Chapter 6

Bonds and Bond

Valuation




1. Understand basic bond terminology and apply the
time value of money equation in pricing bonds.
2. Understand the difference between annual and
semiannual bonds and note the key features of
zero-coupon bonds.
3. Explain the relationship between the coupon
rate and the yield to maturity (YTM).
4. Delineate bond ratings and why ratings affect
bond prices.
5. Appreciate bond history and understand the
rights and obligations of buyers and sellers of
bonds.
6. Price government bonds, notes, and bills.
Learning Objectives
6.1 Application of the Time Value of
Money Tool: Bond Pricing
Bonds - Long-term debt instruments (maturity -
over 1 year)
Provide periodic interest income annuity series
Return of the principal amount at maturity future
lump sum
Prices can be calculated by using present value
(PV) techniques i.e. discounting of future cash
flows.
Combination of PV of an annuity and of a lump
sum
Table 6.1 Bond Information on July 15, 2008
6.1 (A) Key Components of a Bond (continued):
Figure 6.1 Merrill Lynch corporate bond
Par value : Typically $1000
Coupon rate: Annual rate of
interest paid.
Coupon: Regular interest
payment received by holder
per year.
Maturity date: Expiration
date of bond when par value
is paid back.
Yield to maturity: Expected
rate of return based on
current market price of bond

6.1 (A) Key Components of a Bond (continued)
Example 1

Lets say you see the following price quote
for a corporate bond:

Issue Price Coupon(%) Maturity YTM% Current Yld. Rating
Hertz Corp. 91.50 6.35 15-Jun-2010 15.438 6.94 B

Price = 91.5% of $1000 $915;
Annual coupon = 6.35% *1000 $63.50
Maturity date = June 15, 2010;
If bought and held to maturity Yield = 15.438%
Current Yield = $ Coupon/Price = $63.5/$915 6.94%

6.1 (B) Pricing a Bond in Steps [Figure 6.2 ]

Since bonds involve a combination of an annuity
(coupons) and a lump sum (par value) its price
is best calculated by using the following steps:
6.1 (B) Pricing a Bond in Steps (continued):
Example 2
Calculate the price of an AA-rated, 20-year, 8% coupon
(paid annually) corporate bond (Par value = $1,000) which
is expected to earn a yield to maturity of 10%.





Annual coupon = Coupon rate * Par value
= .08 * $1,000 = $80 [+/-] [PMT]
YTM = r = 10% [I/Y]
Maturity = n = 20 [N]
Principal at maturity (par value) = FV = 1000 [+/-] [FV]
Price of bond = PV of coupons + PV of par value
= 681.08 + 148.64 = 829.72
CPT [PV] 829.72
Year 0 1
$80
2
$80
3
$80
20
$80
$1,000
18 19

$80 $80
Example 2: Calculating the price of a
corporate bond (continued)

Present value of coupons =




=


= $80 x 8.51359 = $681.09

Present Value of Par Value =

Present Value of Par Value =

Present Value of Par Value = $1,000 x 0.14864 = $148.64
Price of bond = $681.09 + $148.64
= $829.73

( )
|
|
|
|
.
|

\
|
+

r
r 1
1
1
PMT
n
( )
|
|
|
|
.
|

\
|
+

0.10
0.10 1
1
1
$80
20
( )
n
r 1
1
FV
+

( )
20
0.10 1
1
$1,000
+

Example 2: Calculating the price of a

corporate bond (continued)
Method 2. Using a financial calculator


Input: N I/Y PV PMT FV
Key: 20 10 ? -80 -1000
Output 829.73



Most corporate and government bonds pay coupons on a
semiannual basis.
Some companies issue zero-coupon bonds by selling them at
a deep discount.
For computing price of these bonds, the values of the inputs
have to be adjusted according to the frequency of the coupons
(or absence thereof).
For example, for semi-annual bonds, the annual coupon is
divided by 2, the number of years is multiplied by 2, and
the YTM is divided by 2.
The price of the bond can then be calculated by using the
TVM equation, a financial calculator, or a spreadsheet.

6.2 Semiannual Bonds and
Zero-Coupon Bonds



6.2 Semiannual Bond Example
Figure 6.4 Coca-Cola Semiannual Bond



.
6.2 Coca-Cola Semiannual Bonds at original issue
(continued)
Using TVM Equation:

8.8% YTM at original issue
Using Financial Calculator:

30 x 2 = 60 [N] 8.8 2 = 4.4 [I/Y] at original issue
85 2 = 42.50 [+/-] [PMT] 1000 [+/-] [FV]
CPT [PV] 968.48
Figure 6.5
Future cash
flow of the
Coca-Cola
bond

6.2 Semiannual Bonds and Zero-
Coupon Bonds (continued)

6.2 (A) Pricing Bonds after Original Issue
The price of a bond is. a function of the remaining cash flows
(i.e. coupons and par value) that would be paid on it until
expiration

As of August, 2008, the 8.5%, 2022 Coca-Cola bond has
only 27 coupons left to be paid on it until it matures on Feb. 1,
2022
Figure 6.6 Remaining cash flow of the Coca-Cola bond
EXAMPLE 3 - 6.2 (A) Pricing Bonds After Original Issue

Four years ago, the XYZ Corporation issued an 8% coupon
(paid semi-annually), 20-year, AA-rated bond at its par value of
$1000. Currently, the yield to maturity on these bonds is 10%.
Calculate the price of the bond today.

Remaining number of semi-annual coupons
= (20 - 4) * 2 = 32 coupons [N]

Semi-annual coupon = (.08*1000)/2 = $40 [+/-] [PMT]

Par value = $1000 = [+/-] [FV]

Annual YTM = 10% YTM/2 5% = [I/Y]
CPT [PV] 841.97

Input: N I/Y PV PMT FV
Key: 32 5 ? -40 -1000
Output 841.97




6.2 (A) Pricing Bonds after
Original Issue (continued)
Method 1: Using TVM equations
Bond Price =
( )
( )
|
|
|
|
.
|

\
|
+

+
+

r
r 1
1
1
Coupon
r 1
1
Value Par
n
n

Bond Price =
( )
( )
|
|
|
|
.
|

\
|
+

+
+

0.05
0.05 1
1
1
$40
0.05 1
1
$1,000
32
32

Bond Price = $1000 x 0.209866 + $40 x 15.80268
Bond Price = $209.866 + $632.107
Bond Price = $841.97
6.2 (A) Pricing Bonds after
Original Issue (continued)
Method 2: Using a financial calculator



Input: N I/Y PV PMT FV
Key: 32 5 ? -40 -1000
Output 841.97


6.2 (B) Zero-Coupon Bonds
Known as pure discount bonds and sold at
a discount from face value
Do not pay any interest over the life of the
bond.
At maturity, the investor receives the par
value, usually $1000.
Price of a zero-coupon bond is calculated by
merely discounting its par value at the
prevailing discount rate or yield to maturity.

6.2 (C) Amortization of a Three-Year Zero-
Coupon Bond w/ 8% Yield [Table 6.2]
The discount on a zero-coupon bond is amortized over its life.
Interest earned is calculated for each 6-month period.
for example .04*790.31=$31.62
Interest is added to price to compute the ending price.
Zero-coupon bond investors have to pay tax on annual price
appreciation even though no cash is received.
Example 4: Price of and taxes
due on a zero-coupon bond
John wants to buy a 20-year, AAA-rated, $1000
par value, zero-coupon bond being sold by
Diversified Industries Inc. The yield to maturity on
similar bonds is estimated to be 9%.

4A - How much would he have to pay for it (=
what is the reasonable price of this bond)?

4B - How much will he be taxed on the investment
after 1 year, if his marginal tax rate is
30%?
Example 4A Answer (continued)
Method 1: Using TVM equation
Bond Price = Par Value * [1/(1+r)
n
]
Bond Price = $1000*(1/(1.045)
40
Bond Price = $1000 * .1719287 = $171.93


Method 2: Using a financial calculator

Input: N I/Y PV PMT FV
Key: 40 4.5 ? 0 -1000
Output 171.93

Example 4B Answer (continued)
Calculate the price of the bond at the end of
first year.
19 x 2 = 38 remaining coupons
Input: N I/Y PV PMT FV
Key: 38 4.5 ? 0 -1000
Output 187.75


Taxable income = Price at the end of first year
price at the issue = $187.75 - $171.93
= $15.82

Taxes due = Tax rate * Taxable income
= 0.30*$15.82
= $4.75

Example 4B (Answer) (continued)
Alternately, we can calculate the semi-annual
interest earned, for each of the two semi-annual
periods during the year.
$171.93 * .045 = $7.736
$171.93+7.736 = $179.667 Price after 6 months
$179.667 * .045 = $8.084
$179.667+8.084 = $187.75 Price at end of year
Total interest income for 1 year
= $7.736 + $8.084 = $15.82
Tax due = 0.30 * $15.82 = $4.75
6.3 Yields and Coupon Rates
A bonds coupon rate differs from its yield
to maturity (YTM).
Coupon rate -- set by the company at the
time of issue and is fixed (except for newer
innovations which have variable coupon
rates)
YTM is dependent on market, economic,
and company-specific factors and is
therefore variable.

6.3 (A) The First Interest Rate:
Yield to Maturity
Expected rate of return on a bond if held to
maturity.
The price that willing buyers and sellers settle
at determines a bonds YTM at any given point.
Changes in economic conditions and risk factors
will cause bond prices and their corresponding
YTMs to change.
YTM can be calculated by entering the coupon
amount (PMT), price (PV), remaining number of
coupons (n), and par value (FV) into the TVM
equation, financial calculator, or spreadsheet.

6.3 (B) The Other Interest
Rate: Coupon Rate
The coupon rate on a bond is set by the
issuing company at the time of issue
It represents the annual rate of interest that
the firm is committed to pay over the life of
the bond.
If the rate is set at 7%, the firm is
committing to pay .07*$1000 = $70 per
year on each bond,
It is paid either in a single check or two
checks of $35 paid six months apart.
6.3 (C) Relationship of YTM and
Coupon Rate
An issuing firm gets the bond rated by a rating
agency such as Standard & Poors or Moodys.
Then, based on the rating and planned maturity
of the bond, it sets the coupon rate to equal the
expected yield as indicated in the Yield Book
(available in the capital markets at that time)
and sells the bond at par value ($1000).
Once issued, if investors expect a higher yield
on the bond, its price will go down and the
bond will sell below par or as a discount bond
and vice-versa.
Thus, a bonds YTM can be equal to (par
bond), higher than (discount bond) or lower
than (premium bond) its coupon rate.

6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
(continued)
Table 6.3 Premium Bonds, Discount Bonds, and
Par Value Bonds
6.3 (C) Relationship of Yield to
Maturity and Coupon Rate
(continued)
Figure 6.8 Bond prices and interest rates move in opposite
directions.
Example 5: Computing YTM
Last year, The ABC Corporation had issued 8%
coupon (semi-annual), 20-year, AA-rated
bonds (Par value = $1000) to finance its
business growth.

5A - If investors are currently offering $1200 on
each of these bonds, what is their expected
yield to maturity on the investment?

5B - If you are willing to pay no more than $980
for this bond, what is your expected YTM?

Remaining number of coupons = 19 * 2 = 38
Semi-annual coupon amount
=( 0.08 * $1000 ) 2 = $40
Example 5A - Answer
PV = $1200 (current market price)

TI-BAII+: 38 [N] 1200 [PV]
40 [+/-] [PMT] 1000 [+/-] [FV]
CPT [I/Y] 3.097

Thus, annual YTM = 3.097 x 2 = 6.19

Note: This is a premium bond, so its YTM
(6.19%) < Coupon rate (8%)

Example 5B - Answer (continued)
PV = $980
TI-BAII+: 38 [N]
980 [PV]
40 [+/-] [PMT]
1000 [+/-] [FV]
CPT [I/Y] 4.1048

Thus, the annual YTM = 4.1048 x 2 = 8.2

Note: This would be a discount bond, so its YTM
(8.2%) > Coupon rate (8%)

6.4 Bond Ratings
Ratings are produced by Moodys, Standard and
Poors, and Fitch
Range from AAA (top-rated) to C (lowest-rated) or D
(default).
Help investors gauge likelihood of default by issuer.
Assist issuing companies establish a yield on newly-
issued bonds.
Junk bonds: is the label given to bonds that are rated below BBB.
These bonds are considered to be speculative in nature and carry
higher yields than those rated BBB or above (investment grade).
Fallen angels: is the label given to bonds that have had their
ratings lowered from investment to speculative grade.
Credibility Issue: 2008 Financial Crisis revealed serious
corruption and incompetency of the rating agencies, which
led the U.S. Department of Justice to sue them recently
[2013.02]
Table 6.4
Bond Ratings
6.5 Some Bond History and More
Bond Features

Corporate bond features have gone through
some major changes over the years.
Bearer bonds:
Indenture or deed of trust:
Collateral:
Mortgaged security:
Debentures:
Senior debt:
Sinking fund:
Protective covenants:


6.5 Some Bond History and More
Bond Features (continued)
Callable bond:
Yield to call:
Putable bond:
Convertible bond:
Floating-rate bond:
Prime rate:
Income bonds:
Exotic bonds:
Example 6: Calculating Yield to
Call
Two years ago, the Mid-Atlantic
Corporation issued a 10% coupon (paid
semi-annually), 20-year maturity, bond with
a 5-year deferred call feature and a call
penalty of one coupon payment in addition
to the par value ($1000) if exercised.
If the current price on these bonds is
$1080, what is its yield to call?

Example 6 Answer Yield to Call
Remaining number of coupons until first call date
= 5 (5-year deferred call feature) 2 (2 years passed)
= 3 years = 3 x 2 = 6 [N]

Semi-annual coupon = 1000 x 10% = $50 [+/-] [PMT]

Call price = Par value + penalty (one coupon in this case)
= 1000 + 50
= $1050 [+/-] [FV]

Current market price = $1080 [PV]

CPT [I/Y] 4.2131

Therefore, the annual Yield to Call (YTC)
= 4.2131 x 2 = 8.43%
6.6 U.S. Government Bonds
Include bills, notes, and bonds sold by the
Department of the Treasury
State bonds, issued by state governments
Municipal bonds issued by county, city, or local
government agencies.
Treasury bills, are zero-coupon, pure discount
securities with maturities ranging from 1-, 3-, and
6-months up to 1 year.
Treasury notes have between two to 10 year
maturities.
Treasury bonds have greater than 10-year
maturities, when first issued.

6.6 U.S. (Federal) Government
Bonds (continued)
Table 6.6 Government Notes and Bonds,
Prices as of April 8, 2008
6.6 (A) Pricing a U.S. Government Bond
Similar to the method used for pricing corporate bonds and can be
done by using TVM equations, a financial calculator or a spreadsheet
program.
For example, lets assume you are pricing a 7-year, 6% coupon
(semi-annual) $100,000 face value Treasury note, using an
expected yield of 8%:
Figure 6.11 U.S.
Government Treasury
note cash flows.
TI-BAII+: 7 x 2 = 14 [N]
8 2 = 4 [I/Y]
100,000 x 0.06 2 = 3,000 [+/-] [PMT]
100,000 [+/-] [FV]
CPT [PV] 89,436.88
6.6 (B) Pricing a Treasury bill
Price of T-bill
= Face value * [1 - BDY * DTM 360]

DTM = Days to maturity

Bank discount yield (BDY) is a special discount rate used
in conjunction with treasury bills under a 360 day-per-year
convention (commonly assumed by bankers).

Bond equivalent yield (BEY) is the APR equivalent of the
bank discount yield calculated by adjusting it as follows:

BEY = 365 * BDY________
360 - (DTM * BDY)

6.6 (B) Pricing a Treasury bill
(continued)
Table 6.7 Selected Historical Treasury Bill Bank
Discount Rates
Example 7: Calculating the price and BEY
of a Treasury bill
Calculate the price and BEY of a treasury bill which matures in
105 days, has a face value of $10,000 and is currently being
quoted at a bank discount yield of 2.62%.

Price of T-bill
= Face value * [1 - BDY * DTM 360]
= 10000 x [ 1 (0.0262) x 105 360 ]
= 10000 x 0.9923583
= $ 9,923.58


BEY = 365 * BDY________
360 - (DTM * BDY)

= [ 365 x 0.0262 ] [ 360 ( 105 x 0.0262 ) ]
= 9.563 357.249
= 0.0268
= 2.68%
Additional Problems 1:
Pricing a semi-annual bond
Last year, The Harvest Time Corporation sold
$40,000,000 worth of 7.5% coupon, 15-
year maturity, $1000 par value, AA-rated;
non-callable bonds to finance its business
expansion. Currently, investors are
demanding a yield of 8.5% on similar bonds.
If you own one of these bonds and want to
sell it, how much money can you expect to
receive on it (= what is the reasonable price)?


Additional Problems 1 (Answer)
Using a financial calculator

TI-BAII+: 15 1 = 14 years remaining
14 x 2 = 28 [N]
8.5 2 = 4.25 [I/Y]
1000 x 0.075 2 = 37.5 [+/-] [PMT]
1000 [+/-] [FV]
CPT [PV] 919.03



Additional Problems 2:
Yield-to-Maturity
Joe Carter is looking to invest in a four-year
bond that pays semi-annual coupons at a
coupon rate of 5.6 percent and has a par
value of $1,000. If these bonds have a
market price of $1,035, what yield to
maturity is being implied in the pricing?
Additional Problems 2 (Answer)







Using a financial calculator

[TI-BAII+] 4 x 2 = 8 [N]
1035 [PV] current market price
1000 x 0.056 2 = 28 [+/-] [PMT]
1000 [+/-] [FV]
CPT
[I/Y] 2.3157

The expected annual YTM is 2.3157 x 2 = 4.63%
Additional Problems 3:
Zero Coupon Bond
Krypton Inc. wants to raise $3 million by
issuing 10-year zero coupon bonds with a
face value of $1,000. Their investment banker
informs them that investors would use a
9.25% discount rate on such bonds.

[3A] At what price would these bonds sell in
the market place assuming semi-annual
compounding?

[3B] How many bonds would the firm have to
issue to raise $3 million?
Additional Problems 3 (Answer)
Using a financial calculator [TI-BAII+]

10 x 2 = 20 [N]
9.25 2 = 4.625 [I/Y]
0 [PMT]
1000 [+/-] [FV]
CPT
[PV] 404.85

[3A] The zero-coupon bond would sell for $404.85

[3B] To raise $3,000,000, the company would have to sell:

$3,000,000 $404.85 = 7411 bonds
Additional Problems 4:
Tax on zero-coupon bond income
Lets say that you buy 100 of the 7411 bonds
that were issued by Krypton Inc. as
described in Problem 3 above for $404.85.
At the end of the year, how much money
will the bond be worth, and how much tax
will you be assessed assuming that you have
a marginal tax rate of 35%?

Additional Problems 4 (Answer)
[1] Get the current bond price
[2] Find the bond price after one year
[3] Find the implied interest = price differences = [2] [1]
[4] Compute the tax on the interest = 0.35 x [3]

[1] Current Price = 404.85

[2]The bond price after 1 year with YTM of 9.25%:

20 2 = 18 [N] 9.25 2 = 4.625 [I/Y] 0 [PMT]
1000 [+/-] [FV] CPT [PV] 443.16

[3] Implied interest earned = price differences = [2] [1]
= Price after one year Current Price
= $443.16 - $404.85 = $38.31

[4] Taxes due =Tax rate * Taxable income
= 0.35 * $38.31 = $13.41



Additional Problems 4 (Answer)
[3]The bond price after 1 year with YTM of 9.25%:

19 1 = 18 [N]
9.25 2 = 4.625 [I/Y]
0 [PMT]
1000 [+/-] [FV]
CPT [PV] 443.16


[3] Implied interest earned
= Price at 12 months Current Price
= $443.16 - $404.85 = $38.31

[4] Taxes due =Tax rate * Taxable income
= 0.35 * $38.31 = $13.41

Additional Problems with Answers
Problem 5
Price, and BEY, on a Treasury bill:
Calculate the price, and BEY of a treasury bill
which matures in 181 days, has a face value
of $10,000, and is currently being quoted at a
bank discount yield of 2.32%.




Additional Problems with Answers
Problem 5 (Answer)
Price of T-bill
= Face Value * [1-(discount yield * days until maturity/360)]
= $10,000 * [ 1 - (.0232 * 181/360)]
= $10,000*0.98833555
= $9,883.36

BEY = 365 * Bank discount yield = 365 * .0232
360 - (days to maturity * discount yield) 360 - (181*.0232)

= .023799 = 2.38% (rounded to 2 decimals)

Figure 6.3 Future cash flow of a
Merrill Lynch bond
FIGURE 6.7 Goodyear
semiannual corporate bond.
TABLE 6.5 Annual
Interest Rates on
Corporate Bonds Rated
Aaa to Baa, 1980 to 2006
FIGURE 6.9 Pacific Bell semiannual
callable corporate bond
FIGURE 6.10 Pacific Bell callable
bond cash flows.