LECTURE 2

BOND VALUATION

Ming Liu
International University of Japan
 Learning Objectives
• Review the basic characteristics of a bond
• Discuss common provisions in a bond
indenture
• Value fixed-coupon bonds, zero-coupon
bonds, perpetual bonds
• Discuss the use of bond ratings to assess a
bond’s default risk
• Discuss the determinants of bond yield

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 What is a bond?
• Long-term debt security issued/sold by an entity (issuer)
to raise funds
• Issuer
– Firm (corporate bond), municipality (Municipal bonds), or
national government (Treasury bonds & notes)
– Promises future payments to the bond investor
– Future payments: interest payments &/or principal repayment
• Issuer promises to pay interest (coupon) payments periodically
and par value (principal) at maturity.

• Interest payments tax deductible in the U.S.

• If issuer fails to make promised payments, creditors can
seize the firm’s assets

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 Bond indenture
• Written agreement between bond issuer and
bond holder describing details of the debt issue
• Indenture can include the following:
– Collateral
– Seniority
– Sinking fund
– Call provision
– Protective covenants
– Convertibility provision

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 U.S. Bond Outstanding in 2017 Q3 =
$40.27 Trillion
Money Markets Federal Asset-Backed
2% Agency 4%
Securities
Municipal
5%
9%

Corporate Debt
22% Treasury
35%

Mortgage Related
23%
• Source: www.sifma.org

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Size of the stock markets as of December
2017
Market Capitalization
Exchanges
(USD Trillions)
NYSE $19.60
NASDAQ $8.13
Japan Exchange Group $5.12
Shanghai Stock Exchange $4.27
London SE Group $3.61
Euronext $3.49
Hong Kong Stock Exchange $3.37

Source: www.world-exchanges.org
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Size of the financial market in Japan

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 Yield to maturity (YTM)
• The discount rate that equates the present value of
a bond’s payments (interest & principal payments)
to its price.
• It is the compound rate of return that will be
earned over a bond’s life if
– It is bought now and held until maturity
– All coupons are reinvested at the same YTM.
• Usually stated as an annual percentage rate
• Used as required rate of return / cost of debt

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 Fixed-coupon bond (FCB)
• Issuer pays a fixed interest payment (‘coupon’) to
the investor every period until bond matures.
• At maturity, firm pays principal amount (face value/
par value) of the bond to investor.
• For corporate bonds, face value is usually $1,000.
Assume this to be so, unless otherwise stated.
• Coupons can be paid annually, semi-annually,
quarterly
• Coupon rate: annual coupon payment divided by
bond’s face value.
• Current yield: annual coupon payment divided by
bond’s price
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 FCB valuation
• FCB gives you a stream of fixed payments plus a
single payment (face value) at maturity.
• This cash flow stream is just an annuity plus a
single cash flow at maturity.
• Therefore, we calculate the value of a FCB by
adding the PV of the coupons (annuity) and the
PV of the face value (lump sum)

FCB value = PV of coupons + PV of face value

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 Find FCB price
• A $1,000 par value, semi-annual payment
bond has a coupon rate of 5%. The bond
matures in 20 years and has a required rate
of return of 10%. Compute the current price
of this bond.
– Excel function: PRICE, YIELD

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 Useful property
Go back to the bond in the last problem.
Suppose annual coupon rate = 10%.
Verify that price = $1000 = par value

Suppose annual coupon rate = 12%

Verify that price = $1,171.59 > par value.

• It turns out that the following property is true.

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Coupon rate < discount rate Price < face value Bond is
selling at a
discount

Coupon rate = discount rate Price = face value Bond is

selling at par

Coupon rate > discount rate Price > face value Bond is
selling at a
premium

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 Apply what we learnt
A 10-year annual coupon bond was issued four
years ago at par. Since then the bond’s yield to
maturity (YTM) has decreased from 9% to 7%.
Which of the following statements is true about
the current market price of the bond?
A.The bond is selling at a discount
B. The bond is selling at par
C. The bond is selling at a premium
D.The bond is selling at book value
E. Insufficient information

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 Find YTM, Coupon rate
1)A $1,000 par value bond sells for $863.05. It matures in 20
years, has a 10 percent coupon rate, and pays interest semi-
annually. What is the bond’s yield to maturity on a per annum
basis (to 2 decimal places)?
Verify that YTM = 11.80%

2) ABC Inc. just issued a twenty-year semi-annual coupon bond

at a price of $787.39. The face value of the bond is $1,000,
and the market interest rate is 9%. What is the annual coupon
rate (in percent, to 2 decimal places)? What is the current
yield?
Verify that annual coupon rate = 6.69%,
current yield = 8.50%
What happens if bond pays coupon annually? Quarterly?

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 Zero-coupon bond (ZCB)
• Zero coupon rate, no coupon paid during bond’s
life.
• Bond holder receives principal repayment (face
value) at maturity

ZCB value = Face value/(1+r)t

• r : discount rate / required rate of return / YTM

• t : number of periods till maturity

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These problems are just basic TVM problems where you receive a single
cash flow in the future.

ZCB Problems
1) Find the price of a ZCB with 20 years to
maturity, par value of $1000 and a required
rate of return of 15% p.a.
N=40, I/Y=7.5, FV=1000, PMT=0. Price = $55.42
2) XYZ Corp.’s ZCB has a market price of $ 354.
The bond has 16 years to maturity and its
face value is $1000. What is the cost of debt
for the ZCB (i.e., the required rate of return).
PV=-354, FV=1000, N=32, PMT=0.
Required rate of return/ Cost of debt =6.60% p.a.

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 Perpetual bond/ Consol
• Pays a fixed coupon every period forever.
• Has no maturity.
• Investor who buys a consol is buying the perpetuity of
the fixed coupon.
• Use PV formula of a perpetuity to find the present
value/price of the consol

Consol value = fixed coupon / r

• r : discount rate / required rate of return / YTM

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 Consol problem
• ABC Corp. wants to issue perpetual debt in order to
raise capital. It plans to pay a coupon of $90 per
year on each bond with face value $1,000. Consols
of a comparable firm with a coupon of $100 per
year are selling at $1,050.

1. What is the discount rate for ABC consols?

2. What is the price at which it will issue its consols?
3. How many consols must ABC sell to raise $100m?

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The negative relation between bond
price and discount rate

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 Risks Associated with Bond
• Market Risk, or interest rate risk : Change in price due to
changes in interest rates
– All other things being equal, long-term bonds have more price risk
than short-term bonds
– All other things being equal, low coupon rate bonds have more price
risk than high coupon rate bonds

• Reinvestment Rate Risk : Uncertainty concerning rates at

which interim cash flows (coupons) can be reinvested
– All other things being equal, high coupon rate bonds have more
reinvestment rate risk than low coupon rate bonds
– All other things being equal, long-term bonds have more reinvestment
rate risk than short-term bonds

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 Inflation and Interest Rates
• Real rate of interest – change in purchasing power
• Nominal rate of interest – quoted rate of interest,
change in actual number of dollars
• The ex ante nominal rate of interest includes our
desired 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 = nominal rate
 r = real rate
 h = expected inflation rate
• Approximation
 R=r+h
 Example
 If we require a 10% real return and we expect inflation to
be 8%, what is the nominal rate?

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Term Structure of Interest Rates
• Term structure is the relationship between time
to maturity and yields, all else equal
• It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
• Yield curve – graphical representation of the
term structure
– Normal shape – upward-sloping; long-term yields are
higher than short-term yields
– Inverted shape – downward-sloping; long-term yields
are lower than short-term yields

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Upward-Sloping Yield Curve

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Downward-Sloping Yield Curve

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 Put everything together – what
determines bond yield?
• Debt securities have different yields because
they have different characteristics.

1. Real rate of interest

2. Interest rate risk
3. Expected future inflation
4. Credit (default) risk
5. Tax status
6. Liquidity

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Credit (default) risk & bond ratings
• Key concern for bond investors
• Uncertainty in cash flows arising from the
possibility that the issuer fails to make
promised payments, i.e., will default
• One popular way of measuring default risk is
to use bond ratings assigned by credit rating
agencies
– The higher the rating, the lower the perceived
default risk
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Well-known credit rating agencies
• Moody’s
• Standard & Poor’s (S&P for short)
• Fitch
– Different rating agencies can assign different
ratings to the same bonds. Differences are
usually small.

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 Bond ratings
Ratings Assigned by:
Description of Security Moody’s Standard and
Poor’s
Highest quality Aaa AAA
High quality Aa AA
High-medium quality A A
Medium quality Baa BBB
Medium-low quality Ba BB
Low quality (speculative) B B
Poor quality Caa CCC
Very poor quality Ca CC
Lowest quality (in default) C DDD, D
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 Investment vs. Speculative
• Investment-grade bonds
– Baa or better (Moody’s)
– BBB or better (S&P)

• Speculative-grade / junk bonds

– Ratings below Baa or BBB

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 Tax status
• Investors are more concerned with after-tax
income than before-tax income earned on
debt securities.
• Other things being equal, taxable securities
have to offer a higher before-tax yield than
tax-exempt securities to be preferred.
– Extra yield depends on investors’ tax rates.

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 After-tax yield
Yat = Ybt (1 – T)
• Yat = after-tax yield
• Ybt = before-tax yield
• T = investor’s marginal tax rate

• Investors retain only a percentage (1 – T) of

the before-tax yield once taxes are paid.

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 After-tax Problem
• Consider a taxable security that offers a
before-tax yield of 14 percent. If your
marginal tax rate is 20 percent, what is the
after-tax yield to you?

• Verify that the after-tax yield is 11.2%.

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 Liquidity
• A liquid security is one that can be easily converted into cash
without a loss in value.
• Liquidity is a desirable characteristic.
– Investors prefer a security with higher liquidity to a security with
lower liquidity.
• Other things being equal, a security with lower liquidity has
to offer a higher yield to be preferred.
• Liquid securities are those with:
– Short maturities
– Active secondary markets

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 Estimating a debt security’s yield (1)

• Start with the risk-free rate for the bond’s maturity.

– This is usually the yield on a Treasury security with the
same maturity.
• Make adjustments to this risk-free rate to capture
various characteristics (“yield spread”).
– Control for the effect of maturity by matching the
Treasury security’s maturity to that of the debt security.

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 Bond yield - example
• Suppose that the three-month T-bill’s annualized rate is 8% and
Elizabeth Company plans to issue 90-day commercial paper. The
federal tax status of commercial paper is the same as for T-bills.
However Income earned from investing in commercial paper is
subject to state taxes, while income earned from investing in T-
bills is not.
• Elizabeth Co. believes that a 0.7% default premium, a 0.2%
liquidity premium and a 0.3% tax adjustment are necessary to sell
its commercial paper to investors.

• Calculate the before-tax yield of the commercial paper.

• Verify that the before-tax yield is 9.2%.

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For next week
• Recommended exercise for Ch. 8:
1, 2, 3, 5, 10, 14, 20, 24

• Read Ch. 9 (stock valuation) and Ch. 10 (Risk

and Return)

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