Lecture 07A Valuation of Bonds The value of any asset is given by the present value of the expected cash

h flows received from that asset during the holding period. This means that to value any asset the investor needs an estimate of: An estimate of the cash flows. The timing of the cash flows (for time value purposes). The opportunity cost of funds or discount rate. The difficulty in valuing different types of assets is related principally to the ease with which the different pieces of information are known prior to purchasing these assets. For example, bonds are easier to value than common stock because bonds promise specific payments at specific times. This means that the expected cash flows and their timing are known. Common stock on the other hand makes no explicit promise to pay anything. So neither the expected cash flows nor their timing is known ahead of time. Bonds have two types of cash flows, periodic interest payments, and the face value at maturity. Bond Valuation: The value of a bond is equal to the present value of its future cash flows, discounted at the rate of return the financial markets expect for the risk of the bond. Where P = Price of the bond C = Coupon (Annual) R = Yield or Discount Rate N = Number of periods to Maturity M = Face Value of the Bond. The value of the bond is given by:
P=

(1 + R )

C1

+ .... +

(1 + R )

CN

(1 + R ) N

Since the coupon payments are the same each year, they could be treated as an annuity. Thus the value of a bond could also be written as: P = C (PVIFAR,N) + M (PVIFR,N) Consider an 8% coupon, 10 year bond with $1000 face value. What would be its value today?

We know that this bond will make interest payments of $80 per year, and will pay $1000 at the end of year ten. The value however depends on the market rate, or the discount rate. If the discount rate is 10%, the value of this bond is P = 80(PVIFA10,10) + 1000(PVIF10,10) P = 80(6.1446) + 1000(.3855) = 877.07 If the discount rate is 5%, the value of the bond is P = 80(PVIFA
5,10

) + 1000(PVIF5,10) = 1,231.65.

At 8% discount the value of the bond is P = 80(PVIFA8,10) + 1000(PVIF8,10) = 1,000. Note: When the discount rate is greater than the coupon rate, the bond value is lower than the face value (it sells at a discount). When the discount rate is equal to the coupon rate, the bond sells at par (its face value). When the discount rate is less than the coupon rate, the bond sells at a premium (greater than its face value). Principles Bond prices move inversely to bond yields. Holding the coupon rate constant, for a given change in market yields, percentage changes in bond prices are greater, the longer the term to maturity. Consider two $1,000 bonds with 12% coupon rates. Bond A has 5 years to maturity, and B has 15 years. Assume they are both currently selling at par. Let rates change to 14%. PA = $931 PB = $877 The percentage price change described above increases at a decreasing rate as maturity increases.

Holding maturity constant and starting from the same market yield, equal yield changes up, or down do not result in equal percentage changes in prices. Price change effects are asymmetric with respect to changes in yield. Consider a $1,000, 12%, 8 year bond selling at par. If yield rises to 14% the price will fall to $907, a fall of 9.3%. If yield falls to 10% the price will rise to $1,107, an increase of 10.7%.

Holding maturity constant and starting from the same market yield, the higher the coupon rate, the smaller the percentage change in price for a given change in yield.

Implications: Changes in market interest rates will not affect all fixed income portfolios in the same way. In periods of high volatility, portfolios heavily invested in long-term securities have greater price fluctuations than portfolios concentrated on short-term securities. Portfolios heavy in low coupon instruments are more affected by changes in interest rates than portfolios of high coupon instruments.

Bond Yields: Suppose you were offered a 10 year, 8% annual coupon, $1,000 par value bond at a price of $877.07. What rate of interest would you earn on your investment if you bought the bond and held it to maturity? This is called the yield to maturity. We know that the value of a bond is given by:
P=

(1 + R )

C1

+ .... +

(1 + R )

CN

(1 + R ) N

Thus for our bond,

P = $877.07 =

(1 + k )

80

+ .... +

(1 + k )

80

10

(1 + k ) 10

1,000

It is possible to find k by trial and error. That will take too much time, so it is easier to use the smart machines. They will give us a value k = 10%.

As we shall see later, the yield to maturity is not the effective yield on a bond. You will only male 10% on this bond if you invest all the interim cash flows at 10%. We explore this below as we talk about interest rate risk. Interest Rate Risk is defined as the variation in returns caused by unexpected changes in interest rates. There are two components to interest rate risk. Price or Market Value Risk is the potential variation from unexpected changes in market prices of securities. Reinvestment Risk is the potential variation from unexpected changes in the rate at which intermediate cash flows can be reinvested. Consider a bond that currently sells at par (1,000) and has a 10% coupon rate with a 5 year maturity. Assume that you were investing in this bond in order to accumulate a sum of money at the end of 5 years. In other words, you will reinvest the coupon payments over the course of time. Your total accumulation at the end of 5 years will consist of the face value of the bond, the coupon payments, and the interest earned on the coupons. Case 1. The interest rate stays at 10% during the life of the bond. So you can invest the coupon payments at 10%. The total accumulated at the end of year 5 will be: Face value 1,000 Coupons plus reinvestment 610.51 Total 1,610.51 This produces a yield over five years of 10%. Case 2. Rates fall to 5% immediately after the bond was purchased and stay there for 5 years. The total accumulated at the end of 5 years will be: Face value 1,000 Coupons plus reinvestment 552.56 Total 1,552.56 This produces a yield over five years that is less than 10%. It is important to note that the bond is exposed to reinvestment risk even when it is not sold before maturity. As we see from the above principles, differences in the way interest rate risk affects securities will occur because of: types of instruments maturity size and timing of cash flows planned holding period relative to maturity of security.

Assignment It is now January 1, 2004, and you are considering the purchase of an outstanding RDC bond that was issued on January 1, 2002. The bond has a 9.5% annual coupon and a 30 year original maturity (it matures in December 31, 2031). There is a 5 year call protection (until December 31, 2006), after which time the bond can be called at 109 (that is, at 109 percent of par, or $1,090). Interest rates have declined since the bond was issued, and the bond is now selling at $116.75 percent of par, or $1,165.75. You want to determine both the yield to maturity and the yield to call for this bond. What is the yield to maturity in 2004 for the bond? What is the yield to call? If you bought this bond, which return do you think you would actually earn? Explain your reasoning. Suppose the bond had sold at a discount. Would the yield to maturity or yield to call have been more relevant?