s are typically in default.
D Default

• The debt ratings are an assessment of the creditworthiness of the

corporate issuer.
• If a bond has a higher rating, it is considered to be safer. So interest rates
are lower. 23
 Government Bonds
• Treasury Securities: debt of Federal government
– T-bills: pure discount bonds (zero-coupon bonds) with original
maturity of one year or less
– T-notes: coupon debt with original maturity between one and
ten years
– T-bonds: coupon debt with original maturity greater than ten
years
– U.S. Treasury issues have no default risk.
– Interest received is tax-exempt at the state level (not federal
level).
• Municipal Securities: debt of state and local governments
– Varying degrees of default risk, rated similar to corporate debt
– Interest received is tax-exempt at the federal level (not
necessarily state level).

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 Government Bond VS. Taxable Bond
• A taxable bond has a yield of 8% and a non-taxable
municipal government bond has a yield of 6%.
• If you are in a 40% tax bracket, which bond do you
prefer?
– 8% × (1 − 0.4) = 4.8%
– The after-tax return on the corporate bond is 4.8%, less
than 6% return on the municipal, hence prefer municipal
• At what tax rate would you be indifferent between the
two bonds?
– 8% × (1 – T) = 6%
→ T = 25%

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 Outline
• Bond terminologies

• Determinants of bond yields

– Fisher effect

• Bond Valuation

26
 The Bond Pricing Equation
1− 1/(1+𝑟)𝑡 𝐹
• 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 (1+𝑟)𝑡

PV of the coupons PV of the

face value
– where 𝐶 is the coupon paid per period
– 𝐹 is the face value paid at maturity
– 𝑟 is the yield to maturity (market interest rate) per
period
– 𝑡 is the number of periods

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 Yield to Maturity (YTM)
• The rate earned if a bond is held to maturity
• The rate which discounts all future bond cash
flows to their current value (price)
• The ‘market’ rate for the bond, i.e., the
interest rate required in the market on the
bond
• YTM, required return, and market rate are
used interchangeably.

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 Example: Valuation of a Bond
• Suppose the Star Co. were to issue a bond with 10
years to maturity. The Star bond has an annual
coupon of $80 and $1,000 face value. Similar bonds
have a yield to maturity of 8 percent. What would
this bond sell for?

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 Example: Valuation of a Bond
1− 1/(1+𝑟)𝑡 𝐹
• 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 (1+𝑟)𝑡
1−1/1.0810 1,000
= 80 × + = $1,000
0.08 1.0810
• The bond sells at its face value, as coupon rate =
YTM.
Inputs 10 8 80 1,000
N I/Y PV PMT FV
Compute −1,000
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 Example: Valuation of a Bond
• Suppose one year later, the interest rate in the
market has dropped to 6 percent.
0 1 2 3 4 5 6 7 8 9 10

$80 $80 $80 $80 $80 $80 $80 $80 $80

$1000

• Shift the timeline by one year…

0 1 2 3 4 5 6 7 8 9 10

$80 $80 $80 $80 $80 $80 $80 $80 $80

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$1000
 Example: Valuation of a Bond

Inputs 9 6 80 1,000
N I/Y PV PMT FV
Compute −1,136.03

• The bond sells for more than its face value (premium
bond), as coupon rate > YTM.

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 Example: Valuation of a Bond
• Suppose one year later, the interest rate in the
market has risen to 10 percent.

Inputs 9 10 80 1,000
N I/Y PV PMT FV
Compute −884.82

• The bond sells for less than its face value (discount
bond), as coupon rate < YTM.
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 Important! Coupon Rate ≠ YTM
• Coupon rates are based on initial contracts
– Coupon rates are determined when bonds are first
created
– 8% in the previous example

• Interest rates are determined in the bond

market
– 6% in the previous example

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 Relationship of YTM and Bond Prices
• As YTM increases, bond prices decrease and vice versa.
• The actual future change in bond prices could involve
both discounts and premiums depending on future
movements in market interest rates.
• Bond prices fluctuate as interest rates change, so a
bond can trade above or below the par value based on
what interest rates are.
• If you hold the bond to maturity, you won’t lose your
principal as long as the borrower doesn’t default.
• However, if you sell the bond before it matures, you
will have to sell it at the going rate, which may be
above or below par value.

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Graphical Relationship: YTM and Bond Prices

Long-term bond is
more sensitive to
changes in interest
rates.

The lower the coupon

rate, the greater the
interest rate risk
(why?)

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 Quick Review MCQ
• Which one of the following bonds is the least
sensitive to interest rate risk?
A. 3-year; 4 percent coupon
B. 3-year; 6 percent coupon
C. 5-year; 6 percent coupon
D. 7-year; 6 percent coupon
E. 7-year; 4 percent coupon

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 Current Yield
• Current yield is the annual coupon paid by a bond,
expressed as a percentage of its current market price.
• Weakness: not account for any capital gain or loss
associated with the principal to be paid at maturity.
• YTM includes not only the interest payments you will
receive all the way to maturity, but it also takes into
account any difference between the current par value of
the bond and the actual trading price of the bond at that
time.
• The actual use of current yields is limited.

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 Summary
• Example: 8% coupon bond, with annual coupons,
face value of $1,000, 10 years to maturity

Coupon Rate YTM Bond Price Current Yield

8% 8% $1,000 8% = 80/1,000
8% 10% $877.11 9.12% = 80/877.11
8% 6% $1,147.2 6.97% = 80/1,147.2

• Par value bond: Coupon Rate = Current Yield = YTM

• Discount bond: Coupon Rate < Current Yield < YTM
• Premium bond: Coupon Rate > Current Yield > YTM
39
 Summary
• Determining bond prices and yields is an
application of basic discounted cash flow
principles.
• Almost all bond trading is OTC, with little or no
market transparency in many cases.
• Bond yields and interest rates reflect the real
interest rate, inflation, interest rate risk,
default risk, taxability, and lack of liquidity.

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 Quick Review MCQ
• Suppose the following bond quote for the Beta Company appears in
the financial page of today's newspaper. Assume the bond has a
face value of $100 and the current date is April 15, 2009. What is
the yield to maturity (quoted at APR) on this bond ?
*Assume semi-annual coupon payments. You don’t have to know “EST
spread / UST” to solve this question

• A. 6.64 percent
• B. 8.96 percent
• C. 10.23 percent
• D. 12.47 percent
• E. 13.27 percent

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 Quick Review MCQ
• All else constant, a bond will sell at _____
when the coupon rate is _____ the yield to
maturity.
A. a premium; less than
B. a premium; equal to
C. a discount; less than
D. a discount; higher than
E. par; less than

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 Quick Review MCQ
• A zero-coupon bond has a yield to maturity of 9.26
percent and 8 years until it fully matures. What is the
current price of this bond if the face value is $1,000?
Assume semiannual compounding.
A. $458.80
B. $471.20
C. $484.73
D. $503.72
E. $625.34
1− 1/(1+𝑟)𝑡 𝐹
• Answer: 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × + =
𝑟 (1+𝑟)𝑡
1,000
= $484.73 as C = 0
(1+0.0926/2)8×2

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